Join hosts Michael Byrd and Brad Adatto as they delve into the tech start-up world and share the story of two Harvard roommates with a big idea. We walk through the legal lessons learned from the lack of hard conversations in this venture. Tune in as we discuss the importance of defining roles and responsibilities, compensation models, and setting realistic expectations when starting a business.
Listen to the full episode using the player below, or by visiting one of the links below. If you have any questions or would like to learn more, email us at info@byrdadatto.com.
Transcript
Intro: [00:00:00] Welcome to Legal 123s with ByrdAdatto. Legal issues simplified through real client stories and real world experiences. Creating simplicity in 3, 2, 1.
Brad: Welcome back to another episode of the Legal 123s with ByrdAdatto. I’m your host, Brad Adatto with my co-host Michael Byrd.
Michael: As a business and healthcare law firm, we meet a lot of interesting people and learn their amazing stories. Brad, this season’s theme is hard conversations.
Brad: Yeah, it is.
Michael: We’re going to take real client stories. Of course we’ll scrub their names and we’re going to build these stories around confronting and having hard conversations. They don’t all have great outcomes, but there are plenty of teachable moments.
Brad: Alright, Michael, what do we have in store for today?
Michael: Brad, we’re going to talk about a couple of sayings or truths that will definitely weave their way into today’s story. The first truth I want to share with you is money is the root of all evil. [00:01:00]
Brad: Of course. I’m sure everyone has actually heard this before, and Michael, as your friend, I’m here to help you take your money so you don’t have to associate with evil.
Michael: Brad, your generosity knows no bounds.
Brad: That’s true. Thank you.
Michael: That’s amazing. You’re such a giving person. Brad, the saying is not that money is evil.
Brad: No?
Michael: No. It’s that money is the root of all evil, so when our hearts get consumed by money, bad things tend to flow from this.
Brad: Okay. I think I need an example of this, please.
Michael: Okay, well I got Siri to give me some help.
Brad: Mm-hmm.
Michael: I’ve got a couple stories. In Ohio, at a fishing tournament, a fishing tournament director grew suspicious that a group of walleyes that were set to take first place in a fishing tournament weighed heavier than they looked, so the director dramatically sliced open the fish to discover that there were weights inside their stomach. The team that was set to win [00:02:00] $30,000 was caught cheating and they were disqualified.
Brad: Audience members, if you have not seen this video of this cheating team, go look it up cause when it was discovered, I’m surprised they made it out of there alive.
Michael: Oh no.
Brad: Yeah.
Michael: Well, let’s switch to the world of poker, Brad. There’s a viral video on Twitter, walking through a complicated step-by-step of how a poker player apparently rigged a winning hand to take a $265,000 pot. At the time of the article, more than 7 million people had watched the video.
Brad: Okay, well we’ve gone from fishing and poker and I guess these are other sports that we are discovering. Are you going to talk about some typing scandal next, Michael?
Michael: Well, Brad, you know, typing is one of the last remaining pure sports. It’s clean.
Brad: It’s clean?
Michael: Yes. Now it probably is cause there’s no money in typing.
Brad: Oh, okay.
Michael: Yeah. There’s been no scandals [00:03:00] in typing.
Brad: Okay.
Michael: To date.
Brad: That we know of, right?
Michael: Yeah. That we know of. Now, if I were to lose, I would investigate. Well, let’s switch to a more cerebral sport for you, Brad.
Brad: Mm-hmm.
Michael: In the world of chess, a 19 year old beat a world champion for a $350,000 prize.
Brad: Geez.
Michael: The 19 year old was accused of cheating, and now has been accused of cheating over 100 times.
Brad: Yeah. I actually read this article also and, you know, the accusations against this 19 year old on how he cheated, if correct, Michael, some people could consider foul play.
Michael: Yes, Brad. Yes, so now we’ve got a couple of examples of when people get kind of wrapped up in money, some really bad decisions they make on cheating. Let’s move on to the second truth that will weave its way into the story today.
Brad: Okay.
Michael: Comparison is the thief of Joy.
