The New Deal – A Founding CEOs Value is Non Linear

As a founder I fought with VC’s over vesting as they brought in a new CEO and walked me out the door. As a board member I negotiated with founding CEO’s over vesting when I thought it was their time to go. At best this is an argument where no one wins, at worst it’s like a nasty divorce.

I’ll offer that both entrepreneurs and VC’s have the wrong model for founding CEO equity compensation. The customary vesting model has founders vest their stock over 4-years, and when the founding CEO gets in over their head the VC’s bring in professional management. More often than not the founding CEO leaves the company. The fallacy is believing that a founders value is evenly distributed over four years. We now have three decades of experience that says otherwise.

Preparing For Chaos
Every VC knows that the founding CEO is the individual you throw into the chaotic battle of a startup. Investors are praying they’ve backed a founder who can think creatively and independently, because more often than not, conditions on the ground change so rapidly that the original well-thought-out business plan becomes irrelevant. They’re hoping they funded a CEO who can manage chaos and uncertainty, is biased for action and isn’t waiting around for someone else to tell them what to do. They’re betting that the founding CEO can quickly separate the crucial from the irrelevant, synthesize the output, and use this intelligence to create islands of order in the all-out chaos of a startup. And that they’ll emerge from this fog of war with a scalable business model.

They also know that most founding CEO’s don’t scale past the early stage.

That’s the source of the trouble. Most founding CEO’s don’t know that they’re cannon fodder in the search for a business model.

It’s My Idea and Hard Work
Some founding CEOs believe the value they bring to their startup is their idea and the time and energy they put into their company. In their mind, since they thought of the idea of the company, spec’d the product, found the first customers and worked their tails off, they are entitled to vest all their stock over time and run their company.

Where’s My Liquidity Event
Some VC’s feel that if a startup has grown past the founder’s ability to manage and scale (and hasn’t had a liquidity event,) they should be able to remove the founding CEO and (at best) walk them out the door with only the stock they vested to that day.

It’s About Finding the Business Model
I’ll posit that both views are wrong. Lets start with what the real job of the founding CEO’s job is: to find a repeatable and scalable business model. The goal of your business model can be revenue, or profits, or users, or click-throughs (or even just to get the technology into production) – whatever the founders and their investors have agreed upon.

If you don’t find this business model there is no company.

The odds are if the founder is going to find the first business model it’s going to be in the first few years. Yet the traditional vesting model ignores this. It assumes that founders contributions are linear over 4-years. Not only is this unfair it has the founding CEO focussed on the wrong goal – hanging on as long as they can to vest their stock. Why on earth would investors want to have the incentives set up this way? 30 years of accumulated experience says these perverse incentives actually diminishes the value of their investment.

It’s time to rethink how we vest stock for founding CEOs.

The New Deal
The founding CEO vesting model should start with a new deal between VC’s and founders. Recognize that a founders value is non-linear over 4 years and heavily weighted towards the chaotic first few years. Agree that the founder is being rewarded not just for the idea or technology of the company but rather for finding a way to make money.

Founding CEO’s need to agree that it’s rare that founders are the right people to take a startup through the transition to build and scale it into a company. Instead, it’s likely that after they do the hard work of finding the business model, the company will need to hire their replacement to grow the company to the next level.

The New Founding CEO Vesting Model
Therefore, if the founding CEO gets the company to a repeatable business model they deserve to vest all their stock if they are removed. If they fail to find a business model, by taking investors money they’ve implicitly agreed they can be walked out the door. (But can keep the stock they’ve vested to date.) Specifying what the metrics are for a repeatable business model is what the board and founders should be doing in the first place. This new deal would keep everyone focused on the search for the model.

I’ll suggest that this new deal more accurately reflects the time-weighted contributions that founding CEO’s make and more accurately aligns founders and investors interests.

Lessons Learned

  • The job of the startup CEO is to find a repeatable/scalable business model.
  • The contribution of the founding CEO is not linear over 4-years.
  • If the founding CEO gets the company to a repeatable business model they deserve to vest all their stock if they are removed.
  • Accountants shouldn’t be putting together the vesting schedule.

