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Kartik sarwade: A Pre-nup for your Startup - the Founders' Agreement

  1. 1. Execution Advisory for Startups A pre-nup for your startup: The Founder's Agreement Nasscom Product Conclave 2013 Kartik Sarwade Capital 7
  2. 2. Disclaimer • Nothing contained in this presentation should be considered as legal advice. • Tax, regulatory and legal issues around valuations and equity issuance are complex matters and you should consult with a law firm / a Chartered accountant or other advisors to advise you on them.
  3. 3. 2 Quick Poll How many of you are entrepreneurs?
  4. 4. 3 Definitions Agreement vs Contract Agreement (Understanding) Legally Enforceable Provisions Contract (Written document)
  5. 5. 4 Take aways What if you get the Founders’ Agreement wrong? Likely reasons why you might get this wrong Approaches to making better Founders’ Agreements What should be in the contract? When should you get one done? “Watch out” issues
  6. 6. 5 Quick Poll How bad is the problem: How many think >50% of startups have serious cofounder issues?
  7. 7. 6 The Data VC Portfolio startups* All startups ? 61% Serious Key Personnel issues Relationship Role Reward *10,000 founders of 4,000 startups, The Founder’s Dilemmas – Noam Wasserman
  8. 8. 7 Famous blowouts Facebook Zopnow Eduardo Saverin B K Birla
  9. 9. 8 Quick Poll How many of you Entrepreneurs have a written Founders’ Agreement?
  10. 10. 9 Common choices Relationship Reward Roles Co-found with people you have social relationships with – friends, relatives, co-worker/friends Split equity early, static arrangement A social relationship increases the likelihood of a cofounder leaving by ~30 percent >85% of startups will have a major change in strategy/ business model/ cofounder involvement Assign roles based on Attitude and skills almost competencies demonstrated always trump competency in the past
  11. 11. 10 Exercise: Why agreements fail
  12. 12. 11 A commonly used agreement RTO Notification on Autorickshaw fares and terms in Bangalore Minimum fare: Above minimum fare: Waiting charges per hour: Luggage charges: Night Timings: Night Extra fare percentage: Outside city limits: Rs 20 for first 1.8 Km Rs 11 per Km Rs 30. Minimum 10 minutes are charged. No charge for first 20 kgs. For every additional 20 kgs or part thereof Rs. 5 23:00:00 - 05:00:00 50% 50% extra
  13. 13. 12 The situation You’ve reached an agreement with an auto driver You have full intentions to keep your end of the agreement Yet, you sometimes end up with a conflict List down 3-4 scenarios that could cause you get into an argument
  14. 14. 13 Reasons Agreements fail 1 Primary intentions no longer valid 2 Significant shifts in balance of power 3 Incorrect assumptions (Stated or otherwise) 4 Ambiguity – no “Meeting of the minds” 5 Boundary conditions – uneven or unhandled
  15. 15. Notes to slide 13 • Agreements in general (not just Founders’ Agreements) cause problems between agreeing parties at one of these 5 common points of failure. • Point 1 is far more common for agreements involving startups than usual agreements because of the propensity of startups to pivot their business plans frequently. • Negotiating a framework rather than fixed numbers works well in handling problems caused by Point 1.
  16. 16. 14 The Framework Approach
  17. 17. 15 A good framework.. … should strike a balance between complexity and effectiveness: Aim for “Simplest that is good-enough”, not perfection … be based on objective variables … makes judicious choices in underlying assumptions … is validatable, ideally using back testing
  18. 18. 16 Equity allocation Hypothetical startup: Fddzzrrbl.ly Problem: What percentage of equity in a startup should be allocated to each founder Basic tenets All founders contribute to the startup in various ways – cash, effort, expertise The startup should repay founders in equity commensurate with their contribution to the startup
  19. 19. 17 Model / assumptions Cash: Most objectively determined, startup values at face value Effort: Time as substitute for effort “Market salary” as good enough estimate of value of time Expertise: Nebulous to value; Take subjective circumstantial call
  20. 20. 18 Background Amar Senior guy, agreed to invest 10L, will go without a salary for now Akbar Relatively junior, agreed to put in 5L, will also go without salary for the time being Anthony Domain expert, cannot invest, will need a basic salary of 5L
  21. 21. 19 The framework Amar Year 1 Anthony Akbar Cash 10,00,000 5,00,000 0 Effort 50,00,000 20,00,000 25,00,000 Expertise 0 0 5,00,000 Value Added 60,00,000 25,00,000 (-) Salaries/Perks 0 0 Net Contribution 60,00,000 25,00,000 54.5% 22.7% Equity split 30,00,000 5,00,000 25,00,000 22.7%
  22. 22. 20 The framework Amar Year 2 Anthony Akbar 0 Gabbar 0 0 Cash 0 Effort 50,00,000 20,00,000 25,00,000 25,00,000 Expertise 0 0 0 0 Value Added 50,00,000 20,00,000 (-) Salaries/Perks 0 0 Net Contribution 50,00,000 20,00,000 20,00,000 20,00,000 Previous year’s contribution Cumulative Contribution Equity split 60,00,000 25,00,000 25,00,000 0 1,10,00,000 45,00,000 45,00,000 20,00,000 50.0% 20.5% 25,00,000 5,00,000 20.5% 25,00,000 5,00,000 9.1%
  23. 23. 21 To sum up The model is: (i) not unduly complex (ii) based on objective variables (iii) back-testable In practice, a slightly more complex model provides pretty good results. Discounting later time periods’ contribution geometrically is a particularly helpful adjustment.
  24. 24. Notes to slide 21 • A framework such as this comes in handy to take care of unexpected events. A founder moves out or comes in, one founder decides to work part time, one of them decides to invest a few lakhs – all these can be handled fairly easily by tweaking the numbers. • You could even extend the framework to help determine the quantum of equity to allocate to Advisors, Mentors or even for ESOPs. • In our experience, we’ve found that a slightly more sophisticated model gives good results but complicating the model beyond that isn’t worth the effort and in fact soon becomes detrimental • You should consult with appropriate professionals to advise you on valuations and equity issuance matters. You cannot take anything contained this presentation as legal advice.
  25. 25. Thank you kartik@capital-7.com +91 81232 83248

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