Stock Distribution for Start-Ups

You’ve got a commercially viable idea for your start-up. You’ve successfully secured funding for your idea and in the process (we hope) managed to avoid “rock fetches” and other bad VC behavior.  Now, how do you optimize stock distribution to make your company successful?


Mike Stonebraker says:

Mike Stonebraker

I should start with the template for my experience.  

I have started companies with an initial A round investment by a VC.  I have also started companies with an initial seed round investment from a VC.  In this case, the seed has always been structured as a “down payment” on an A round: that is, an A round with the same investors has been pre-negotiated, with a clause added that allows them to walk away if they don’t like the result of the seed effort.  I have never had angel funding, so I can’t comment in that area.  I also have never self-funded a start-up.  In my opinion, that creates far  too much domestic stress with my wife!

Anyway, my experience has been negotiating A rounds.  My last seven start-ups have conformed to the following.  The VCs have gotten between 45% and 50% of the company in exchange for $5M to $7M of capital.  The range is determined by how attractive the VCs think your idea is and how strong your initial team is.

The rest of the ownership is split into two buckets, one for the founders and then a pool for yet-to-be-hired employees.  In general, the pool is intended for the rest of the company hires during the A round period.  However, the VCs will typically insist on covering a complete complement of executives, all of whom will not be hired before a B round (for example, a CFO).  Hence, the pool is almost certainly larger than you will give out in the A round, and is designed to knock down the size of the founders' pool.  So, in round numbers, figure on 20% for the pool.

That gives you 30+% for the founding team.  I have seen two kinds of initial teams:

Initial Team Format #1

One executive, with the company idea

A collection of supporting programmers

Initial Team Format #2

One or more technical people with the initial idea

Additional technical people, recruited into the team

An executive, recruited into the team

With the first kind of team, the initial executive can expect 20+% of the company and allocates the remainder to the supporting programmers.  If you are such a supporting programmer, you should expect at least 2%: therefore,  don’t let the initial executive be too greedy.

With the second kind of team, the initial executive can expect 10% or so.  The remaining 20+% can be allocated among the technical founders.  Again, supporting programmers should expect at least 2%.

Always remember that the VCs will never let the founders control the company.  They will make sure that they can “outvote” the collection of founders.  Hence, a typical scenario is the VCs with 45-50% and the founders with 30-35%. 

Also, the VCs may well veto the stock distribution proposed for the founders.  This will occur if the VCs think the value of the various individuals is not reflected in their percentage ownership.  They will also typically insist on approving everyone’s salary.  Again, they will veto salaries that are out of whack.  I have also seen them make everybody “take a haircut,” if proposed salaries are too generous.

I would like to close with one plea.  The VCs have a lot of information on the above numbers: they see far more deals than you do.  Hence, the current negotiation (yours) is conducted with them having all the information (many deals) and you having none.  They will very often respond to a proposal with “That’s not market.” 

In a sense, it’s similar to the way we used to negotiate with a car dealership when buying a car; blindly, because the dealer knew the numbers and you didn’t.  With the advent of Web sites like Edmunds, there is now much better new-car cost information, and the playing field has been leveled. 

I would love it if somebody would put up a Web site so entrepreneurs could share stock information among themselves – an Edmunds of deal flow.  That is the only way that the information playing field will be leveled. 

Until then, I hope that this information about my personal experience is helpful.


Andy Palmer says:

In my experience, the key to stock distribution is to take the long view.  Stock distribution is a strategy not an event.  And, if you do it right, it can be a highly effective strategy for attracting, keeping and motivating good people.  I’ve published some of my other thoughts on The Fundable blog in the past. You can read them here.

Andy Palmer

To build a great company, you need an inspired, non-incremental idea and the people who can turn that idea into a solid starting point for building a great company.  Then, you need a bunch of people who can scale the idea into a repeatable business.  Through this you’ll need great leaders who can find their way through seemingly insurmountable ambiguity and a roller coaster of big wins and brutal setbacks ―without giving up or believing their own BS. 

In taking the long-view approach, remember two important things:

Starting Companies is a Team Sport: Given all the different kinds of essential people, stock compensation can be a difficult balancing act.  All of the people who are necessary to create a great company from scratch are going to be prone to overvalue their own contributions.  Many will truly believe that, without them, the company would not have been successful ― and many of them will be right.  However, starting companies is a team sport.  Over-allocating stock to any one individual or group of individuals can prevent you from having enough stock to compensate the other people required to start and scale a great company through its life cycle ― from birth through adolescence to adulthood and maturity.

