This post is the twelfth installment of “Laying Down the Law” – a series where our attorney friends at Troxel Fitch give legal advice for budding entrepreneurs. View the previous post about Do I Need An Operating Agreement here.
Entrepreneurship can be lonely, and sometimes a business partner can be a saving grace in times of stress and isolation. However, next to marriage, co-ownership of a business is one of the most legally significant relationships recognized and can be even harder to unwind than a marriage. For that reason, you must carefully choose your business partners, and once you have, you must be thoughtful to ensure your relationship is built to last. In this installment of laying down the law, we’ll talk about self-interest, and how to align incentives to ensure your self-interest is in your business partner’s best interest too.
To understand the value of aligned incentives, its easiest to start with a bad example. Consider your friendly neighborhood used-car dealership, and its shark tank of hungry salesmen. We all know how this story goes…as soon as you step onto the lot you are swarmed by pushy sharks who will eat each other to sell you a car, and everyone hates it. Why then, do dealerships and salesmen keep doing it? Because the incentives of the dealership and salesmen are divergent, and therefore each individual values their personal sale over the reputation of the dealership. Each salesman has a cash incentive to win the sale at all costs, but no incentive to promote the overall “goodwill” of the dealership. As can be expected, self-interest takes over, and the “shark tank” environment persists, because for the salesmen, there’s no money in harmony.
So how does this apply to your startup, and why should you care? You care because people go into business to benefit themselves, and if you ignore divergent self-interest as used-car dealerships do, you might find your Founders pulling the company in opposite directions.
Step By Step
The first step in aligning incentives and self-interest is to accept that opportunistic behavior in business is to be expected, and is not the boogie man. We do business to make money. It’s not selfish, it’s not greedy, it’s a fact. Some people spent it, some save it, some give it away, but the cold hard fact is that we do business to make money. Don’t run from it, use it.
Second, put some thought into what exactly each Founder’s interest is. Three of the big ones that apply to almost every company are money, time, and risk.
For the sake of explanation, let’s use a hypothetical company…NewCo, with two Founders. Johnny is a 25-year-old coder with big dreams of being the next Zuckerberg and traveling the world on yachts. Joseph is a 55-year-old operations guru who has grown and sold multiple companies, and plans for NewCo to be his encore before he retires sails into the sunset with his family.
Consider their incentives as they apply to money, time, and risk… In this small startup, neither Johnny nor Joseph can sell their stock because it is unregistered, so their ownership in the company is illiquid. Then, 5 years into the company’s existence, Google offers to buy NewCo for $5 million.
Joseph is ecstatic! He tells Johnny he wants to sell. He’s now 60 and can enjoy one more windfall before retirement. Johnny, however, is livid! Sell to Google now?? NewCo is just getting started and this offer is an indication that they’re on the right track! Plus, Johnny is interested in the $100 million payoff, not the $5 million pacifier Google is offering…
At the moment, Johnny and Joseph’s incentives are divergent. Johnny wants $100 million, but Joseph would be happy with $5 million. Johnny is willing to pour decades into NewCo to win big, but Joseph is only willing to put 5 to 10 more years into it, tops! Finally, Johnny can live with the risk that NewCo fails, because he’s chasing the big win, while Joseph would rather not continue to tolerate the risk when there’s a $5 million payoff on the table already.
If left unaddressed, this disagreement could tear the company apart. So how do we fix this now, or avoid it from the beginning?
We face the issue head-on. Let’s look at what Johnny and Joseph each want, respectively, and what NewCo needs from the Founders.
Assess the Situation
Johnny wants lots of money, has time to burn and can bear lots of risk. Joseph will accept less money if it’s more certain, and wants it relatively quickly. What does the company need from each? NewCo needs Johnny to be the visionary leader and give it everything he’s got. NewCo needs Joseph to pass along his operational expertise, but once that is acquired, Joseph himself is no longer needed.
With this in mind, we can use a variety of tools to structure the company to align self-interest to everybody’s benefit. Preferred and common stock can be used to provide different financial incentives to different Founders. Stock vesting, based on either time or project milestones, can be used to align divergent time horizons of Founders. Liquidations preferences, drag/tag-along rights, preemptive rights, convertible notes, and more can be used to mitigate divergent risk appetites. The list of tools is extensive. The key is knowing which incentives need to be aligned, and therefore which tool to use.
The bottom line is this: don’t bury your head in the sand and let potential disagreement derail your company when a little forethought can help you predict it and avoid it. Founders will act in their self-interest. Embrace it, plan for it, channel it. If you need help spotting divergent incentives, or applying tools to bring them back into alignment, the business attorneys at Troxel Fitch, LLC would be happy to help.
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Troxel Fitch, LLC, is a law firm designed to meet the needs of businesses operating in the hyper-competitive modern marketplace. By combining low-overhead operations with efficient technological solutions, Troxel Fitch is built to provide you with responsive, professional, and affordable legal representation.