Guest Post: Cofounders. How to choose and deal with them?
Updated: Mar 10, 2021
It's that time of the year again! Spring is coming, and many founding teams are getting ready to raise their next funding round. Many of them are at the start of their journey. They have just found their cofounders, are finalizing their pitch, and are ready to show the world that they are the perfect team to crack this opportunity.
Today we cover a topic that doesn't get too much attention: Up to 65% of startup failures can be attributed to problems within the cofounding team. I mean, this is even higher than the current marriage failure rate... On the other hand, 55% of successful startups listed on Crunchbase have two or more founders. So, it does work in most cases... Some investors even think that having a single founder is one of the main mistakes startups make. Personally, I don't care much if you are a cofounder team or a solo founder, as long as I am convinced that you can build a great team around you and that all the employees are compensated fairly and smartly (check out this post on employee compensation packages and ESOP). As Andy Rachleff puts it well, the reason is simple:
Let's have a look at some of the do’s and don'ts when choosing your cofounders. One of the most important aspects determining the chances to succeed of an early-stage startup is the quality and alignment of its cofounding team. How to evaluate it? What are the red flags? Can the identified risks be mitigated?
I recently came across Jana's book called Cofounding The Right Way. After having received questions on this topic many times, she had decided to write a book. She was so kind to summarise for us her key findings on how to approach this challenge:
What is the right team for your venture? A 'fuzzy' challenge.
Proven entrepreneurs and many studies will tell you, the number 1 factor for investors to back an early-stage venture is the cofounding team.
Rather surprisingly then, here is where the supply does NOT meet the demand. When you start looking, you will find out that there is a LOT of information on how to evaluate early-stage startups from business reviews to financial forecasts, valuations, and overall (legal) due diligence. But very LITTLE on what is the 'right' cofounding team. My hypothesis on why that is the case is that some of the ‘hard’ business stuff, especially when expressed numerically, SEEMS more objective and therefore can be more easily subjected to a review. The future performance and stability of a team (meaning a bunch of PEOPLE) is the other side of this (perceived) objectivity and predictability scale.
Not a magic formula, but a structured process.
So is there any guidance that can help? What should I actually look for in a cofounder, and how can I evaluate my cofounding team? What mechanism can I put in place to make sure it lasts? Let me share how I do the cofounding team due diligence (DD) when working with investors or accelerators in their selection process.
There is no magic formula or silver bullet that would deliver 'if this, then jackpot'. However, some flags will tell you, “if this - then most likely not a jackpot”. By eliminating or mitigating the risky factors, you can significantly increase the chances of the team you are betting on.
Here are the three main areas I always look at: Does the team have the competencies, experience, and credentials to realize their dream, and their key milestones (for which they are raising money)?
a) The business aspects
Does the team define the commitment, roles, and targets for each of the cofounders?
Does the team's equity split seem fair?
Did the team deliver on their commitments in the past?
b) The legal aspects
Is there a written cofounding agreement in place?
Is the IP of the project clearly assigned by the cofounders to the project & clean?
Is there an equity recovery framework in place to protect your investment?
c) The team dynamics
Is the team aligned on the big why and ambition of the company?
Does the team understand their blindspot risk? Is the team aware of their friction risk?
Did they define (and test) their internal conflict resolution?
Let's deep dive...
a) The execution skills: Could they fly?
This is the first obvious thing to consider, of course. Given the early stage, it is fairly difficult to predict how things will go, e.g. if many pivots (more on the different pivot types in a later post!) will be needed, and likewise. It is, therefore, difficult to predict if there might be other capabilities required. Also - later on, the company is more likely to get the skills from employees, not necessarily cofounders. So what is important to look for at this stage is the skills for key milestones. A great VC once mentioned to me that there is nothing more valuable than observing a team over time. It is about the past, and the future. So meet VCs as early as possible. Engage with them: Tell your story, make them dream, and get them excited. It is part of their process. They will follow how you execute and evolve. This 'get to know you' process takes time. And you should want to do the same with VCs of course. The shorter the 'get to know you' period, the more they will look at the past. How did the team deliver on their past commitments? If they are really fresh entrepreneurs, how did the founders execute in their previous lives? Do they have an amazing story?
a) The commitment: Will they fly?
