Y Combinator Startup Podcast - Co-Founder Equity Mistakes to Avoid with Michael Seibel | Startup School

Episode Date: November 16, 2024

In order to get your startup off the ground it's critical to keep your co-founders motivated. One of the best ways to do that is to figure out a fair co-founder equity split. In this episode of Startup School, YC Group Partner Michael Seibel explains the ins and outs of co-founder equity, why it's important to be generous with that equity, and how to avoid bad advice that can lead to co-founder breakups.

Hello, I'm Michael Seibel, and today I'm going to talk about co-founder equity splits and co-founder breakups. To be clear, we want people who are building tech, software, startups that they expect to be VC funded. This is advice for you. I can't really comment on other types of businesses. There are many types of businesses that have equity. And to be clear, this is not really about them. Also, this is really focused on conversations that founders are having in the beginning of a company. For pre-product market fit companies, you're really talking about the beginning of companies. All kinds of interesting and crazy things happen later on. And it would be a misuse of this video and this advice to apply to companies that are later on or to apply to

companies that are not tech companies. So here's the TLDR. The core advice we want to give is be generous with co-founder equity. What you're trying to do is motivate your founding team to work extremely hard when it looks for many of the first couple years like things are not working. The biggest mistake is to be stingy on equity during this very, very, very delicate time in the beginning of a startup, causing people to leave while it's still possible you might make something big. So the Jedi founder and the dumb founder, they're both generous with co-founder equity. The midwit, oh, they're thinking about skill sets and contributions and time commitments and the network and future roles and da-da-da-da-da-da. Thinking about all of these things and trying to do a really complicated calculation.

I'm going to argue today that's not required. Let's go over what we're talking about. First, co-founder equity splits, then co-founder breakups, bad reasons for very unequal equity splits, common bad advice, and then some final thoughts. All right, co-founder equity. In my experience, the mistake that founders make is they don't think about how to motivate their team, their founder, co-founders today and tomorrow. Typically, you're giving people equity that they're going to earn over the course of four years. And you don't want them to be thinking in year two, year three, year four, I don't have enough

equity. I'm not motivated. Or I have this amount of equity and the CEO is four times more, but I'm grinding every day and I've been here since the beginning, which would create resentment. So the job of a CEO when distributing co-founder equity is to not just think about what's going to convince your co-founder to work on your company today. It's a thing about what's going to keep them motivated over the course of all four years and hopefully much longer.

In that situation, our typical advice is to go for close to equal equity splits. Don't have to be exactly equal, but the more generous you are, the more you can expect a strong founder to stay motivated. Next, vesting and cliffs. Most often when you're giving founders equity, that equity vests over a period of time, which means it's earned over a period of time. And if you leave during that period of time, you don't get all of the equity. In addition, Cliff is essentially designed to say, if you don't make it to this moment in the company's history, if you don't make it through year one, you don't get any of your equity grant.

Both of those tools are extremely valuable and they should apply to all founders. I have to be honest. Sometimes founders ask me, why are we doing this? Like, we all like each other. We're not going to break up. Nothing's going to go wrong. I would just say this. Giving away founder equity is not something that you should be innovating on. And the best practice is that all of equity comes with vesting and cliffs when it's given to founders. Life happens. Crazy shit happens. Sometimes people have to leave and they don't even want to leave. Sometimes family circumstances change. Sometimes people get sick. Sometimes people don't perform. So by having vesting and having a cliff, that gives founders the ability to be able to be to let other founders go or for those founders to leave without destroying the cap table.

So you should be using vesting in cliffs. What's extremely typical is four-year vesting. You earn your stock over four years and a one-year cliff. You don't earn any stock until you've hit one year of working at the company. Next, your co-founders must be essential to your founding team. One of the things I think about with the founding team is like it's the smallest number of people who can get an MVP built, get it in the hands of customers, and start learning. One of the reasons why we tell people, one of the other reasons why we tell people to be generous with their equity is it helps them remove, quote-unquote, co-founders who are not essential, who really shouldn't be on the team or perhaps should be employees instead of founders.

You should understand that, like, the co-founder title is not something that should just be given out willy-nilly. You know, teams that come into YC with, you know, five, six, six, seven, co-founders, clearly there's something weird, some conversation hasn't happened. It's almost always the case that seven people are not essential to getting a product up and out and in the hands of customers. Next, always remember that once again, in almost every case, when you're giving a co-founder equity, most of the work in your company hasn't been completed. So this kind of comes back to the first point. Equity is about motivating people for work. They have not yet done as opposed to rewarding people for work they have done.