Brad: Oh yes, Michael. You know this one really well. [00:04:00] I keep telling you, Michael, stop trying to compare yourself to me.
Michael: Brad, I’m striving to have your level of humility. I mean, between your self-proclaimed humility and your generosity, I just can’t help but compare myself. I need to stop.
Brad: Yes.
Michael: But it’s amazing. Seriously, Brad, it is not about us and we see this one, comparison is the thief of joy play out all the time. The most common scenario, for me, is when I hear “no fair” from one of my kids.
Brad: Yeah. “It’s not fair” is like nails on a chalkboard to me. However, I didn’t hear this one until I moved here and your response you give your kids is really one of my favorites.
Michael: Oh, yeah. In our house there’s only one fair. It’s the State Fair of Texas that comes in September.
Brad: Yeah.
Michael: Yeah.
Brad: That’s a good one.
Michael: Too bad it doesn’t work, but it makes me feel good.
Brad: Yes, it does.
Michael: Okay. Well, so [00:05:00] this comparison issue, actually it’s not today’s story, but also this played out recently with a client of ours. I had a retina surgeon that was negotiating his new employment agreement in conjunction with this practice being acquired by private equity. He wasn’t an owner, so he was just an employed physician, but he had some leverage and we were able to successfully negotiate a $500,000 increase in his compensation package.
Brad: Nice.
Michael: Our client’s goal was a $200,000 increase, so he, as you might imagine, he was ecstatic, well, at least initially.
Brad: Oh, oh no. Initially is a bad word there, Michael.
Michael: Yes, Brad. He found out that one of the junior physicians, younger than him had received a $350,000 increase. Now, my client felt much more valuable than that. Much more than the $150,000 delta that was in play there. He started comparing [00:06:00] and was not happy with his own increase and really started spiraling towards almost blowing the deal up. Thankfully, I was able to kind of refocus him back into reality and what his own goals.
Brad: Alright. Well, with these stories in mind, Michael, I’m looking forward to hearing how this connects to today’s hard conversation.
Michael: Alright, well, let’s jump into today’s story. Today our story, Brad, is set in the tech startup world. We have two college roommates who went to Harvard with a big idea.
Brad: Oh, Michael, are you about to tell us the Facebook story?
Michael: This story actually took place during the Facebook startup era. I don’t know if they even overlapped with those kind of famous people, but today is not an OPP season, so we’re going to be talking about a different story.
Brad: So are you saying that Harvard might graduate people with really great ideas?
Michael: Yeah. Yeah.
Brad: Yeah. Okay.
Michael: It’s funny how that [00:07:00] works. Yeah. Harvard does tend to do that.
Brad: Got it.
Michael: Well, we’re going to call these bro roommates from Harvard, Matt and Ben.
Brad: Okay. Random, generic names. What’s up with the names? I feel like you’re going to trap me somehow here.
Michael: Well, the first thing I think of when I hear Harvard is the movie, Goodwill Hunting. The stars of the show were actors, Matt Damon and Ben Affleck.
Brad: Yeah, neither of them in the movie actually went to Harvard, Michael, Ben’s character worked in construction, Matt’s character worked in construction, and eventually did attend MIT.
Michael: But Brad, did you know that Matt Damon, in real life, attended Harvard? I felt like that was a close enough connection that you would approve the names.
Brad: Alright. For the sake of our audience, I’ll accept the names so we can get onto the story and more importantly, I’ll try to keep my Goodwill Hunting quotes out of the podcast, but Michael, you like Apples?
Michael: Don’t do it, Brad.
Brad: Well, I got her number. How do you like them apples?
Michael: Brad, I have to [00:08:00] learn to accept that you cannot not insert famous movie lines.
Brad: Alright.
Michael: Let’s get back to today’s story. Matt and Ben were in an entrepreneurship class together at Harvard, and they teamed up on writing a business plan for one of their major grades for the semester and Brad, they crushed it.
Brad: Nice.
Michael: They got an A in the class and they actually got recommended to enter their idea in a national competition.
Brad: Alright. Well, what was their big idea?
Michael: It’s funny, I don’t actually remember.
Brad: Oh no.
Michael: It was a medical technology type invention.