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19 Responses

  1. Thanks, any thoughts on how we can establish those metrics? Not sure we know which metrics are relevant if we don’t know which business model is coming out of the process… Should we have nonlinear vesting (e.g. akin to accelerated depreciation in accounting)?

    Thanks for the post!

  2. Fantastic post-
    I agree with you 100%. I especially see this in the biotech startup atmosphere. There is a distinct difference between the visionary CEO and the day to day CEO and the sooner everyone is on the same page the less distractions there will be in years 3-5.

    Jon

  3. What happens when you pivot and discover that your metrics are no longer the right thing you should have been measuring? Renegotiate? Over and over?

    • Nothing to renegotiate. The trigger for compensation is finding a repeatable business model. The metrics are just the way to know you found them. You’ll be resetting them as you Pivot.

    • But, Steve, defining those new metrics *is* a negotiation. Esp. in setting the *value* for such metrics that defines whether the model is repeatable.

      So it smells like there’s risk there of bad-faith from either party, because good chunks of equity are at stake…

    • I assumed that vesting would be tied (contractually) with metrics. Will the vesting language just say, “The CEO will vest when he finds a repeatable business model?” If so, said CEO needs to find a new lawyer.

  4. Arguably, a non-linear reward schedule is embodied in Series FF stock.

  5. I guess I’m a little old fashioned but isn’t there only one metric for determining if you have a business model – revenues?

    Perhaps a secondary metric is profits – or – potential to make a profit at some reasonable scale?

    @comradity

    • You are right on the dot. Real customers, revenues & profits is the best way to validate any business. The time & efforts taken to get there must be reasonable.

  6. It’s very hard to determine what is the right metric. And setting in stones may have adverse effects as the exec may be optimizing for ‘his’ metric, rather than the right one.

    Shouldn’t we use something like the share price of the company over subsequent rounds. Use that as a proxy to determine whether value has been created?

    Put in a hurdle over time, and if hurdle is met, founder/CEO keeps all options and even a parachute. If not, he’s like other non-performing employees…

  7. I couldn’t disagree more with the generalities and fundamentals discussed in this email.There is data that supports the reverse. Just look at Steve Jobs and Apple as a case study. Apple went through several CEOs after they kicked out Jobs and the company floundered. Then they had to bring him back and they are doing great. Every case is different and unique, and must be treated uniquely. I have personally found CEOs that were able to take it all the way from startup to IPO and beyond and those companies have done better than founding CEOs that have transitioned out of their CEO role.

  8. Furthermore, I truly believe that the energy and passion that is lost in companies that lose their founding CEO leads to their eventual decline or stagnation. They may do well for a while, but eventually they stagnate or decline. That is because they have no one to turn to at that point because they have lost their vision. Again, lets site another great example besides Apple. How about Microsoft? The list goes on.

  9. Seems like founding CEOs get screwed at every turn. More and more the startup scene seems like a sham. It really should be split up into different scenes with different goals for today’s ever increasingly aware environment and engagement. Those that want to flip and sell focus on that, make a widget make it profitable and flip it, passion or it. The CEOs that sign on for that experience are clear in what that experience end train is gonna be about, I mean that’s the cold hard logic of it yet humans are wildly passionate people and I don’t that’s as easily on/off as we’d like to think we can control. Meanwhile those that want to build for the itch of something with in, granted they aren’t as attractive to vc, can and do because the barriers are low, the risk can be ok and they dare on their own terms,profit or no profit. That may not be sustainable in the atypical biz light but they are chasing something else- and many companies today are built on the long term passion I dumno wtf I’m doing model ie a twitter etc, eventually models appear but the first game is grow and see.

    It sucks that founding CEOs are like dead weight to vc today, were the guys and gals building the next big dream out of nothing and we get this shafted disrespect for that. True CEOs builders of tomorrow don’t want a dime cause the dimes will come to them in time, they want their vision enabled simple as that.

