I’ve coached a ton of founders in the past years and the one thing which bothered me most is that founders can get a lot of things wrong, which can be prevented by simply taking them through all the hidden rules of play.
The problem with these bad choices is that once the founders made them, they’re very hard to reverse and nobody in the team knows that this is problematic until the whole thing turns into a dumpster fire with no elegant way to put it out.
Here are the ones I’ve seen the most. I use technical and legal terms from time to time in which case I added a link to a useful resource explaining it in the startup context:
Poor shareholder and equity arrangements
Lots of things can go wrong when it comes to the equity split between founders and what they agree on in terms of how they run the business.
#1 Being greedy when it comes to equity
I’ve seen many greedy founders who onboard a co-founder, and expect them to join their multi-year journey on a completely skewed equity split. But if you’re going to give your co-founder a very small portion of the shares you basically toy with their opportunity costs. It’s much easier for your co-founders to abandon your startup in favor of a well-paid job somewhere else or worse so, for a different startup they’re joining. Once, they’re inclined to leave the startup it will be impossible to fix.
You might think things are going great, yet your co-founder…
In my opinion, you divide the shares based on expected future commitments and the skills the co-founder adds to the team. Don’t overestimate the value of past work. It takes 7 to 10 years to build and exit a startup. If you’ve worked on it for 6 months you’ve done less than 5% of the work. Here’s an example of a calculator reflecting this.
I’ve also seen other bad practices when it comes to how equity got divided. I’ve seen many startups in which an agency holds a large chunk of equity in return for product development capacity. This backfires very often as agencies end up haggling and deprioritizing those commitments against paid work by other clients.
#2 Not making sure what to do when a founder leaves
The second pitfall is a lack of proper shareholder arrangements. Very often, nothing is in place for scenarios in which a founder leaves the company. This is a shame, because these arrangements do exist and can be very straightforward. The most important two are Leaver Clauses and VestingClauses.
I once met a founder who I advised to take care of this for his new startup. He exited his previous company. It happened to be the case that he had a founder depart in his previous company and the new company at the same time. There were no arrangements in the old company, but the new startup had the appropriate clauses. The departing founder of the old company ended up suing them, while in the new startup the whole thing was settled with a short meeting.
Co-founder fights — as seen in The Social Network
If a co-founder leaves and you can’t recover part of the equity he or she owns, your cap table is going to be a mess and this will reduce your chances with investors.
#3 Not having the right company structure in place
The ‘right’ company structure depends on the country you’re operating from. In most western countries it’s customary to have limited liability companies. The biggest pitfall I’ve seen founders make is that they don’t transfer all their work and goodwill to such a company structure in time. This puts them at risk of having to pay taxes when transferring the assets. Here’s an example of how that works in the Netherlands (in Dutch).
Also, you need to make sure you register that your company owns all the intellectual property you’re developing. If you don’t do this properly this can be a showstopper for investors.
It’s easy to avoid all this by consulting with a couple of service providers in an effort to work with a few of them in the near future.
Lack of administration and cash flow management
Yes, although it is the duty of founders to administrate all revenue, costs and expenses properly I’ve seen many of them completely ignoring this part of doing business.
I was one of those many years ago. After working as a contractor for a while I started to take in assignments which were bigger than what I could handle by myself. I’d be the main contractor of large projects and would work with a couple of subcontractors. In some cases I considered hiring interns and buying computers for them. After doing this for little over a year my neighboring contractor suggested I’d reach out to an accountant. I still remember the horrified look of that accountant’s face when I handed him over a plastic bag of receipts. Luckily, he straightened the whole thing out and recovered some of the tax returns I was entitled to.
Worse so, many founders lack the ability to manage cash flow when the revenues are coming in and growing. The fact that you have sent invoices to customers does not mean you’ll have that cash in the bank anytime soon. Worse so, you might have to pay VAT before you’ll see any of that cash coming in from customers. Hence, growing revenues can lead to bigger cash flow problems.
Founders need to understand that they have the duty to control these growing pains by building and maintaining forecasts on revenue, costs and expectations when payments come in and are due. Sooner than later, someone in your team will have to become the CFO of the company and learn all about business administration.
The inability to execute is the last big category of possible startup failure. Tristan Kromer wrote a great blog post and the importance of the Complete Team. I’ve seen many cases in which people start software companies without a developer in their team. They end up hiring an agency for equity to make up for the lack of development capacity.
Such constructions often fail as I mentioned earlier in this post. Thanks to The Lean Startup we all know that startups are very volatile, and that the product vision founders start out with is often not entirely right. However, an agency will not cooperate with the founders in the same way a technical co-founder will, due to the business-to-business relationship and its requirement to scope work.
Also, I’ve seen the reverse quite often: smart technical founders without someone who has some sales talent. Such teams tend to design great products, which nobody wants. The danger of this team composition is the total lack of business sense, which will result in a complete product after years of development and no customers to sell it to once they’re ready. By the time this team reaches the finish line they expect that revenues will finally come, and if it doesn’t they’re out of runway almost immediately.
Get rid of time bombs & avoid distractions
Unfortunately, these things can become big distractions or time bombs waiting to explode in the face of founders. Once these issues materialize I notice that the team slows down in their business progress.
I hope this post can help you to detonate these time bombs while you still can. In case you’re looking for more practical information to get started with business modeling and lean startup, my Startup Experiment Design Guide can be a good start.