How to Protect Yourself with Startups?

JustAin'tFair asks: "Last year, I took a chance on a small but promising startup. When they approached me, it was a 3-person operation (all involved were investors) with a functional website, a viable piece of technology, and a problem. Their prototype was just that -- a prototype. They were experiencing serious maintenance and scalability problems, and had exhausted their own technical knowledge. I agreed to come on board as their first employee, in return for a decent salary and a nice vesting schedule." To make a long story short:"My old boss & his partners netted a very nice payday, on the backs of their former employees. What would you do to protect yourself? I got a fair salary, but in the end, they got far more out of me than I got out of them. Would you contract? Get a parachute written into your contract? What have you done?" "In 6 months, I rewrote and redesigned most of the key subsystems, built new servers, hired new staff, and got the company rolling on a serious path. Serious senior architect-level stuff. Then it all fell apart: one day, out of the blue, they fired all of us, claiming shortfalls in funding, and so on. It sucked -- it always does (I watched my own startup fall apart in the dotcom 1.0 days). So the other day, I saw they were bought out.

Sucks twice.

In the end, that's their right. At-will employment, and all that. However, it chafes me to get screwed like that."

Comments

You took the wrong class (of equity)

[hirschma]

Most people believe that equity is equity. It isn't.

Let's say that I do a startup. I immediately create two classes of equity - Class A for me, Class B for you and everyone else that I hire. To make things simple in this example, let's say that in terms of ownership, Class A = Class B, but they have different rights. Class A gets to vote on things, Class B doesn't.

OK, so I have 50% of the company in Class A stock, let's say 100 shares. You have options for 50% of the company in Class B stock, also 100 shares. These shares seem to be equal, but they're not.

So, together, we build the better mouse trap. Then we run out of money. The VC's step in... and since we're distressed, they seek to do a cramdown. Which means that they're going to shrink the existing slices of the pie,and perhaps convert things. Time to vote on whether to accept the cramdown. But only I have voting rights. So I agree to do it on whatever terms we can get.

So... first they buy the majority of the company with their investment 89.99%. The company issues 10,000 shares of a new class, Class C, which is what the investors get - 8999 shares worth. Class C becomes the only redeemable equity. The investment terms specify that Class A owners can convert on a 10:1 ratio - so now I have 10% of the company, or 1000 shares. I've been diluted. Class B owners can convert on a 1:10 ratio, or 10 shares. You are diluted, the way the "active ingredients" in homeopathic remedies are diluted. So now you have .1% of the company. You still have the same number of SHARES as spelled out in your agreement, but they're now effectively valueless.

The VCs find someone who wants to buy the company for $100 million. They get $89.99 mil for doing a bit of social networking, and tiding us over through the rough times - in other words, the rich get richer. I get $10 million. Woo hoo. You get $10k. Thanks for playing!

This is how it works. Founders often end up with far less than 10% of the company, if anything at all. Employees typically get screwed. The exceptions are the companies that are so hot, and/or have enough revenue coming in, that they can play one VC off of another. It is not often that founders have the ethical grounding to make sure that employees don't get screwed, at least any more than the founders themselves. But, on the other hand, I've seen employees cut separate deals with new investors to cut the founders out. No one plays nice in this game.

This is what you need to know going forward: get the same CLASS of equity that the founders have. Insist on instant vesting upon change of control. Insist on at least partial vesting if you are fired without cause (although employers will always be able to show cause, there is at least the threat of a lawsuit).

The flipside: if you have the stomach to do another startup... since you helped launch a company that made people money, you can get a better deal the next time around.