kartik sarwade: a pre-nup for your startup - the founders' agreement
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A pre-nup for your startup: The Founder's Agreement
Execution Advisory for Startups
Kartik SarwadeCapital 7
Nasscom Product Conclave 2013
• Nothing contained in this presentation should be considered as legal advice.
• Tax, regulatory and legal issues around valuations and equity issuance are complex matters and you should consult with a law firm / a Chartered accountant or other advisors to advise you on them.
Disclaimer
Quick Poll
2
How many of you are entrepreneurs?
Definitions
3
Agreement vs Contract
Agreement(Understanding)
Contract(Written document)
LegallyEnforceableProvisions
Take aways
4
What should be in the contract?
When should you get one done?
“Watch out” issues
What if you get the Founders’ Agreement wrong?
Likely reasons why you might get this wrong
Approaches to making better Founders’ Agreements
Quick Poll
5
How bad is the problem: How many think >50% of startups have serious cofounder issues?
The Data
6
VC Portfolio startups
61% Serious Key Personnel issues
All startups
?Relationship Role Reward
*10,000 founders of 4,000 startups,The Founder’s Dilemmas – Noam Wasserman
*
Famous blowouts
7
Zopnow
Eduardo Saverin
B K Birla
Quick Poll
8
How many of you Entrepreneurs have a written Founders’ Agreement?
Common choices
9
Relationship
Co-found with people you have social relationships with – friends, relatives, co-worker/friends
A social relationship increases the likelihood of a cofounder leaving by ~30 percent
RolesAssign roles based on competencies demonstrated in the past
Attitude and skills almost always trump competency
RewardSplit equity early, static arrangement
>85% of startups will have a major change in strategy/ business model/ cofounder involvement
Exercise: Why agreements fail
10
A commonly used agreement
11
Minimum fare: Rs 20 for first 1.8 Km
Above minimum fare: Rs 11 per Km
Waiting charges per hour: Rs 30. Minimum 10 minutes are charged.
Luggage charges: No charge for first 20 kgs. For every
additional 20 kgs or part thereof Rs. 5
Night Timings: 23:00:00 - 05:00:00
Night Extra fare percentage: 50%
Outside city limits: 50% extra
RTO Notification on Autorickshaw fares and terms in Bangalore
The situation
12
List down 3-4 scenarios that could cause you get into
an argument
You’ve reached an agreement with an auto driver
You have full intentions to keep your end of the
agreement
Yet, you sometimes end up with a conflict
13
Reasons Agreements failPrimary intentions no longer valid
Significant shifts in balance of power
Incorrect assumptions (Stated or otherwise)
Ambiguity – no “Meeting of the minds”
Boundary conditions – uneven or unhandled
1
2
3
4
5
• Agreements in general (not just Founders’ Agreements) cause problems between agreeing parties at one of these 5 common points of failure.
• Point 1 is far more common for agreements involving startups than usual agreements because of the propensity of startups to pivot their business plans frequently.
• Negotiating a framework rather than fixed numbers works well in handling problems caused by Point 1.
Notes to slide 13
The Framework Approach
14
A good framework..
15
… should strike a balance between complexity and effectiveness: Aim
for “Simplest that is good-enough”, not perfection
… be based on objective variables
… makes judicious choices in underlying assumptions
… is validatable, ideally using back testing
Equity allocation
16
Basic tenets
All founders contribute to the startup in various ways – cash, effort, expertise
The startup should repay founders in equity commensurate with their contribution to the startup
Problem: What percentage of equity in a startup should be allocated to each founder
Hypothetical startup: Fddzzrrbl.ly
Model / assumptions
17
Cash: Most objectively determined, startup values at face value
Effort: Time as substitute for effort
“Market salary” as good enough estimate of value of time
Expertise: Nebulous to value; Take subjective circumstantial call
Background
18
Amar
Akbar
Anthony
Senior guy, agreed to invest 10L, will go without a salary for now
Relatively junior, agreed to put in 5L, will also go without salary for the time being
Domain expert, cannot invest, will need a basic salary of 5L
The framework
19
Amar Akbar Anthony
Year 1 Cash 10,00,000 5,00,000 0
Effort 50,00,000 20,00,000 25,00,000
Expertise 0 0 5,00,000
Value Added 60,00,000 25,00,000 30,00,000
(-) Salaries/Perks 0 0 5,00,000
Net Contribution 60,00,000 25,00,000 25,00,000
Equity split 54.5% 22.7% 22.7%
The framework
20
Amar Akbar Anthony
Year 2 Cash 0 0 0
Effort 50,00,000 20,00,000 25,00,000
Expertise 0 0 0
Value Added 50,00,000 20,00,000 25,00,000
(-) Salaries/Perks 0 0 5,00,000
Net Contribution 50,00,000 20,00,000 20,00,000
Gabbar
0
25,00,000
0
25,00,000
5,00,000
20,00,000
60,00,000 25,00,000 25,00,000 0Previous year’s contribution
Cumulative Contribution
1,10,00,000 45,00,000 45,00,000 20,00,000
Equity split 50.0% 20.5% 20.5% 9.1%
To sum up
21
The model is:(i) not unduly complex
(ii) based on objective variables
(iii) back-testable
In practice, a slightly more complex model provides pretty
good results.
Discounting later time periods’ contribution geometrically
is a particularly helpful adjustment.
• A framework such as this comes in handy to take care of unexpected events. A founder moves out or comes in, one founder decides to work part time, one of them decides to invest a few lakhs – all these can be handled fairly easily by tweaking the numbers.
• You could even extend the framework to help determine the quantum of equity to allocate to Advisors, Mentors or even for ESOPs.
• In our experience, we’ve found that a slightly more sophisticated model gives good results but complicating the model beyond that isn’t worth the effort and in fact soon becomes detrimental
• You should consult with appropriate professionals to advise you on valuations and equity issuance matters. You cannot take anything contained this presentation as legal advice.
Notes to slide 21
