by Jordan Dolgin, CEO of Dolgin Professional Corporation
Hands down and without a doubt the #1 Absolute Start-Up Mistake I see clients make time and time again is far from obvious and far from intuitive.
It has nothing to do with the business concept itself.
It has nothing to do with the size of the ”addressable market” for a new product or service.
It has nothing to do with the quality of key management.
It has nothing to do with raising capital, managing cash flow or the marketing strategies or techniques employed.
#1 Start-Up Mistake
Rather … the #1 absolute start-up mistake I see clients make has EVERYTHING to do with SELECTING BUSINESS PARTNERS and the TIMING IN WHICH EQUITY IS GIVEN TO BUSINESS PARTNERS.
Selecting Business Partners
Who you select as a business partner for a new business is often the very first critical decision you need to make as an entrepreneur.
Not everyone nor every business venture requires partners to launch and be successful.
Frankly, if partners are not required, they should generally not be sought.
However, many businesses need different people with different skills to create the balance and quality of top management needed for a successful launch.
But … if you select the wrong partner (as in marriage), the consequences can be disastrous.
You might want to refer to my recent blog on How to Pick the Perfect Partner for some interesting perspectives on partner selection methodologies.
Often I sit in meetings with clients who want to put in place a shareholder agreement for a new business.
The decision on who gets to be a partner has already been made well before my legal advice is sought.
As I watch the (often) considerable dysfunction among the various partners as we sit in my boardroom and discuss shareholder agreement issues, it strikes me that I am often TOO LATE to save this group from an eventual and very painful breakup.
Rather, I may be just “going through the motions” and the new shareholder agreement won’t function as a proper working operating manual to guide business decisions among suitable partners but, rather, function as their “corporate divorce manifesto” when the inevitable irreconcilable differences set in sooner rather than later.
I remember once getting a call from Client X.
He and a group of 4 colleagues were plotting to quit their jobs to start a competing business with their current employer.
On the phone, I got the sense that all 5 of them were going to be new partners of the business but, when we met in person, Client X showed up alone without the others.
It became clear in the early minutes of our 1st meeting that he was uncertain about whether or not to make all (or some) of his other 4 colleagues formal business partners or just invite them to participate initially as his employees or consultants and avoid partners at the outset.
In fact, he asked me my thoughts on this very topic.
Without knowing anything about the roles and qualities of his 4 colleagues, I did share with him that partnership is very delicate and, statistically, most people do a poor job when it comes to partner selection.
He understood the dangers of “too many cooks in the kitchen” especially in the early days of the business when rapid and astute business decisions needed to be made and having to get 5 owners’ consensus on each of those decisions would be a major additional challenge.
Ultimately, he decided to pick a single “partner” and the others came on board as employees only.
Who Gets Equity and When?
The other aspect of “partner selection” that my clients struggle with is the allocation of equity among the new owners.
There is an assumption that once a person has been invited to join the business as an owner they should immediately from inception get some percentage (%) of the equity pie.
Now … I agree with this if the new partner is contributing cash or assets to the new venture.
In this case, they are making a real and “hard” contribution and have essentially bought or earned an equity stake.
But what about those new partners whose only contribution will be their future sweat equity and their commitment to grow the business?
At the outset, they have “bought” nothing and their contributions to the business will only be known and earned in future AFTER time has passed and they have devoted hours of time and commitment (just like you).
Should this category of owner get equity from inception … or be afforded an opportunity to EARN equity over time as they DELIVER actual CONTRIBUTIONS to the business?
In other words, WHO GOES FIRST?
Do you (as the originating founder) go first and give out equity and cross your fingers that ACTUAL CONTRIBUTIONS will eventually be delivered … or should equity be given only AFTER CONTRIBUTIONS are made (and earned) by the new owners?
If you “go first” and grant a promising potential partner, for example, 20% of the equity without any claw-back rights, you may find yourself very resentful in future if that person fails miserably to deliver what you both agreed and expected him or her to deliver (in terms of time, commitment and/or results) or worse … he or she (after 3 months) decides they’re not cut out to run a business and goes back into the workforce and quits on you … but still gets to keep their 20% equity stake.
What a disaster!!!
Even if you can negotiate a buy-back of their 20% (with or without the benefit of a shareholder agreement), this will impair the business by wasting precious time and money that could have been better used to grow operations, etc.
How can you avoid putting yourself in this situation?
Easy … DON’T GO FIRST!!!
In other words, negotiate a deal with your new partner that goes like this “… we both know that you’re worth x% of the equity once you contribute to the business what we both expect you can and will contribute and, once that happens, the equity will be yours … and if it doesn’t happen then it’s fair that you didn’t earn it and won’t get it …“.
Structurally, the above can be achieved by either:
– granting equity up-front with claw-back rights such that equity is repurchased (for $1.00 possibly) if contributions don’t materialize; or
– granting options (for $1.00 possibly) to purchase equity which vests once agreed contributions are actually delivered.
Contributions may be in the form of:
– the creation/delivery of certain deliverables or work product;
– the achievement of certain performance milestones/metrics; or
– simply the passage of time (i.e., if the proposed partner sticks around for at least so many years), etc.
Legal and tax assistance will be needed to create these structures properly.
The benefit of this approach is that, by NOT GOING FIRST, you force your new partners to EARN (or “purchase”) their equity and avoid giving them equity and “crossing your fingers” and hoping that everything works out fine.
In the words of my former law partner, “HOPE IS NOT A STRATEGY”.
As you can see, avoiding the #1 Start-Up Mistake only requires the right mix of awareness and professional assistance.
There are no guarantees in life and partnerships come and go and taking chances is part of being an entrepreneur.
However, any time you can eliminate “hope” and take your necessary “assumptions” and embody them into legal structures that actually mitigate the risk of your assumptions being false … we’ll now that’s a smarter way to play the game of business.
I hope you are reading this blog post early enough to take action and avoid making this unnecessary #1 start-up mistake.
If it’s too late and you are already in this situation, help is usually just a phone call away. 🙂
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