Despite some of the doomsday commentary about both the NZ economy and VC investing habits in 2024 compared to 2021, there is plenty of capital looking for high-quality investment opportunities.
Barnaby Marshall
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It’s said that more companies die of indigestion than starvation—meaning they get distracted by shiny new opportunities, spreading focus too thin to be effective.
I believe in the old adage, “If you want to be great, learn from the things that great people do.” As investors, observing 100s if not 1000s of entrepreneurs, we are at an advantage to observe what the best founders do, how they think and how they act.
As we spot these trends of what the best founders do, we can then help other founders copy those habits of success. I share these insights with founders often 1:1. But I thought it would be worthwhile to share 1: many for a wider group of founders to benefit from our learnings.
Co-founder splits are seldom discussed but happen maybe more than you think. I wanted to take the opportunity to write a bit about something we have experienced a number of times with our startup portfolio and provide some insights into how to prepare for the worst (while still expecting the best).
The fact is — of 100 companies that the Icehouse has funded through our various investment entities since 2012, 35% of them have had a founder leave the company.
Most of those have left within the first two years of our investment. Some of these have been very messy, some have been more civil, but in all cases, they have cost time and money: the two most precious resources for any startup. Add to that the emotional stress and you have a recipe to rock even the most resilient founders, and in some cases — almost be a lethal blow to the business.
I wanted to write a post to cover off a few things:
Firstly, to bring to light the frequency of start up founding relationships not working out over the short / medium term.
Secondly, for founders to recognise the importance of having the conversation about what would happen in a break up early on.
Thirdly, to talk about how you should set up your vesting and shareholders agreement to prepare for the worst case scenario.
1. Partnership breakups: It happens for different reasons
From talking to many founders in writing this article, I have learned that no two stories are the same, but there are common themes.
Founder relationships are hard. The stress of being in a startup is often heavy, there are disagreements about strategy, there are personality and communication challenges and sometimes the skills that the business needs from the founders change. A founding relationship is like being in a marriage, but many founders’ relationships come together much more quickly than a marriage, with less dating time involved. Sometimes things don’t work out and a co-founder needs to leave.
This shouldn’t be seen as a black mark on the company’s history, in many cases it’s a natural progression of the company’s growth. So, it’s important to have a conversation about what would happen if things weren’t to work out and set up the mechanisms for someone to exit if needed without it killing the company.
2. Plan and talk about it early, even if it’s an awkward conversation
Founders leaving companies is common but something that few founders discuss, thinking of it as “something that won’t happen to us, because we have a great relationship”.
It’s something that should be understood as a risk going in and discussed with care upfront. Many founders defer the conversation, because its hard and sometimes awkward. Things are going well, they have just raised money, they are growing. In most cases, leaving the company is the last thing on anyone’s mind. But it’s much easier to have the conversations upfront than have the conversation when it’s crunch time and someone needs to go. The conversation is 10x more awkward by the time you get to this point!
Some of the things we recommend having a frank conversation about are:
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What are the roles that each co-founder will have in the organisation, how are those expected to change over time?
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What are the deliverables or measures of accountability with each founders’ role?
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How big a company do we want to build?
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How much dilution are you prepared to have along the way?
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Are we both committing to this journey full time, when will that change?
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Is it our life’s work or does one founder consider it to be more of a project?
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How long would you be happy to be in the business for, what’s our time horizon?
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Is there a time at which, if X milestone hadn’t been reached a founder would give up, or are we both committed to the bitter/sweet end?
Once this conversation has been had it’s good to document this understanding in a formal way and clearly outline the steps that would be taken if a founder wants to leave. What is the mediation process, the meetings, the board discussion etc. How is this decision finally made? Having a simple understanding of how this will work can avoid a lot of distraction and dysfunction if the situation does arise.
3. What next? The pragmatic steps to take
The challenging thing is that because most founders don’t talk about vesting until they raise capital, it is seen as an “investors vs. founders” discussion. We see founders stress over the perception that it is a tool the investors might use to “screw them out of their company”. The truth is — good vesting agreements protect everyone from disputes down the line, investors and founders alike. But as a founder it should be very important to you. Founders will be the people who will be committing to spending the next 5+ years with the stress of a startup, working 60+ hours a week, and earning below market salary who feel “screwed” if their co-founder walks out, takes a comfortable corporate job, and gets all the same reward simply because they were there in the early days.
So, the best practice in our experience is to document a vesting in a shareholder’s agreement that outlines the plan. Here is a great Simmonds Stewart Document Maker that can be used to set this out. Generally, we would advise a vesting period of 3–4 years. It takes a long time to create value in a company in most cases. If the vesting schedule is too short, or too much is vested on close of financing and a co-founder leaves the business, they could leave with 20–30% of the company. This is an awkward situation for the company and does not bode well for the next financing round if a large portion of the cap table is sitting with a now ex-employee that will no longer contribute to the future success of the company.
Some exiting co-founders recognise that if they leave the business holding a large portion of equity this could be a burden on the company, perhaps stop them from raising further capital and ultimately affect the value of their own shareholding. In some cases, we have seen founders leaving, sell back, or forfeit shares in light of this. Having said that, it’s still a tough conversation to have. The best-case scenario is having a vesting schedule that would mean at any time a founder could leave without it killing the cap table. Impossible? Maybe. But it’s something to aspire toward. If you have got into business with reasonable and rational people to begin with, this conversation is easier (choose your co-founders wisely! Preferably people you have already known for a long time).
Another way to think about vesting is from the point of view of an investor. When raising venture or angel investment, valuation is based on the future value you will build in the company, not on its ability to generate free cash flows today. With that in mind, founders’ equity should be earned over time, in proportion with the value they create as they grow the company. This also keeps the founders motivated to work and build value in the business for X number of years.
So to sum up; What can you do to avoid a founder break up?
In some cases you can’t, the founders skills don’t suit the job any more, there is no job for them, views on the future change and aren’t aligned any more, or stress gets the better of someone.
But there are a few things you can do to mitigate the risk. The three bits of advice I would have are to:
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Set up your vesting schedule with the worst in mind.
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Focus on internal communication and getting comfortable with strategy among the team.
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Let people know if you are feeling overwhelmed in the business and talk about it to avoid a total blow up!
In all cases — an exiting founder is a stressful and all-consuming process. But if you have the guard rails setup from which to operate within, it can make the process a lot easier.
Hope this helps with anyone setting up a new company or going through this process currently.