    • I can hear your frustration. An idea, hard-work & passion of the entrepreneur is not just sufficient for creating a real business.
      We need to understand that VCs are in this business to make money for their investors and for themselves. They take money from various sources including pension funds, mutual funds, private equity, wealthy individuals, sovereign funds, etc. When they can’t demonstrate returns in a reasonable amount of time, then VCs are out of business and no one will lend them money again.

  10. Great comments – sounds like my post was slightly incoherent.

    Katherine – I’m old fashioned about revenues and profits as well, but there are venture funded companies that grow to >10 million users/subscribers and create a valuable company for someone to acquire. These acquiring companies then figure out how to make money from the user-base. Take a look at Union Square Ventures portfolio.

    JohnBasil – my bad in writing the post so you misunderstood it. I’m not advocating removing the founding CEO’s. Nor was the post about the value of keeping the founders in startups. The post was proposing a way to fairly compensate those CEO’s when the board decides its time for them to go.

    Yann – Completely agree that its hard to determine the right metrics. If it were me I would declare that you found a business model when a unit of sales/marketing dollars produces a predictable unit of revenue/profit/users, etc.
    I would shy away from share price over subsequent rounds as its more of a reflection of company hype, state of frothyness of the venture market, etc. It incents the wrong behavior.

    steve

    • Steve -

      I understand, but your post has some inherent assumptions in it that in my opinion have plagued the VC industry. The inherent assumption is that “founding CEOs have to go”. I claim this is why one reason (financing being the main reason) that one in ten startups are successful. As a successful entreprenuer myself, I was allowed to take the company all the way from founding to sale last year during bad economic times, and as much as I criticized myself and held myself accountable for everything, the company could not have prospered without me despite VCs that wanted me out. It’s all about control and I advocate that entreprenuers keep control for as long as possible since they know their business best.

  11. [...] Blank wrote a recent blog post about the role of a founding CEO is to find a repeatable and scalable process. If they do that they should get all their shares. [...]

  12. I hope my comments below has some relevance, since I am an entrepreneur and I am active within Boston based entrepreneur community.
    1. Entrepreneurs tend to become attached (emotionally & financially) with the company. Lots of their ego & pride plays into this. These aspects make it very difficult for them to let go of their control on the company.
    2. Entrepreneurs believe in being optimistic and show confidence about future prospects for their businesses. Hence they tend to make aggressive plans and over promise VCs on the schedule and deliverables. VCs tend to get control of the company when they sense that the plan is slipping out. Who does not like to protect their investments. Hence they fire founding CEOs. I don’t see this any way different from an entrepreneur firing an employee those who under performer and can’t deliver.
    After-all there is nothing wrong with investors thinking like a owner of the business.
    3. There are few reasons why only few founding CEOs continue to remain in the pilot seat. They grow with the company by acquiring new skills – ability to delegate, being a team player, demonstrate needed patience & crisis management, identify good talent & hire, team management & motive employees, understand basic financials, control on emotions & anger management, becoming a master sales person.
    4. Majority of entrepreneurs love to create something new & original. They love to build it from ground up. After working on an idea for couple of years, work should become routine and sometimes boring. At this stage entrepreneurs may turn out to be less motivated and hence less effective. VCs views such founding CEOs are the bottleneck and decide to eliminate them.
    5. VCs tend to think that founders are no longer required since product had few initial releases and they can have seasoned manager to take from there. Long-term product success is tied to it’s ability to constantly innovate and evolving. Hence remain essential for a client. This requires a good vision, curiosity and domain expertise within the company. Founders take with them when they leave.
    VCs realize this truth after they change few CEOs. Then they resort to recovering their investment. A quick sale is an easy out of such situations. When it become difficult to sell the company VCs don’t hesitate to cut their losses by shutting the company down. They have to focus on other ventures those have good future prospects.

  13. How do you determine that the founder has failed to find the repeatable business model (at what point is their effort considered a failure versus continuing their iterations towards the eventual successful model)?

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