Brad: Okay. Random.
Michael: But because of the rest of the story that played out, it was really not an important part of the story.
Brad: Oh no. Riley, we might be needing you to cue the dark music here.
Michael: No, not yet. Not yet, Riley.
Brad: Oh okay.
Michael: It was all bros and good vibes at this point in the story.
Brad: Okay. Okay.
Michael: Matt and Ben won the national competition and they received a $100,000 prize as seed capital for their business plan.
Brad: Nice. That’s some good cheddar. [00:09:00] Maybe even better than apples.
Michael: Oh, Brad, just back off. You’re really, you’re getting too close to the sun right now.
Brad: Okay.
Michael: Okay. They graduated about the same time and they decided to start the business with the seed capital.
Brad: Yeah.
Michael: Through a friend of a friend they called me to help them start their new venture.
Brad: I’m guessing you walked ’em through the four C conversations to make sure they were aligned.
Michael: Well, I guess we need some context, Brad. Let’s reset. We’ve talked about this in past shows regarding the four Cs and it’s that the four Cs are an internal term we use to, really more than anything, help people find alignment partners that are going to own a business together and our belief is that if they can be on the same page on these four areas, that the chances of them being on the same page, and more importantly, not being on the same page is significant. So we have [00:10:00] cost, compensation, control, and contingencies. Cost is all about what kind of capital are we putting in and what are we getting out of it? Compensation is what does our arrangement look like together once we’re co-owners in this business and we’re running the business together, and how is that set up as far as profits and salary and all that sort of thing? Control is all about decision making and contingencies is kind of like the prenup, the what ifs.
Brad: Yeah, so Michael, is it time now for Riley to cue the dark music?
Michael: Well, yes.
Brad: Okay.
Michael: I did strongly recommend a four C conversation, Brad, and they declined so Riley, you can cue the dark music. I talked about the importance of having the hard conversation with each other at this time because it was, as you know, bros that were happy and I was like, look, I know you don’t want to think about anything [00:11:00] negative or hard that could happen down the line, but you want to work these things out. Well, Matt and Ben explained to me that they were bros and did not need that kind of formality at this stage. They wanted to get started and they would deal with the quote paperwork when they did their $5 million friend and family round after they got things to the right point of development.
Brad: Wa wa waaa. I’m starting to have bad feelings about this, Michael. It sounds like they did not put their big bro pants on and they didn’t have this hard conversation. They elected the rose colored glasses strategy where everything is rainbows, cotton candies, and puppy dogs.
Michael: Oh yes, Brad. Yep, bros forever. They were going to be 50/50 owners and split everything and they would work out the details as they arose.
Brad: I’m guessing because the story today, and we haven’t heard that they had a hard conversation, things may have not gone according to [00:12:00] plan or in this case, lack of plan or lack of paperwork.
Michael: Yes. Gold star for Brad. Riley, make sure you put it on Brad’s sticker chart.
Brad: Yes, please.
Michael: You’re exactly right, Brad. The first phase of the business actually was product development on the underlying in invention and Matt was working 12 to 14 days on the actual product itself.
Brad: Yeah, that makes sense. So what was Ben during this phase?
Michael: Well, Ben was more the business guy and he’s actually the big reason they won the competition in the first place. Ben wrote a killer business plan, leveraging the big product idea that had originated with Matt.
Brad: Did they have any employees or office or other kind of overhead?
Michael: No. Great question. They had this $100,000 and decided that they would work out of their homes. They both actually moved into their respective parents’ homes after graduation. They didn’t want to have any overhead other than product development and applying for patents. [00:13:00]
Brad: I’ll give a little context to your audience. Patent applications are very time consuming. They can be very expensive. One patent application can go anywhere from $20,000 to $40,000 to get it going. Full disclaimer, our firm does not do patent applications. We do work with other people that do this and some of our data numbers might be a little outdated.
Michael: Yeah. Nevertheless, the $100,000 was spoken for amazingly fast. Ben really did not have a ton to do during this first six months. Around the six month mark, it was time to go raise the $5 million friends and family round. They had patent applications in process and they had moved the ball sufficiently on the product development side.
