Update: Also see our 40-minute interview on this topic.

Picking a co-founder is your most important decision. It’s more important than your product, market, and investors.

The ideal founding team is two individuals, with a history of working together, of similar age and financial standing, with mutual respect. One is good at building products and the other is good at selling them.

The power of two

Two is the right number — avoid the three-body problem. Think Jobs and Wozniak, Allen and Gates, Ellison and Lane, Hewlett and Packard, Larry and Sergei, Yang and Filo, Omidyar and Skoll.

One founder companies can work, against the odds (hello, Mark Zuckerberg). So can three founder companies (hello, @biz, @ev, and @jack). In three founder companies, the politics can be tough — gang-up votes, jockeying for board seats, etc. — but it’s manageable. Four is an extremely unstable configuration and five is right out. When 4-5 founder companies work, it’s because two founders dominate.

Two founders works because unanimity is possible, there are no founder politics, interests can easily align, and founder stakes are high post-financing.

Someone you have history with

You wouldn’t marry someone you’d just met. Date first. Guess which pair of famous co-founders is in this photo:

Go through something difficult, like a Prisoner’s Dilemma or a Zero-Sum Game. If being ethical was lucrative, everyone would do it!

One builds, one sells

The best builders can prototype and perhaps even build the entire product, end-to-end. The best sellers can sell to customers, partners, investors, and employees.

The seller doesn’t have to be a “salesman” or “business guy”. He can be technical, but he must be able to wield the tools of influence. Bill Gates and Steve Jobs aren’t salesmen, but they are sellers.

Aligned motives required

If one founder wants to build a cool product, another one wants to make money, and yet another wants to be famous, it won’t work.

Pay close attention — true motivations are revealed, not declared.

Criteria: Intelligence, energy, and integrity

It’s not the kid you grew up next to. It’s not the person you like the most. It’s not the hacker most willing to work for free.

It’s someone of incredibly high intelligence, energy, and integrity. You’ll need all three yourself, and a shared history, to evaluate your co-founder.

Don’t settle

If it doesn’t feel right, keep looking. If you’re compromising, keep looking. A company’s DNA is set by the founders, and its culture is an extension of the founders’ personalities.

Pick “nice” guys

Avoid overly rational short-term thinkers. There are bounds to rationality. Partner with someone who is irrationally ethical, or a rational believer that nice guys finish first. Be especially careful with the “sales” guy here.

What you don’t know

Business founders who don’t code use bad proxies for picking technical co-founders (“10 years with Java!”). Technical founders who don’t sell also use bad proxies (“Harvard MBA!”). Learn enough of the other side to have an informed opinion. If you’re not seriously impressed, move on.

FAQs

What if the right guy already has his own startup? Convince him to work on yours part-time — he’ll drop his idea once yours gets traction.

Breakups are hard

If you’re going to fall out with your co-founder, do it early, recover the equity into the option pool to keep the company going, and recruit someone else great to fill the missing slot. Build in founder vesting (a.k.a. the “Pre-Nup”) to keep the breakup from getting messy. Building a great company without a partner is like raising kids without a…

Nearly everything I’ve written on this topic applies to dating and marriage. Coincidence?

Go forth and multiply.

Update: Also see our 40-minute interview on this topic.

This post is by Naval Ravikant. If you like it, check out his blog and Twitter.

Thanks to Atlas Venture for supporting Venture Hacks this month. This post is by Fred Destin, one of Atlas’ general partners. If you like it, check out Fred’s blog and tweets @fdestin. And if you want an intro to Atlas, send me an email. I’ll put you in touch if there’s a fit. Thanks. – Nivi

If you believe the blogosphere chatter, the entrepreneur-VC relationship seems strained like at no time in the past. The discussion seems to veer towards the “good versus evil” myth of creepy financiers intent on screwing polymath entrepreneurs out of their hard-earned wealth. Good-versus-evil is not a very constructive way of framing complex debates (remember “the war on terror” and the “axis of evil”?). Most sour VC-entrepreneurs relationships are simply partnerships gone bad, and divorce is never a pretty experience.

I see a lot of misguided commentary out there focused on the wrong issues, such as “how can you ask for liquidation preferences and call yourself entrepreneur friendly?” I am happy to answer that one if you are interested.