The less obvious, but in reality a very contagious thing to consider, is how well the team defined each cofounder’s commitment, roles, and performance indicators. Let me take them one by one.
Commitment: Next to unfair (or perceived unfair) equity splits, cofounders' differing commitment levels is among the most frequent break-up reasons. Suppose the team has different commitment levels (some cofounders are perhaps even part-time) and discussed it in detail (and reflected it in their equity split). In that case, you have mature and diligent founders. If the team did not do it, it could be a sign of either inexperience (which is something you might be willing to risk) OR an inability or unwillingness to have difficult conversations - which indicates a dysfunctional team. The conclusion is simple: If a team cannot have difficult conversations, you do not want to bet on them. They will just not be able to have difficult conversations in the future or make difficult business decisions.
Roles: Really? Do we need that? They are not employees; they are founders. Yes. And yes - you do want the founding team to have talked about it and have it defined. Why? It is true that for most startups in the beginning, the team needs flexibility and generalists over specialists. However, for many early cofounding teams, there are frequent risks of shared roles, an unclear allocation of responsibilities and accountability, and a multiplication of effort and inefficiencies... Often the founder's competencies are sufficiently different to be able to define their role outline from the beginning. Sometimes they are not. Both are ok. But you do need a plan.
Performance metrics: Here is where there is usually the most resistance. Some of this is logical (too early stage of the business, pivots ahead, difficult to define), some is emotional (I am a founder, I should not have to have them). Depending your team's maturity and business plan, you have higher or lower exposure to that risk, but you cannot eliminate it. The risk is called a non-performing founders. You don’t want them. They are expensive. It can easily cause a team break up, or have a very bad impact on the motivation and attitude of the team.
a) And the winner is: The (fair) equity split!
In my experience, most of the cofounder breakups and wars could be traced - directly or indirectly - to the category of unfair (or perceived unfair...) equity splits. There are some interesting alternatives to the ‘future unfit’ traditional fixed equity splits. What I mean is that founders need, for legal reasons, to decide on their equity split reasonably early on. Their decision from these early times very frequently does not reflect the founders' actual contribution (more on this topic here). What is essential to evaluate for the cofounding team DD is whether the equity split seems fair. Does it reflect the cofounders' commitment? Experience? Reputation? Abilities? The assets they bring? Roles? And, most importantly, is it perceived as fair by the founders themselves?
The biggest flag is often an equal equity split. To be clear, I am not saying that equal equity splits cannot be the right solution (even though I am still yet to be convinced of their benefits in many cases). But you need to understand the reason why a the team has chosen an equal equity split. And the BIG flag is if the team has actually decided on the equal split because they wanted to avoid the problematic equity split conversation... Typically, equity split is the first really good test of how the team is able to discuss sensitive topics (part of this conversation being, for example, how is my contribution worth more than yours...). It does tell you a great deal about the team, not only how they split the equity, but also how they arrived at their splits.
Let's have a look now at some legal stuff...
b) Write a cofounder agreement
Why does it matter? Depending on the jurisdiction where your startup is (or plans to be) incorporated, a cofounding (shareholding) agreement can be obligatory or optional. In case it is optional, it is still a big risk for the startup not to have it. It is also a big risk to not have a cofounder agreement prior to incorporation if this period has been longer than 3 months. Following the spread of the lean approach, many startups decide to test the idea before deciding to invest in incorporating a company. And from the business perspective that makes sense. You will work on the prototype, get users' feedback, check overall feasibility... The approach's pragmatic benefits though have some legal risks attached to it - from possible (widely) different assumptions of the cofounding team on their equity stakes, to the risk of diluted IP ownership. The much-recommended practice is to have a framework cofounder agreement prior to incorporation of the company. You would want to have this agreement in writing.
b) Assign the IP to the company.