Brad: Yeah. Well, Michael, other than skipping this hard conversation, it sounds like things were going great.
Michael: Brad, even they would’ve said at this point that things were going great. However, there was a crack in the relationship that was created by these [00:14:00] kind of unspoken communications when they kind of ignored things and when the rose colored glasses were out. Matt and Ben did not realize this at the time, but the comparison is the thief of joy truth was kind of starting to expand this crack.
Brad: Okay. I think everyone, including our audience is curious. What happened?
Michael: Well, Matt was doing the heavy lifting, and though he knew there would be work to do later by Ben, he noticed that Ben was going out most nights with their college buddies while Matt was working way late. The no fair feeling was growing some momentum, but not communicated by Matt to Ben.
Brad: Uh oh. So some undercurrents are developing here. How did that impact the fundraising?
Michael: Well, great by any standards for 2, 22 year old bros, brilliantly.
Brad: Oh good.
Michael: Yeah. They had three and a half million in commitments in the first month. [00:15:00] It was amazing. They actually were sailing into the Christmas break with 4 million in commitments and they were pretty sure they could raise an extra 3 million to extend their runway. They used the holidays kind of to re-look at their business plan and look at the runway to assess whether to modify the raise to 7 million.
Brad: That’s incredible and audience members, rarely do you see a group on their first private offering get such a high commitment that quickly and even have potential over subscription.
Michael: Oh yeah. It’s amazing. I mean, they both had wealthy families and wealthy friends of the family, so this did help them create some initial momentum to get the ball rolling. They were quickly going from, you know, cash strapped living in their parents’ homes to flush in no time. In fact, in their business plan, built into it was a $400,000 pool set aside for compensation for the two of them [00:16:00] after the close. Unfortunately, Brad, the crack was about to split open.
Brad: Oh, no. I feel like I should be covering my eyes. I don’t want to see this train wreck.
Michael: Yes, Brad. The other truth, money is the root of all evil was about to come to play. Matt, while carrying these no fair feelings started seeing lots of green when all these commitments started coming in, and he went into one of those, what we know is really bad, you know, brain loops, internal conversations are never good, and he is having one of those that probably went something like this. This is my invention and it’s going to be worth hundreds of millions of dollars. Ben’s not carrying his weight. He’s out partying with my friends and I’m here doing all the work. I need to deal with this now before we get too far down the road.
Brad: Please tell me he did not act on these thoughts with over 4 million in [00:17:00] commitments.
Michael: Brad, cover your eyes. Riley, cover your ears. Money is the root of all evil, Brad. There was nothing wrong with the 4 million in commitments. Nothing wrong with the money, so you don’t need to get my money as we talked about earlier. The evil was in the choices that Matt, and actually after that Ben made. Matt approached Ben to discuss compensation. He decided that it was fair for him to receive $300,000 and Ben to receive $100,000 post-closing.
Brad: Did Ben kind of work through and communicate his thoughts with Matt?
Michael: Yeah, I mean, fair question. Ben had a chance to work through this and get things back on track, but he went a different route Brad.
Brad: Oh no.
Michael: He decided to vent with his family.
Brad: Oh no.
Michael: And his family was responsible for about a million and a half in the commitments, not to mention the introductions they made to their friends [00:18:00] and his family was biased towards their sweet, brilliant award-winning child. Ben, fueled by the encouragement about how awesome he was, went hard at Matt. The situation escalated. The investors all eventually caught wind. Actually, it was pretty fast. It was actually like a barn catching on fire. It was that fast, and every single investor backed out, Brad. Wow. Matt and Ben, not surprisingly broke up and to this day, nothing ever happened with this business.
Brad: Ugh. So close yet so far.
Michael: Let’s go to break and talk about some lessons to be learned from Matt and Ben.
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Brad: Welcome back to Legal 123s with ByrdAdatto. I’m your host, Brad Adatto. I’m still here with my co-host, Michael Byrd. Now Michael, this season our theme is hard conversations. Now, Matt and Ben learned that rose colored glasses strategy doesn’t really work with their partnership or generally with each other. They believe they’ll be all good, seeing that they’re bros forever and all and they could just talk through anything. In other words, they didn’t really have any hard conversations.