What I wanted to do here instead is focus on a few of the clauses that entrepreneurs should absolutely avoid; the wrong tradeoffs which later expose them to really “losing” their company. There are rational explanations for all of these, but as we know hell is paved with good intentions. Here are some of the pathways to hell:

Now we own you: Full ratchet anti-dilution

Anti-dilution says “your company has no tangible value and as result I accept 20% ownership today but if we don’t create value I want some protection on potential share price reduction”. This protection is embodied in a clause called anti-dilution protection which results in additional “bonus” shares being issued where there is a down-round, i.e. a subsequent financing at a lower price per share. You can attack this clause conceptually but if VCs did not have any form of anti-dilution they would set the initial price lower. In other words, you as entrepreneur are getting less diluted today but with some ownership risk if company value goes down (at least that’s the theory, would be interesting to see how prices adjust without anti-dilution).

Anti-dilution is usually mild. Broad-based weighted average anti-dilution says that a number of anti-dilution shares are issued (or the conversion price of the preference shares is adjusted) based on a formula nicely explained by Brad Feld back in 2005.

Here is how you can get really screwed: there is one version of anti-dilution whereby the number of shares issued to the investor is FULLY readjusted if subsequent financings are downrounds. Say you raise $1M at $10 per share and hence issue 100,000 shares to your VC, in exchange for 10% of your company. The next round is at $5 per share; the original VC now gets an additional 100,000 shares issued; in the original cap table, he now owns 20% of your business, before the new money comes in.

This gets nasty when serious money has been raised. Imagine the following happens: the pre-money valuation on your next round is less than the cash you raised previously. Say your company is in difficulty and raises $10M at $10M pre-money, having raised $10M previously. Because the anti-dilution calculation is iterative, guess what, the share price mathematically converges to… zero. Legally it will be set at the par value, say €0.0001.

Your ownership just evaporated.

If your VC understands how the world works, you will sit around the table and hammer out some deal. But your negotiating position is weak. If on top of that a new CEO has been hired, the rational optimisation is to keep as much equity free for the new sheriff in town and not for the original entrepreneur. You are now relying on people’s ethics, sense of fairness, or belief that long-term you don’t build venture firms by screwing entrepreneurs. In, say, 75% of cases, good luck — few people really believe in win-win in these situations.

Note that there is usually a shared responsibility in full-ratchet: the entrepreneur is obsessed with maximising the headline number and accepts anti-dilution as a tradeoff (“OK, I will agree to this silly price but you better not screw up”). Often a Pyrrhic victory.

“Thank You and Good Luck”: Reverse vesting without good leaver clause

First, let me state that reverse vesting matters to me. I would not do a deal without some form of reverse vesting. Here’s why: I invest in three founders, two of which work hard and one of which decides to leave to open a restaurant. I (and his co-founders) are screwed. The guy or girl who left gets a free ride on the back of everyone else. He needs to be replaced, for which additional stock options are required. This is why reverse vesting exists.

The usual reverse vesting that you will find in our term-sheet is: quarterly reverse vesting of founder stock over 4 years. This is watered down or adapted based on individual circumstances.

I have seen cases where reverse vesting is not qualified: you leave the company, you lose your stock. That is a very toxic clause, and you should never accept it. You are now fire-able at will and there is even an economic incentive to do so. Unfair and abusive.

So don’t find reverse vesting per se, but fight on the details. Can a percentage of your stock be considered yours? Probably. Make sure there is a good leaver / bad leaver clause. You get fired for cause, you lose some. You decide to leave, you lose some. The company decides it does not want you around anymore, you keep it. The need to be watchful of the details; sometimes you will be asked to sell your stock at “fair market value” when you leave, or at last round price etc. Negotiate hard.

Continued in Part 2 with limited exercise period options, multiple liquidation preferences, cumulative dividends, and the trap of complexity…

If you like this post, check out Fred’s blog and his tweets @fdestin. If you want an intro to Atlas, send me an email. I’ll put you in touch if there’s a fit. Finally, contact me if you’re interested in supporting Venture Hacks. Thanks. – Nivi