Don’t Get Distracted by the Screamers:  The biggest stock-distribution pitfall that a company can fall into early is basing allocation on who screams the loudest or is the most aggressive. Tech start-ups tend to be littered with business people who overvalue their contributions and are good at screaming louder than the average engineer.  As a result, in general -  engineers end up being under-compensated just because business people are more aggressive.  Now, the converse can and does happen, where engineers/technologists view the business work that needs to be done as “intellectually trivial” and thus undervalue the benefit of strong business execution. 

I think that the best companies are those that (1) appreciate the mix of talent and the quantity of people required to build a great company and (2) are thoughtful and conservative about stock distribution throughout the full company life cycle.

There are many ways to be successful with stock distribution.  I’ve been part of companies where one person owned more than 95% of the stock and other companies where no one person owned more than 5% of the stock.   The most important thing is to pick a model that is right for you as a Founder/Co-Founder and then work towards that model, managing the development and motivation of your team accordingly. 

If you’re generous in sharing stock with the people who work at the company, they should be expected to align their behaviors with the best interests of the company in the long term to maximize the value of their stock.   If you hold the stock close and don’t share with many people, don’t expect folks to make unnatural sacrifices in the interest of the value of the long-term value of your stock. You’re probably going to have to pay them a lot more and be more deliberate in how you motivate them.

Meeting Funding Requirements for Your Start-Up

Serial Entrepreneurs Mike Stonebraker and Andy Palmer Sound Off 

Ok, you have the #1 requirement for starting a company:  a good idea that’s commercializable. Now, what’s the best way to get the money you need to build your start-up? 

Andy Palmer says:

Andy Palmer

First, figure out how much capital you really need – before you go out asking for money. Then, go and get it – carefully.  Just because someone wants to give you money doesn’t mean you should take it.

Determining capital requirements: Having done start-ups in biotech and information technology, I’ve seen first-hand that different types of companies have very different capital requirements. (More on this in a minute.)

Regardless of your industry, be thorough and dispassionate about determining your capital requirements. Push yourself to figure out how to be capital-efficient. Ask yourself: “How can we make the most progress on the least amount of money in the shortest period of time?” How well you optimize the capital you raise can make a huge difference in how quickly the company progresses and how you protect the value of common shareholders’ equity.

In biotech in particular, the landscape is littered with companies that raised (and spent) so much money that the value of their common stock at company sale is lower than when the company started.  I know – bummer – right?  Especially if you are successful in achieving your mission and building a successful companyL.

Some companies are fundamentally capital-intensive in their early days. In biotech, you often need a great deal of physical infrastructure, which can consume capital.  In information technology, some companies can be completely bootstrapped all the way through to profitability. This is increasingly the case because technology companies today can use cloud-based resources to radically reduce start-up costs. 

Regardless of industry, capital efficiency is ALWAYS a good idea. Often I watch entrepreneurs spend a huge amount of effort and time trying to raise money. Later, even those who are successful often realize that they might have created more value for the business and avoided the need for fundraising altogether if they had invested more time, energy and effort in acquiring customers or building product. 

So, it’s a good general practice to ask yourself “How little money could I raise and still achieve my mission and exceed my expectations for the company?”   

Getting the money:  If and when you do go out to raise capital, develop a strategy and set of tactics that minimize the time and the number of people you need to meet before you get the money into the bank.  Remember that venture investors get paid to meet with you: don’t automatically interpret their interest as an indication that they think you’re doing great (either pre-funding or post-funding). To venture investors, all that really matters is that you make them money and improve their “batting average” (returns relative to all their other deals.)   

Assuming that you know what kind of capital you need in order to be successful, my recommended approach is as follows. It’s pretty simple.

(1) Identify an investor (or two) that you trust.  I’m not talking about a firm, but a person. Without someone who you trust, the start-up process (a roller coaster on a good day) will be riddled with second-guessing, a lot of time wasted on educating investors, and more angst than fun. (For more on the importance of trust in funding relationships, read Jo Tango’s posts on trust. Jo really gets it.)

(2) Line up people who can reference your character, abilities, commitment and values.  This step is often the hardest for first-time or young entrepreneurs, but it’s essential. Make sure that your prospective investors can talk to people who know you well and can describe – empirically, openly and honestly – your strengths and weaknesses. 

(3) Prepare a simple and thoughtful description of your idea and how you will make money.  This is the area where a lot of start-up founders get into trouble.  They spend a lot of time writing detailed business plans with lots of text, tables and charts.  Often detailed business plans created early in a company’s life-cycle are nothing more than a confidence-building exercise: you were trying to convince outsiders that you know for certain things that are fundamentally uncertain. Investors strongly prefer a short, powerful and direct summary of your plan.

(4) Write – and commit to memory – a pragmatic description of how you will execute on your mission.  How will you hire and retain the people you need at the company? What are your key challenges – technically, organizationally, operationally – and how will you meet them? I’m not suggesting a long document. But you must know these things well enough so that, if asked, you could stand up at a whiteboard and communicate the important points and drivers.