It is important to make sure that all the intellectual property which is being developed is clearly assigned and belongs to the project and not to the individuals working on it. Individuals come and go; the company doesn't. Without getting too technical on the definition of intellectual property and the concepts of legal and economic ownership of the intellectual property, what you need to know is that there should be clearly written documentation with everyone who has been working on the project that assigns the intellectual property to the project.
Intellectual property does not only include R&D, but has a much broader scope, including business know-how, valuable network information, and connection, customer or investor relationships. This is a somewhat more difficult risk to heal when discovered - the visible sign of this risk being a disgruntled ex-member of the founding team that didn't leave on agreed terms and could claim (partial) ownership of the project’s intellectual property. Depending on the stage of neglect - this can be usually fixed, though.
b) Get an equity recovery framework
If founders leave, you must have clarity on what happens with their rights to equity ownership. Was this discussed? Was the equity already pre-allocated? Was there a cliff and vesting period set? Is there a good/bad leaver framework? In the worst-case scenario, you can imagine an equal equity split of 3 founders with no vesting period. And one of the founders leaving in the first 12 months. The remaining 2 founders have an early-stage project with 33% dead equity. For many, this is the end of this journey. The easy fix of this risk is the equity recovery framework - aka what happens if a cofounder leaves - in the written cofounder agreement. This is also the reason why VCs require a partial (or complete if a very early stage company) vesting scheme. As always, choose clarity over complexity here.
c) Are you aligned on the what, how, and why?
This is the area that is the most difficult to evaluate. In the years I have worked with cofounding teams I have learned how careful one needs to be with its own judgments and assumptions. There are teams that I thought had it all, and 3 months later they would not talk to each other. There are teams that I wouldn't have bet a penny on - and 3 years later they are successfully growing and scaling their business. Now, these ‘mis-estimates are rare. But they exist. Here are some objective tools I have found to minimize the risk.
Mission and values. It does not get ‘softer’ than that. However, if the founding team does not align with the what, how, and why, in almost every decision ahead they will struggle to reach an agreement. Irrespective of what legal voting powers may be in place, the business is not likely to get very far if cofounders want to go in different directions on every crossroad.
Even though some people try to convince us otherwise, there is no way to eliminate all risks. But... you can spot many major risks early on - which either gives you the chance to mitigate them, or walk away. What I learned is that going through this structured process does help. It gives the parties a checklist and tools to work through. The outcome is typically a more stable cofounding team, with existing risks (every team will have them) clearly identified and mitigated. One of the frequent side-effects also being an increased trust as everything was on the table and looked at.
I firmly believe that there is much more under the surface that can be researched, learned, and improved when it comes to (cofounding) teams. Whether you are a founder, investor, or anyone else with ideas to explore, please feel free to reach out to Jana.
In the meantime, harboring big hopes for more human contact again & having all the fun we can possibly have with the good winter in Switzerland.
Next week I will be staying in Paris again. The startup ecosystem is going from strength to strength here. Here a picture I took when I left my office a couple of weeks ago.
Life is awesome,
Other content I have found useful.
- The tech world's latest hype are NFT. It will be interesting to see if it lasts. Here the Best NFT 'pitch' I have come across so far: 'You’re right that one of the other reasons why we collect is to show it off status, but I would actually argue it’s much easier to show off our collections in the digital world. If I’m a car collector, the only way you’re going to see my cars is to come over to the garage. Only a few people can do that. But online, we can display our digital collections. In the real world, we could only collect things because digital collectibles were too easy to copy. Then the blockchain came around. You can screenshot it, but you don’t really own the digital collectible, and you won’t be able to do anything with that screenshot. You won’t be able to sell or trade it. The proof is in the blockchain.'
- My friends at Heartcore published their cool annual 2021 consumer report. Check it out. They put a lot of work into it, and it has some great insights.
Check out also our previous blog posts here.