Business Law and its Crucial Role for Entrepreneurs

Using a case study on how a startup discusses equity splits and ownership at the earliest point in time, Margo Reder illustrates the importance of business law in the entrepreneurship process

Aoi has a great idea for an app.  She begins development, sketches, and designs a rough prototype.  She asks her friend Bhavin, a talented coder to help with the project, and suggests he can be a co-founder with her.  Bhavin revises all coding, changes everything aspect and creates a better user experience.  Plus he is studying for an MBA.  But the app gets no downloads, no business.  So they ask Cooper, an undergraduate marketing major, to work on solving the customer adoption challenge.  Aoi pays Cooper an hourly rate out-of-pocket, and does not think he should be a co-founder because he started so much later.  Cooper works hard, writes both business and marketing plans, makes key changes to the app, suggests additional features, develops strategic partnerships and then executes.   The app is now an astonishing success.  Cooper thinks he should be a co-founder and receive equity.  There is no paperwork.  Ownership of this app must be worked out before the founders can seek money from investors.  How should ownership equity in this startup be divided?  And who can be considered a founder?  Since Aoi had the idea, should she receive 50% of the equity?  Since Bhavin upgraded everything, should he receive 25% of the equity?  What about Cooper?  His contributions made everything “click” into place and without his contributions, there was no revenue.  

This is a classic startup story, similar to the earliest stages of Snapchat, Facebook, Tinder, Square, Skype, and so many more, in which founders feverishly pursued development work that raced ahead of documenting paperwork or even a basic confirmation of terms among the founders.  

In many startups, team members are there right at the beginning.  Others start later.  Still others stay for awhile and leave to pursue something else.  Who is a founder?  Who is responsible for the key work? Is there any creative work, or inventions to patent (these are actually owned by the individuals until assigned to the startup).  How should the parties resolve these matters?  

Clarification is critical on these questions for the startup cannot make contracts, incorporate, receive funding and so forth, until these matters are resolved.

Let’s focus on what has each contributed thusfar and what are their goals, how to split ownership percentages in the startup, and who makes the decisions?  While there are a number of other considerations, this is the first round of questions to tackle. 

In making a brief assessment of their contributions, while Aoi was there at the beginning, contributing the idea, sketches and prototype, her early contributions diminish in value over time. Bhavin worked on coding the app and made clear improvements.  Finally, Cooper’s later-in-time cross-functional integrated work seemed to “tie all the pieces together” and only then did the app gain traction.  

On the first point, founder status is linked to closeness in time that work started, but there is no firm rule on this point. While Cooper started later, his request for co-founder status is not out of the question since he was a key participant in the earliest successful iteration of the app.  As this work was collaborative and iterative, it’s difficult to come to a firm conclusion on relative value of their roles, and most individuals tend to overvalue their contributions.

On the second point, how to split ownership and agree to decisionmaking power, the parties’ frank appraisal of their contributions, their future career goals, and their talents, are all part of the discussion.  Aoi would reason she should be the decisionmaker since she was the earliest participant and had the vision for the app.   Bhavin might assert he should be the decisionmaker since he has superior coding experience, and is gaining management training.  Cooper might challenge this since he brings many skills, although he is still an undergraduate, and unsure of long-term career goals.  In this case, all three participants could be considered co-founders, and it would not be surprising for Aoi to demand a majority of equity in the startup and decisionmaking power.  

The equity split and corresponding decisionmaking could conceivably be Aoi is the decisionmaker and owns 40% of shares in the startup; Bhavin: 25%; and Cooper: 10% (with the remaining equity reserved for talent and investors).  Attorneys do not guide this discussion, but thereafter prepare supporting paperwork and documentation based upon the participants’ understanding.  In a subsequent post, we will consider what happens to the equity in the startup if one of the co-founders wants to leave or becomes impaired.

Margo E. K. Reder is Lecturer in Law at Boston College’s Carroll School of Management, on faculty of the Shea Center for Entrepreneurship and teaches Law for the Entrepreneur. 

Her co-authored textbook, Business Law for Entrepreneurs is out now.  The material featured above is covered extensively in Chapter 1 of the textbook.

Request your examination copy now.