Last things, which are kind of negative. One, the CEO should have the ability to fire founders who are not performing. And so however you set up the equity split, the CEO should reserve this right. And honestly, there has to be a captain of the ship. There has to be someone who's ultimately held accountable. And they need to be given the responsibility to let people go who aren't performing. If you're not willing to join a team under these circumstances, that's tricky. I would say that you're not understanding the seriousness of a company.

Or maybe you should go start a company and be the CEO. But the CEO should have this responsibility, regardless of the equity split. And then finally, what's most responsible is if co-founders have a conversation about what will happen if things don't work out. Now let me give you some guidelines, at least YC's thoughts, on how that should go. If you have a co-founder breakup and you are pre-product market fit, here's some guidelines that YC has seen work over the years. And these are things that perhaps you should consider talking amongst the co-founders.

So first, if a co-founder leaves or is fired before their one-year cliff, it's extremely typical for them to get just a token amount of equity. 0.5% to 2%. Remember, this is pre-product market fit, so there's no evidence that the company is going to work and the vast majority of work still has to be done. After the one-year cliff but pre-product market fit, we recommend that if a founder leaves or is fired, they leave with no more than 5% of the company, which often means they have to give back some equity.

Now, this can be a tricky conversation, but when the company's pre-product market fit, once again, so much work is left to be done and you want to motivate the people who are remaining at the company to distribute that equity to people who can actually help continue to increase the value of the company, employees and founders. The founder who's leaving can't help increase the value of the company anymore. So if they're holding a whole bunch of equity, they're basically reducing the chances of the company being successful and therefore reducing the value. of their equity. So that's what I recommend if a founder is leaving or is fired after their one-year

cliff, they should retain no more than 5% of the company. Next, if a founder is fired, it's extremely reasonable for them to give in a small severance, you know, one to three months. But if a founder leaves, that's not typical. You can do it, but it's not typical. And finally, every founder, regardless of whether they leave or they're fired, should be expected to resign from the board, sign a release, And often give proxy voting rights to the founders that are remaining, basically allowing the founders that are remaining to vote their shares. More often than not, it is a founder that's not the CEO who is going to either leave or be fired.

But I will say this, sometimes it's the CEO, right? Life happens. And so if that's the case, whoever the new CEO is has to kind of arrange this breakup accordingly. And even the CEO, the previous CEO, should understand these expectations because, you know, like I said, sometimes CEOs screw up in the, or sometimes CEOs choose to leave. So with the expectations on how equity should be distributed and what happens with the breakup, let's talk about some cases where we see unequal equity splits that let's just say don't make any sense. The first and most common bad reason for a massively unequal equity split is,

well, my co-founder agreed. You know, I own 90% of the company. I asked my co-founder if they're willing to own 10. They said yes, so everything's good, right? I would say as a CEO, this is a perfect example of optimizing for today and not optimizing for tomorrow. You should be thinking not, what is your co-founder going to be happy with today? You should be thinking about what's your co-founder are going to be excited with when it's year three of the company and everything sucks, what's going to keep them motivated to stay and work extremely hard then? And as CEO, you always have to be thinking about tomorrow, regardless of whether your co-founder does. And you probably should be more generous with your equity to compensate for when those bad times are happening. How do you

keep that co-founder motivated? Next, well, I came up with the idea. So I deserve more equity, right? It was my idea. They're just building it. We get almost 30,000 companies apply to YC every six months, and we see every idea that exists. It's extremely obvious that ideas are a dime a dozen, and execution is the game here, and that co-founder is going to be essential in executing the company. If they're not, they shouldn't be a co-founder. So I come up with an idea is not a great reason for a 90-10 equity split. Next, I started working six months before my co-founder, so I deserve a lot more equity.

They weren't there at the beginning. you still have to ask yourself how much work is left to be done. If this is a traditional tech software startup, then 99% of the work is left to be done. This could be a 10, 20, 30 year journey if it's really successful and a difference in starting date of six months probably is not that significant when it comes to it. Next, my co-founder needs a salary and I don't. I would argue that you should be thinking about salary and equity differently. Salary is the money that someone needs to live, to pay their rent, to buy food, to literally give themselves the ability to work in your company. Equity is what's going to motivate them to work extremely hard and do extremely well and often

get a below market salary. So I never like to think about reducing someone's equity because they need more salary. I always like thinking about giving every person of the founding team the salary they need so they can live. for some people that might be zero if they come up with some money, and then giving people the equity they need to be motivated to work extremely hard. All right, next, I'm older and much more experienced than my co-founder. You know, this is a tricky one.

