When you start a company, you and your founders own 100% of the company. That is usually in the form of founders stock. If you never raise any outside capital and you never give any stock away to employees or others, then you can keep all of that equity for yourself. It happens a lot in small businesses. But in high growth tech companies like the kind I work with, it is very rare to see the founders keep 100% of the business.

The typical dilution path goes like this:

1) Founders start company and own 100% of the business in founders stock

2) Founders issue 5-10% of the company to the early employees they hire. This can be done in options but is often done in the form of restricted stock. Sometimes they even use "founders stock" for these hires. Let's use 7.5% for our rolling dilution calculation. At this point the founders own 92.5% of the company and the employees own 7.5%.

One of the topics I get asked about most on MBA Mondays is "options." But options are only one form of employee equity. I am going to do a series of posts on this topic over the next month of MBA Mondays. I will start by laying out the logic for employee equity, going over some target ownership levels, and describing the various securities you can use to issue employee equity.

One of the defining characteristics of startup culture is employee ownership. Many large companies provide employee ownership so this is not unique to startup culture. But when you join a startup, you have the expectation of getting some ownership in the company and if the company is successful and is sold or taken public, that you will share in the gains that result.

Employee ownership is such an important part of startup culture. It reinforces that everyone is on the team, everyone is sharing in the gains, and everyone is a shareholder. I can't think of a company that has come to pitch us that has not had an employee equity plan. And I can't think of a term sheet that we have issued that didn't have a specific provision for employee equity. It is simply a fundamental part of the startup game.

A reader asks:  My co-founder and I have been talking to some VC firms on Sand Hill Road, and I think we’re pretty close to getting at least one term sheet.  I read your post a few weeks ago about how one of the common mistakes startups make dealing with VC’s is focusing too much on valuation.  You also mentioned there are other important terms that affect the economics of a financing, including the size of the option pool.  Can you please explain that?  Our company never issued any options – and my co-founder and I each own 50 percent of the shares.  Will the VC firms require an option pool? And, if so, how will that affect us?

Answer: The issuance of stock options by startups is quite common, because it gives key employees an opportunity to benefit directly from any increase in the company’s value, but doesn’t require any cash outlays by the company.  That makes them an important tool to attract talented staffers.

“I’ve got this HUGE idea. I just need to find a technical co-founder.” Ugh. I’ve heard that too many times over the last few years and it almost always ends badly.

I was in this situation and we barely escaped. I write this post to put you out of your miserable technical co-founder search and give you some realistic options.

The Challenge of Finding a Technical Co-Founder

To find a great technical co-founder, you need to convince them of the following:

• Your idea is better than all of their ideas
• The equity is worth spending all of their spare time working for no money
• You are worth 50% of the equity of the company
• You will execute and convert an idea into a big successful business
• You’re better than all of the other biz people pitching them

I had coffee with an ex student earlier in the week that reminded me yet again why startups burn through so many early VP’s. And after 30 years of Venture investing we still have a hard time articulating why.

Here’s one possible explanation – Job titles in a startup mean something different than titles in a large company.

You Can’t Always Get What You Want
I hadn’t seen Rajiv in the two years since he started his second company. He had raised a seed round and then a Series A from a name brand Venture firm. I was glad to see him but it was clear over coffee that he was struggling with his first hiring failure. “I’ve been running our company, cycling through Customer Discovery and Validation and the board suggested that I was running out of bandwidth and needed some help in closing our initial orders. They suggested I get a VP of Sales to help.”

I resisted the temptation to jump in with a response because I knew it was too complicated of a topic to discuss on Twitter.  But I thought I should do a quick post on the topic.

1. Options are gravy — I lived through the first dot com era where we used stock options as a recruiting tool.  I freely admit this (along with nearly everything between 1999-2000) was a mistake.  We set our sites on our IPO price and then worked back to our current valuation and showed potential employees what we thought they could earn (with all legal caveats) if the company was successful.

The stupid thing is we sort of believed it ourselves.  If Ventro was worth $8 billion on $2 million of sales surely a paltry $1 billion would suffice. Goldman Sachs was an investor and the assured us an IPO would happen and riches would be had by all. I think they believed it, too.

We obviously attracted the wrong people for the wrong reasons and this led to a lot of disappointment.  We had a lot of re-setting of expectations to do.

Options are obviously a very important economic motivator for your first 3-5 employees and your most senior management team. But unless you become Facebook or Zynga they likely aren’t going to pay off big for everybody else.

It’s not uncommon for one or more of the founders of a startup to decide not to work on the statup full-time after the company’s first institutional financing. Such departures happen for a lot of reasons.

Sometimes the founders have a falling out early in the company’s life, in other situations founders realize that there isn’t a clear need for their skill-set in the company going forward or they decide that they want to pursue a different career path.

While a founder’s decision to pursue other activities can be a signal to investors that they don’t believe in the merits of the startup, this does not necessarily prevent the remaining founders from raising capital.

As long as there is an acceptable reason for the founder’s defection, investors will likely evaluate the opportunity based upon the merits of the remaining founders & management team. Ultimately, investors are generally focused on who will be leading the company going forward. 

This is the second part of a two part series of posts. The first post was entitled What To Look For In A Business Co-Founder. It seems that potential technical cofounders are approached by business cofounders a lot more than business cofounders are approached by technical cofounders. I thought about why that was after writing the post. In essence, I think it comes down to the fact that it’s a lot easier to identify the tangible skills of a technical cofounder from a high level perspective. Do they code? Yes. Okay, they could be a technical cofounder. At the end of the day “being able to code” is a small piece of the technical cofounder puzzle. Here are the qualities that make sense to look for in a technical co-founder.

A past record of building things

Potential technical cofounders should have a past record of building things. They may be very large projects with hundreds of people or they may just be very simple applications that never went anywhere. Learning how to code often happens best through practice exercises. The same can be said for building an entire company or large product as a technical cofounder. The more your potential technical cofounder has built things, the more pattern recognition they will have.