Michael: Yeah. I mean, it’s a pretty common scenario that we see. Everyone [00:20:00] is excited and optimistic at the beginning. To kind of recap, you know, Matt and Ben graduated from college, they had a hundred thousand dollars set aside to start their business, and they had had nothing but unexpected momentum from their last semester class with this business plan that they had ended up putting together. They didn’t communicate well with each other and that’s created a fracture. So as you know, Matt was working hard on his part of the the product development side of things and Ben was lying low. Some fractures started to kind of develop, and we didn’t talk about this a lot, but when it came to the fundraising side, Ben actually was back at it. He was the big reason they were so successful in raising all that money so quickly, but there was a disconnect that was starting to happen and a [00:21:00] little bit of greed with the amount of money. They were starting to believe their own stuff. It didn’t have your level of humility, Brad, is what I’m trying to say.
Brad: That does help a lot.
Michael: Yes and things went bad quickly, but let’s pause and take a step back and catch our audience up on some of the legal issues raised with this story.
Brad: You know, Michael, you kind of addressed this in a story earlier on when, you know, we’re working with our clients, we have to help develop their corporate documents and often we use this internal tool that we reference as the four Cs and it really does help let our clients really focus on really the important elements of developing a great customized plan for what they need to happen. I know you mentioned it earlier, maybe just a quick refresher of what the four Cs are.
Michael: Yeah and we’re going to camp out on the C that was the problem here, but a reset is that you have the cost, [00:22:00] compensation, control and contingencies are kind of these four areas that you want to get alignment on when you’re going into a partnership with somebody.
Brad: Yeah, no doubt. Now, as you said today, you know, the focus is, and as you and I both know, ccompensation drives a lot of stuff right? So it’s an important element, as in the four Cs, what are some of the compensation considerations to consider when you’re having these conversations?
Michael: Yeah. I mean, and it’s more than the compensation. It’s all about roles and responsibilities.
Brad: Yeah.
Michael: So think about it this way cause Matt and Ben illustrated this greatly, they figured out that they were going to be 50/50 partners and that part was easy for them. It’s not always easy, but for them, that was the easy part.
Brad: Right.
Michael: But they didn’t think about the fact that once the business is going, they’re going to have to be spending their time doing stuff and so part of what setting compensation [00:23:00] does is it also brings out a conversation about who’s going to be doing what. I mean, if it was understood on the front end that Ben was not going to be expected to be working hard, but that he was going to be expected to be the leader on the 5 million raise, perhaps Matt wouldn’t have started getting those, you know, built up feelings at the beginning, or they would’ve worked through it if they would’ve had that conversation. The real kind of point to what drives that is, you know, if they have two different roles, are they still going to split things 50/50? Are they going to be paid for their time during the day that they’re doing their day jobs? Is it going to be equal? I mean, you know, they kind of assumed because they were 50/50 owners that it was going to be equal until all of a sudden at the very end Matt was thinking, oh well you know, I actually think I should get 300 grand and you should get a [00:24:00] hundred and that blew up the whole thing cause it was way too late at that point.
Brad: I think a lot of people don’t realize, in a business there’s so many different hats to be worn and we’ve talked about this in other shows, but you know, in this particular case, you could have owners being 50/50. That’s hat one. I’m just an owner. Well, hat number two is one person could have an actual paid job inside of this business where they’re paid for their work performance while another person doesn’t get paid at all. So in this case, you know, it could have been that Matt gets paid while Ben doesn’t get paid anything because he just happens to be an owner and one person takes a salary, another person doesn’t, or even one person’s, the officer, the face of the business, the CEO that goes out and helps develop the business, and that’s part of his job and responsibilities while the other person is on the engineering side, and that compensation can be different, but at the end, if they sell it for hundreds of millions of dollars, they’re still 50/50. Having [00:25:00] those discussions about what are those expectations, what are the roles that you plan to do, is going to be so helpful and understanding those hats that they’re wearing can be different and not get too caught up in it, but again, that’s probably why that fourth C on comp is so important.
