Pitfalls in Startup Equity Allocation

Typical Cases:

• AcFun: Investors forced out the founder and replaced seven CEOs.
• Kungfu Fast Food: The brother-in-law sent the founder to prison.
• Douguo Recipe: A co-founder was forced out and had to keep track of the company via social media updates.
• Chunyu Doctor: The sudden death of the founder left unresolved equity issues.

Key Takeaways:

• Always plan for the worst outcomes and document them in agreements. After drafting agreements, consult a lawyer for revisions. If necessary, invest in professional legal services.

• Equity distribution should be fair and reasonable, ensuring that founders feel satisfied during the allocation process. This allows them to focus on growing the business rather than dwelling on perceived inequities.

• Founders must confront their own motivations and desires honestly. Trust within the team is easier to establish when everyone is upfront about their intentions.

• The most critical agreements on equity and stock options often aren’t with financial investors. These investors rely on lengthy agreements to safeguard themselves due to their limited influence on governance and post-IPO management.

• Technical co-founders: Choose wisely. Once equity is distributed, small shareholders cannot easily be removed. Ensure everyone contributes financially, as financial commitment often aligns with greater responsibility.

• Beyond financial investors, all shareholders should take charge of specific business areas. If a segment underperforms, the corresponding shareholder should exit, potentially with a premium buyout. Alternatively, the company can replace the leader for that segment, transferring equity to the new appointee. Discuss terms with technical co-founders in detail. Business co-founders are usually more flexible. Major business partners should not hold other jobs.

• Every individual must sign a non-compete agreement.

• When shareholders are numerous, consider equity trusts. Chinese law now recognizes the legal rights of true shareholders, even if their names are absent from the registry. Agreements confirming the identity of the true investors protect their rights. However, forming a partnership is often the best option.

• Sign a unanimous action agreement to ensure company operations continue smoothly when major decisions encounter dissent.

• “Building relationships” is crucial: Pay attention to the emotions and daily lives of minor shareholders and colleagues. Help solve their problems when possible.

• Industry veterans: Avoid granting shares to experienced professionals with industry resources who participate part-time. Their resources may not benefit the company, and their eventual exit can complicate matters.

• Valuation issues: Valuation impacts both the funds raised and the equity percentage allocated.

• Board seats: Decide early how many seats to allocate to future investors, and clearly document this in the first investment agreement. The number of board seats should always be odd.

• Small companies can operate informally, but proper governance becomes essential as they grow.

• Proportion allocation: Negotiate and decide on reasonable equity proportions.

• Avoid reserving stock options upfront. Instead, reward current contributors by giving them substantial equity stakes. Distribute options later if exceptional talent joins the team.

• Equity allocation must include vesting agreements to ensure meaningful distribution. Vesting allows equity to be earned progressively over a founder’s tenure with the company.

  For example, equity can be vested over 4–5 years. After the first year, 25% of the equity is vested, with 2% vested monthly thereafter. This structure protects the company and its team. Founders rarely stay together for 5–7 years. Often, one or more founders leave for various reasons. Without vesting, scenarios like a co-founder returning after five years to claim 25% equity despite minimal contributions could arise.