Certainly people who are more experienced can contribute to the company, can help fundraise often. There are many things they can do that a younger or less experienced co-founder can't. But if you're making this person a co-founder, that means that they're going to have to be a key contributor to the team that should mean you couldn't do it without them. So you should be very careful about how motivated that person's going to be. You should be generous with equity as a result. Next, well, I hired my co-founder after raising some money. Well, once again, you know, fundraising, I think people are surprised that fundraising doesn't massively change your chances of being successful. There are lots and lots and lots of startups that raise money and very few that go on to generate

a billion dollars in revenue. So I would argue that even if you have $100,000, $500,000 in investment, 99% of the work is still left to be done. And then finally, I heard my co-founder post-launch. Same thing. That first launch of MVP is just the beginning of the journey. So to sum up, I think that all of these answers are a flavor of the same thing. It's a flavor of short-term thinking. The best founders are long-term thinkers. The best founders are not only thinking about today, but they're thinking about tomorrow. And the best founders are thinking about their co-founders needs, even if those co-founders are not thinking about them. It's the best founders, the best CEOs understand that this small team has to accomplish a lot or else the whole endeavor isn't going

to work. The best founders using equity to try their best to motivate people to work extremely hard. They're not thinking about equity as something that should be hoarded. They're thinking about equity as a tool that can produce maximum motivation for a small number of people. So let's move on to some common, let's say bad advice that I see, right? So if our advice is, hey, you should be generous with your co-founder equity. You want to motivate people for the long term and you should protect yourself by having vesting in cliffs. Some bad advice that I see is like, oh, we should at performance-based equity. You know, if my CTO writes this number of lines of code or if my, you know, if the founder that's doing sales like generate a million dollars in revenue will set

their equity based on that. Needless to say, at the beginning of the journey of a tech startup, it's really unclear how to set those types of goals. And those goals change. We see companies pivoting. And thinking that you can kind of measure things so precisely at the start is it really big fallacy. Furthermore, this is probably not an area that you should be innovating. If you're innovating in your product and how you interact with your customers, distributing equity, there are best practices that tend to work. So that's why a performance based equity is not something I would consider. Well, what about part-time founders? I would argue that a part-time founder isn't a founder and shouldn't really be considered in this equation.

I know there are some edge cases where there are some part-time founders or like, you know, people who swoop in and swoop out and yet-e-y-y-a-eater. But I think if you look at the most viable companies in the world, you don't see a lot of prevalence of part-time founders. So I just don't think they should be considered. If you want to be a founder, you should be working full-time. And then, like, what about other kinds of, like, dynamic equity agreements? Like, oh, if the company accomplishes this or if yet-a-y-da happens and, like, the equity is not really set. If you're trying to motivate people, it's really nice for them to know what they have. And especially founders, they're going to be a lot more motivated if they know what they have

when they're starting versus some weird kind of thing that's like hard to define and the rules might change, et cetera. So I think, you know, these options are too fancy and or ill-advised. Oftentimes they're created because people don't understand the value of vesting in a cliff. If founder relationship isn't working out, that founder should leave or be fired. And that should happen before the cliff. That's your protection. That's your protection if things aren't working out. Not fancy formulas and weird kind of made up stuff.

And to be honest, if you don't have the wherewithal to ask a co-founder to leave if they're not performing, or as a co-founder, if you realize that you're not able to perform, if you don't have the wherewithal to leave on your own accord, you shouldn't be doing this. Like, you're not respecting how hard this is and how much work your co-founders are putting into it. That's why Vesting in Cliffs work. That's your downside protection. And that gives you the ability to be generous with your equity, as opposed to create fancy schemes. So to wrap up, one common thing that you see among successful companies is that over the long term, over 10, over 15 years, one founder will often stick with the company a lot longer, be more responsible for a lot longer, and you

could argue was more valuable to the company, right? You know, you see these famous companies like Amazon, Jeff Bezos, or Mark Zuckerberg at Facebook, et cetera, et cetera. It's true. And you would think that that means that those people should deserve vastly more equity than their co-founders who might not have stuck around for, you know, a decade, etc. Here's the tricky bit about that. It turns out with tech startups, the beginning is extremely important.

Those first four to six years is where a lot of value is being created and those first four to six years is when most companies die. So I would argue that even if you're in this lucky situation of your company being massively successful and you know, you being the one that stays around the longest, you still want to be extremely generous with co-founder equity. Because those co-founders actually got you, the energy of activation your company needed to even be in the game. And without them, maybe you're not in the game at all. And you don't get to see this company scale to something great. You should really understand how important the early years are and the co-founders are.

And co-founder motivation is to making successful products happen. And you should use your co-founder equity to give yourself the best chance of building something that people want. after that, hey man, you're off to the races. You're doing better than 99% of other startups. And of course, the rules change.