Michael: And you introduced investors that they were coming into it, and that’s a big part of the equation.
Brad: Yeah.
Michael: First, you know, how are you holding yourself out to the investors? I mean, this is a friends and family round.
Brad: Yep.
Michael: Ben was going to his parents to raise money and get the initial momentum going. That was a really important role, and I’m sure they wanted their prized son to be compensated equally and so whether they did that or not, they should have talked about that, but here’s where the, even more importantly, where the investor considerations come in, what is your comp model going to be? Because the investors are going to put a bunch of money in and they don’t, of [00:26:00] course, want the two founders taking all of it out in terms of salary. So you have to look at a compensation system for the, not just the employees, but the founders and, you know, there’s different ways, there are different models to look at it. There’s, you know, one that we call like the enterprise model, which is really built around hey, what’s a fair compensation for the role?
Brad: Yes.
Michael: Regardless of who’s doing it.
Brad: Yeah.
Michael: But, we’re trying to generate profits here that are going to be distributed and of course, with investors that tends to be the model that you’re going to be in.
Brad: Yeah.
Michael: When you start getting into small businesses, especially in professional services, you’ll have one where it’s more of an eat what you kill model. It’s like, hey, you know, you’re going to go out and you’re going to be generating revenue by providing these services, and I’m going to be doing the same. I want to get paid for what I generate. You want to get paid for what you [00:27:00] generate, and that’s going to happen, but we have to figure out a way to share overhead. Now there’s not a lot of profit left over when you go that model, but that’s still something that they need to talk about. Then finally, you can have the, you know, what we call the communist model, which is kind of inadvertently where they went by not talking about it because it’s the, we’re bros, it’s all good. We’re going to share everything equal. Of course, how it usually turns out under this model is what happened with them which is, you know, they weren’t on the same page about roles and responsibilities. It actually, for our clients that do have the communist model, becomes even more important for great communication on roles and responsibilities.
Brad: Totally agree. So what happened with Matt and Ben?
Michael: Well, I lost track about five years ago. They lost a friendship over this incident and both went from the entrepreneurial [00:28:00] route to becoming employees of companies.
Brad: Yeah.
Michael: They’re both good people and it was probably due to maturity as much as anything that they failed to have this hard conversation with each other. So, Brad, any final thoughts as we wrap up today?
Brad: Yeah. Unfortunately, you know, you and I are really too familiar with these kind of stories. When you start up a business, understanding the duties of each owner and understanding the impact the comp will have is extremely important much like the different hats we just talked about, the owners can wear. It can impact your compensation that the owner versus operator, and there can be big swings and time and energy and compensation, but by skipping that hard conversation, it rarely works out at the end and that’s why it’s so important to have in the beginning. So, Michael, final thoughts?
Michael: Yeah, I mean, the two truths we talked about today, all of us, every single person has been impacted by them at some point or another. Again, [00:29:00] it’s not that money itself was bad, but when our hearts get set on the money, it could cause us to make some really bad decisions. We just can’t, as humans help from trying to compare ourselves and it robs us of our joy and I’ll say the one thing that you can do to flag whether either of these are happening is if you start having that internal dialogue and that loop going on and you’re working yourself up, it’s likely there’s some really unhealthy things happening and you want to figure out how to manage that and get control of it before you make some bad decisions.
Brad: No doubt about that. Well, audience members next Wednesday’s show we discuss hard conversations, control, who gets to make what decisions on behalf of your business and practice.
Outro: Thanks again for joining us today, and remember, if you like this episode, please subscribe. Make sure to give us a five star rating and share with your friends. You can also sign up for the ByrdAdatto newsletter by going to our [00:30:00] website at ByrdAdatto.com. ByrdAdatto is providing this podcast as a public service. This podcast is for educational purposes only. This podcast does not constitute legal advice, nor does it establish an attorney-client relationship. Reference to any specific product or entity does not constitute an endorsement or recommendation by ByrdAdatto. The views expressed by guests are their own, and their appearance on the program does not imply an endorsement of them or any entity they represent. Please consult with an attorney on your legal issues.
