Tuesday, January 18, 2011

CTO Equity - Negotiation After Funding

I received an inquiry from a reader of my blog and thought I would provide some thoughts, but would definitely welcome input:

I am an unpaid CTO of a small startup. I have been working full time with two founders for about 10 months on full time basis. I have been through many months with them but because of lack of funds, I spent lot of time doing non-technical work for first 4-5 months, spending time with them on putting pitches for investors, cash flows,  budgets, writing business plans, product prototype setups etc. There was an informal verbal agreement that I would work for a certain hourly rate for my time. During that time one of the founders had mentioned that for the initial agreed time (3 months, equivalent dollars could be translated to 2% of equity but no agreement was reached at that time).

Now, they were able to raise enough money in the last 3 months to launch a product along with all the necessary software development to launch a pilot program for validating the idea. During all this time, valuation pitched to the investors was in the $1M – $3M range. I was also responsible to get a top-notch technical architect to build the necessary back-end at very affordable hourly rate to be able to launch the product in a very short time.

Because we were so busy in the last 3 months, I did not had a chance to talk to the founders about my compensation for the time spent and future salary etc. When finally, I sat down and started talking, they basically tallied up the hours I spent and gave a choice to get equity at current $3 mil valuation or get full cash for my time or blend of both cash/equity. I tried to argue that the equity should be what it was at the time I joined and discussed but there was no formal agreement at that time. Now I feel like I was part of the team to build the company but equity valuation offered to me is not fair.  I am thinking of taking full cash and slowly easing myself out.  I would appreciate if you could provide your guidance on this one.

Obviously, in hindsight it would have been a really good idea to get an agreement that spelled out your equity position and how you would be treated cash+equity prior to and after funding.  Please let this be a lesson to everyone – founders and CTOs.  Don’t put yourself in this situation.  Of course, that doesn’t help here.  So …

I have probably more questions than answers.  The reality of your situation is that you are now in a different negotiation.  The situation is what it is at this point and it’s a question of where there’s leverage. 

Actually, I should start by saying – I’m not a lawyer and you might want to get someone who can help you understand your position here.  Find a lawyer and someone who does CTO searches for VC backed companies in your area.  They both would have lots of thoughts and ideas.  The lawyer will charge you for more than the initial conversation.  The search person likely won’t charge you if you have a strong enough background, i.e., later would provide value to them.

Some things to consider about the negotiation:

  • Do you want to remain with the company?  Likely this greatly affects cash vs. equity.  Most founders and investors won’t want you with a chunk of equity if you are no longer there.  But they also don’t want to part with cash.  Still, likely everyone would be happier with a cash settlement.  But I’m assuming you want to remain at the company.
  • Do the founders recognize that they had verbally agreed to 2% for 3 months work?  Do they recognize that you’ve spent 10 months not 3 months on it?  Do they feel responsible to honor that?  Realistically, you took a lot of risk here and should be rewarded.  That said, they likely also are a bit under pressure because of the loss of the reality of funding and investors to keep your equity component down.  But, you should probably start with understanding where they believe that prior verbal agreement stands.  You likely to get the best result based on this equation.
  • What are the specifics of the 2%?  Was it pre or post?  What type of shares?  Vesting?  Or was it options?
  • What are the terms the founders got in the deal?
  • My guess from the way you’ve worded the question is that you’ve done a really good job as the CTO.  You’ve put the right team in place to essentially make yourself less valuable to the founders because they feel they can move forward effectively without you.  A cornerstone of your negotiating position is how valuable you are to the company going forward.  Think Tom Cruise – “With me, without me.”  Do the founders and investors believe that your are essential to their success?  Do they have a good relationship with the architect?  Do they recognize any Startup Founder Developer Gap?  You might use some of the key questions in Startup Software Development – Do Your Homework Before You Develop Anything and Startup CTO or Developer to help you point to issues where you have particular input and value.
  • What’s your relationship with the investors?  Do they believe you are important?  Do you have a direct line of communication?  I don’t think you pull the trigger on this anytime soon, but it’s negotiating leverage.
  • What’s the rate for your time that would be used in a discussion?  Is it market rate or some reduced rate that you’ve discussed at some point?   What would the cash equivalent for your time at market rates be for the amount of time you’ve invested to date?  Somewhat for the cash settlement or the worst case equity discussion, this would be the basis for the discussion.
  • What will your involvement be going forward?  Are you full-time, part-time, advisory (take a look at Part-Time CTO, Technology AdvisorActing CTO for other models)?  What is your cash+equity compensation for that period?  What happens when this round of funding begins to dry up?  (Don’t make the same mistake.)

For me – I would definitely start by soul-searching – do I want to still be involved?  Do I trust the founders?  Do I want to work with them?  Having a successful negotiation where you get a reasonable equity position with vesting over four years and a salary going forward only to find yourself working at a place you don’t want to be is probably not a great result?

I would then also consider closely what your real contribution has been to date and what they owe you for that and then what they should compensate you for your contribution going forward. 

Some other possible sources:

  1. Splitting Startup Equity for Your Piece of the Pie
  2. How much should you pay an executive in a startup company?
  3. How Much Stock to Ask For When Joining a Startup
  4. Reincubate: Blog: Chief Technology Officer job description (for web, start-up or corporate
  5. Doing It Right the First Time: The 15 Most Common, but Avoidable, Mistakes Made by High Growth Start-ups

Again – I would love to hear input on this and other sources of information.

3 comments:

Erick Herring said...

Your questioner has likely given up very little leverage if there's no clear and binding work-for-hire agreement and likewise an assignment of inventions. If such agreements are in place, then that shows an attention to detail that tells me the lack of a well-defined deal was intentional on the part of the other founders.

As to what's "fair" or "right" it seems to me that this CTO should expect and get the same deal the other founders did. For me, that means that, if they were paid for back work, s/he should be, too (and if not, then not) and a founding-CTO slice of the equity pie - say 10% pre-dilution (with early acceleration, early exercise, etc - just as the other founders got).

My guess is that boat has sailed. I also may be misunderstanding the situation - it wasn't clear to me whether the CTO feels entitled to treatment as a "founder".

As a side note, I can't believe no one else reading this has valuable input - come on, guys! Help this poor guy out :-)

Mariko said...

Nice post, CTO should get the same deal.

Tony Karrer said...

Thanks for the thoughts Erick.