If you’re forming a startup, then you need to put thought into who is a co-founder and who is an employee early on. Founders typically have a significant ownership stake in the business, though many do not get paid much or at all in the beginning. Early employees might receive a small amount of equity as part of their compensation package, however, they are more likely to be paid an hourly wage or salary. Founders are interested in building, expanding, and profiting from the company’s success, while employees’ profits are limited to their compensation packages. Additionally, founders’ rights and responsibilities in regard to the business are far different than those of employees.
This distinction between co-founders and early employees is important and can be tougher to delineate than you think. “You’ve got to make a distinction between the two in order to make the decision about how much equity someone is going to get and how much cash someone is going to get as part of their compensation package,” says attorney Fred Kingren of Hand Arendall. When starting a new business, it’s important to work with an experienced business lawyer who can guide you through the legal aspects of bringing onboard co-founders and your first employees.
Who is a founder?
Not every person involved in your business from the very beginning or early on is a co-founder. To determine your co-founders, analyze whose contributions to the enterprise are integral to getting it off the ground and its potential success compared to whose contributions are important, yet could be provided by someone else.
A co-founder is someone who is not easily replaceable. They may contribute all or part of:
- The initial idea the business is built on
- Intellectual property you need to provide the product or service
- Startup capital
- Business expertise
- Crucial industry connections
Someone who is a co-founder plans to be with the business for the coming years and deserves a greater equity stake in the company, not just a salary.
Who is an early employee?
Early employees are essential to startups; however, at the end of the day, they are replaceable. An employee may be let go or choose to leave, and with some effort, you can hire someone to take their place. You can tell someone is an employee and not a co-founder if you work with them on tasks that others with similar skills could complete or tasks that when finished, end your need for that person’s services. Common positions like sales representatives or receptionists, or limited-duration projects like building a website, are more often the arena of employees or independent contractors than co-founders–though this is not a hard and fast rule since many co-founders wear a variety of hats when getting a company off the ground.
Founders and early employees are not based on timing
Don’t assume you will have your co-founders before any employees. Sometimes, it does work that way. You and a colleague come up with a business idea. You get it off the ground, incorporate, and find funding before you bring on any employees.
However, there are situations in which you may have one or more early employees before you bring a co-founder into the fold. For example, you have a great business idea. You work on it for about a year, during which you hire an employee to handle basic administrative tasks for a small salary. After a year of work, you realize you need help. Through your industry connections, you find another professional who believes in your idea as much as you do. You two become co-founders, each with a significant equity stake in your new business. You had an employee first, but that does not make the employee a co-founder.
Define founders and early employees as soon as possible
When you start a new business, you need to define who are the founders versus early employees as soon as possible. You may be able to make this distinction before you form a legal business entity. You and your founders may form a corporation or LLC together, and then hire employees. However, you may have formed a corporation or LLC on your own. In this situation, carefully determine who you wish to bring on as a co-founder versus an employee. A co-founder may be willing to work for a sizeable ownership stake and little-to-no salary. An employee, however, needs to be earning a paycheck from day one.
This distinction matters because you must determine the founders’ and early employees’ equity splits in the company. Founders typically begin with large amounts of equity, while employees split a much smaller equity pool. Dan Shapiro, CEO of Glowforge, discusses how much equity each founder should receive. The Founder Institute lays out information regarding setting aside an equity pool for employees.
Work with an attorney experienced with startups
If you want to get a business off the ground, the best thing you can do is hire an experienced business lawyer from the very beginning. You need to define who is a co-founder and who is an employee, determine your equity splits, and then finalize contracts with each of them regarding their ownership stake, compensation, benefits, and other partnership or employment terms.
“Many companies have failed as a result of the company’s owners being unable to co-exist. Founders of a company should explore the potential pitfalls of co-ownership and learn what rights and restrictions are covered by existing laws, and what new agreements might be reached via contract,” says John Cross, a corporate attorney with Brooks Pierce. “Founders should also know that minority owners do have rights in a company, and these rights should be taken into consideration prior to issuing new stock or other equity interests to new shareholders for money or to employees for services.”
By hiring a seasoned lawyer, you gain insight into how to define founders versus employees. Your lawyer can advise you on creating your company’s stock, including whether to have restricted or preferred shares, and on how to split equity among founders and employees. Your lawyer will ensure you and your co-founders negotiate fair and comprehensive contracts, and that you have appropriate contracts for your initial employees.
If you fail to properly define who is a founder versus an early-employee, you may have an employee with significant ownership not pulling their weight. Or, an early employee who should have been a founder may be angry when they do not see their fair share of the profits. Failing to make the distinction, or misclassifying someone, can lead to legal and financial disputes down the road.