Steps #1 and #2 may feel “soft and fuzzy,” but in my experience, they’re required.  Who you take money from and your mutual trust with those individuals and their firms are essential for both short-term and long-term success in achieving your mission.

When meeting with first-time entrepreneurs, I always work hard to make the sessions informal.  I prefer to avoid the filter of PowerPoint slides and try to understand people’s primary motivations and the clarity of their core ideas and principles.  (That’s not to say you shouldn’t have a PowerPoint presentation or equivalent prepared – just don’t hide behind it.)

If you have a solid idea, know how much money you need to raise, have good primary motivations and have clarity of your core ideas and principles, you should be able to raise the money required.

Mike Stonebraker says:

So you have a good idea.  The next question everybody asks me is “What does it take to get it funded?”  The requirements differ for angel-funded start-ups and venture-capital-backed start ups.  Since I have never had angel funding but have arranged VC backing for eight start-ups, here is my simple (but depressing) answer to the question of VC backing.

Mike Stonebraker

You need “lighthouse customers.”  I discussed this in my previous blog post as a requirement.  To recap, these are real-world potential customers who will say “I like the idea, and if it works as promised, I will buy it.”  Every VC will ask to talk to a few of these sorts of people to validate that a market exists for your product.

You need a prototype.  In effect, you need some sort of demo that you can show the VCs.  The secret is that this demo can be hard-coded with limited functionality: for example, it only runs the queries in the demo script.  Hence it can be very “quick and dirty.”  However, I have not seen a VC who will open his checkbook without being able to see a demo.  In addition, I have never seen a lighthouse customer who will bless an idea without a similar prototype.  Hence, if you don’t have a prototype, figure out how to get one. 

You need a pitch deck.  This should be a PowerPoint presentation that surrounds your demo. The presentation (plus the demo) should be no more than 20 minutes long, since VCs typically have limited attention spans.  It should concisely state the problem you are solving, how you are going to solve it, and how you will market your resulting product.  You should also have a slide indicating how much money you are looking for, what you will spend it on, and over what timeframe.  There is no need to write a business plan; your slide deck should summarize what such a plan would have in it if it existed.  A VC will almost never let you go through your deck in order, so you will be forced to skip around. Make sure your deck is structured to make this possible, and that you can change course quickly.

You need a core technical team.  This is two or three programmers who can hit the ground running.  Presumably, they have been involved in thinking up the idea, and/or coding the prototype.  Hence, they should already exist.

You need one business executive.  This is usually the hard part.  VCs have the adage “If you haven’t done it before, you can’t do it.” In other words, they want to minimize their risk by betting on somebody with a track record.  If you are a techie with a good idea but little or no hands-on experience running a business, then you will need to recruit this person.  If you are an MBA-type, then you will have to recruit a “gray beard” who has done it before.  If you have done it before, you are golden; you pass this particular hurdle. 

So how do you find this person?  I have two answers.  First, network like mad in your local area.  In the Boston/Cambridge area, there are any number of business executives looking for the “next great thing.”   Tell everyone you know what you are doing, and ask for referrals.  Second, try to get an audience with a friendly VC.  Say you are looking for talent.  The VCs have big personal databases of business executives and are used to matchmaking.

Get an audience.  Have the business executive start calling VC firms.  Invariably, he will have enough clout to get them to ask for your pitch deck.  Based on the deck, you may get an audience: that is, an hour of some VC’s time.  An audience does not mean much of anything these days; see the next bullet point.

Be ready for “rock fetches.”  The result of an audience is one of two things.  Either the VC will go silent: i.e., he is not interested.  This will be the typical VC reaction.  However, sometimes the VC will be interested.  In this case, he will try to get you to do the “homework,” that he would ordinarily be expected to do.  The usual way this happens is that the VC will ask you to present the same pitch to a few of his “friends.” 

For example, I am routinely asked by VCs to evaluate pitches for them.  The VC gets a few trusted eyeballs to look over your idea and will base next steps on what they say.   These friends are usually people the VC has funded before or possible executives that might be interested in joining your team.  Usually rock fetches occur sequentially: please pitch to my associate X, now pitch to my associate Y, and so on.   Be prepared for a lot of these. 

The depressing fact of life is that it may take months to get past the rock-fetch stage with a VC.  As you have probably surmised, you will be in this stage with several VCs simultaneously. Be prepared to log a lot of hours. 

The good news is that this process will help you refine your pitch, find and fix holes in your story, and perhaps get a business executive in the process.  The bad news is that it takes months, and is very distracting from your real mission: to move your company down the field.