What are free riders? How to I prevent free riders in my startup?
Jeff
5 Comments
It's been a bit since I've been able to get to the questions, however I will be making a couple of posts this week to catch up. Last week I had the opportunity to speak at an inspiring event, the Entrepreneurial Bootcamp, which is a forum designed to bring entrepreneurial minded college students together with business veterans. I was part of a panel called "War Stories," and also judged an elevator pitch competition as the finale of the evening. I'll post more about that event shortly.
This question is a followup to my previous answer regarding the structuring of founder's equity.
Christian writes:
Your site is excellent and I'm very impressed with the quality of writing! It's very balanced and one of the few places that actually weighs the differences between LLC and C-Corp, where most just give a very one sided view.
My question is regarding free riders. I have an excellent attorney who before incorporating my C-Corp has asked me to prepare a letter of agreement with my business partner going over numerous terms such as confidentiality, non-solicitation, etc. She wanted me to think about how I would handle the situation where a founding partner stops performing his job functions and benefits from ownership of the company.
The solution sounds like it would be similar to the way founders shares are laid out, but I can't quite hit upon the answer myself.
Could you provide any insight?
Thanks for the compliment. First, I suppose it's important to define what a "free rider" is. Assuming your attorney used this term, it would be important to ask them what specifically they mean, because this is one of those ambiguous business terms that can mean different things to different people.
Usually the term "free rider" means someone that has somehow acquired equity in a company, but is not actually providing any value to the organization in order to substantiate that ownership stake--hence they are getting a "free ride" along with your success.
The most common set of circumstances (that I've seen) which leads to the creation of a free rider is poorly constructed founder's equity. So, to answer your question simply: Yes. My post about founder's equity does directly address the issue of free riders.
When you go into business, it's easy to think about just splitting up the shares and jumping in. However, you can't lose sight of the fact that sometimes things don't go according to plan. Founders might not work well together. Your friend might not be the great sales guy you thought he was. Someone might have family obligations that pull them away from the company. Someone might leave so they can pursue their dream of becoming a ninja. Who knows.
The point is, you want to plan for these contingencies. Founders stock is a way to do that. What you have described -- a letter of agreement that states what happens in situations X,Y, and Z, is another way to do that. In fact, a letter of agreement, depending on your attorney, might be the only difference between common stock and "founders stock".
You should ask your attorney if the letter of agreement deals with all the issues I've outlined in these two posts. It probably does, and it probably goes further in non-compete agreements, invention assignment agreements, and confidentiality agreements. Those are all good issues to cover as well (which again, I can go into if someone would like to ask).
An underlying point is that these agreemens should, generally, favor the company while still providing a fair framework. If Joe needs to leave because a family member has become critically ill, the agreement should probably be that any still-restriced shares (or unvested options), return to the company. If you want to make an exception for Joe, and let him keep some or all of it based on his circumstances, that should be a decision made by the company, at the time of Joe's departure, after weighing all the circumstances. Perhaps you let him keep some extra stock. Perhaps you expect him to return, so you stop lifting the restrictions (or stop the vesting) while he's gone, but let him pick up where he left off if/when he comes back.
There are lots of ways to deal with the unique situations that come up, and believe me, 95% of situations where a founder leaves will seem pretty unique when they happen. You should always try to be fair to your employees and partners and can adjust accordingly any plans you have laid out in these agreements. But the point is that you want the starting point to be in favor of the company, and then have the flexibility to adjust from there.
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