An Objective Approach to Dividing Equity
Founders have a laundry list of important decisions to make about their new business. Not to be overlooked is division of equity.
How founders decide to divide the equity at the beginning of the business will have long term consequences for the success of the venture. Often, founders lack an objective method to distribute equity. Instead, they shoot from the hip and arrive at an allocation that they think makes sense, but that doesn’t have a mathematical or fiscal justification.
Equity division should be approached systematically, so the founders can discuss it rationally and arrive at a good and fair balance. Objectivity avoids any lingering bitterness or resentment for an “unfair” equity allocation later.
Two Commonly Used Allocations
These two allocations are common among new business ventures, but that doesn’t mean they are right. On the contrary, founders often choose these path(s) for no other reason than they are easy to implement. Unfortunately, the business is fitted to the allocation rather than the other way around. In other words, the allocations are artificially imposed on the business without any regard to the facts on the ground.
This is where one founder holds 90% or 95% of the equity and the other founders each hold 1% or 2%. Because it takes a team to build a company, this doesn’t work. Why? One word: dilution.
The founders may all agree initially to this division, but the co-founders that hold micro-equity will eventually realize that, after a couple of rounds of investor dilution, they’ll hold nothing of significance and decide the startup isn’t worth their time and risk. The grant of micro-equity doesn’t garner their commitment and contribution.
The founder that holds the mega-equity pushes for this allocation because he’s intent on owning a majority of the stock (i.e. control) after investor dilution. Having done the math, he sees that, without a super majority of the equity at startup, he’ll be a minority shareholder after investors come into the picture.
This isn’t a real problem because of the way equity financing is structured. Investors will require limits on management even where the founders have majority control of the company. So, in effect, holding a majority of the stock offers no benefit.
Instead this lopsided allocation just leads to a premature death of the startup.
All Are Equal Allocation
Another too-common (and equally problematic) method of dividing equity is where all founders have an equal share of the company. Each founder’s initial equity percentage is determined by a simple equation: 100 divided by the total number of founders.
Founders choose this allocation because no difficult conversations are required. Instead, only the math needs to be done. And yet, it fares no better than the lopsided allocation.
We must understand that there are multiple ways in which a founder can contribute resources to a startup: e.g. cash, time, work product. In a perfect world, all the founders would contribute to the company equally: Any extra cash contributed by Founder A could be offset by extra time commitment by Founder B.
But this isn’t the world we live in. Even if all founders contribute equal amounts of cash, it is highly improbable that all founders will contribute equally across all facets of the business. Some founders will, for whatever reason, contribute more to the new business than others. And eventually those founders that are contributing more will get fed up with the fact that they’re being under-compensated for their contributions. Things will start to fall apart.
Either those founders will move on, in which case the business loses out on the resources those founders were contributing, or they’ll scale back their contributions. The best-case scenario here is the business limps along for a while longer, but more likely it simply fails.
A Different Approach: Value Contribution
As I said, the problem with the lopsided and equal-split allocations were that they were a top-down approach to equity allocation: They started with a predetermined allocation scheme and imposed that allocation on the business, irrespective of the facts and circumstances of that business.
Instead, the starting point for dividing equity should be one of value contribution.
When a company has little or no cash, its stock is often used as a sort of pseudo money. Stock is issued to a founder (or investor) as compensation for value contributed.
Take, for example, a company with 90 shares of stock issued, $900 in the bank account, and no other assets. If John contributes $100 to the company, the value of the company has increased to $1,000, and the company can now take John’s $100 contribution and buy a printer. Since John contributed $100 of that $1,000, he should receive 10% of the issued and outstanding stock, or 10 shares (10 ÷ 90 + 10).
Alternatively, John could take a $100 printer that he owns and contribute it to the company in exchange for 10 shares of stock. We end up at the same place, except that there was no cash exchanged. Rather, the stock took the place of the money.
There are four things of value founders can contribute towards a new business venture:
- Tangible or Real Property,
- Intangible or Intellectual Property,
Of course, cash is the easiest contribution to receive. When a founder contributes cash to the startup, two things are undisputed:
- Value, and
- Time of Receipt.
The new business receives a specific dollar value when the money is in the bank account. These two variables should also be applied to the other types of founder contributions to arrive at a logical initial equity allocation.
Valuing Services and Tangible and Intangible Property
Value for contributions of services, tangible property, and intangible property requires a bit more work than contributions of cash.
The only way to assess real value is the market. Because equity is a substitute for cash that could be used to buy the property or the service in the market, the value of a service or tangible property is the price at which it could be acquired in the market using cash.
Of course, the service provider could believe the value is in excess of what the startup could buy it for from another provider. But, this simply isn’t a rational position. Unless there is additional value being provided, why would the startup pay more than the market?
Therefore, the first step in allocating equity is for the founders to determine what contributions—cash, property, and labor—each will make and over what period of time they’ll be made. Market values for contributed property and services are established.
Valuing Intellectual Property
It’s important to note that there are special considerations for intellectual property (IP) contributions, such as ideas, patents, know-how, and copyrights (software).
Though the founders may want to make a special allocation for the startup “idea,” ideas are worth nothing by themselves. That’s right, nothing. Ideas for businesses are a dime a dozen. Everyone has one.
The value is in the execution of the idea and the creation of a viable business. If a founder has taken the idea and moved forward in a meaningful way to create a business, then the value is that of the business that was created. Otherwise, little, if any, value should be attributed to the idea.
What, then, is the value of other IP? Some claim there should be a set value for each patent or copyright. But, in reality, IP only has value if it produces cash flow. There are many inventions, patents, and copyrighted works that produce no cash flow and, therefore, have little or no value.
However, because money and time have typically been expended securing IP, founders will often use the sunk cost as a stand-in number for its value. Because this is such a complicated area, it is best to seek professional advice to determine the value of IP.
Timing: The Difference Between Contributions of Cash and Property, and Services
Even if the ultimate values to be received are the same, the contributions of cash or property and the contributions of services differ in that the values are realized over different time frames. With property and cash, the value is received immediately at the time of transfer. Services, on the other hand, are received over weeks or months.
To equate the periodic value of labor with the instant value of cash or property, labor value has to be adjusted to reflect that time. This is accomplished by determining the present value of the market value of the labor over the time it will be provided to the new business.
Take, for example, NewCo founded by Bob, Carol and Jim. Carol and Jim are contributing cash, property, and labor worth $150,000. Bob is contributing only labor. He’ll be working for one year at a reduced salary of $10,000.
If Bob’s market salary is $75,000 per year, then Bob is effectively contributing $65,000 over the year.
Using an 8% discount rate and assuming Bob would be paid every two weeks, the net present value of Bob’s labor contribution at NewCo is $62,568.
Founder Equity Allocations
The initial equity allocation of each founder at a new business is the ratio of that founder’s contribution to the total contributions of all of the founders:
Founder X Equity = Founder X Contribution / Total Contributions of Founders
Returning to NewCo, Bob’s total contribution of $62,568 is divided by all of the contributions of Bob, Carol, and Jim ($212,568) to achieve a starting point for Bob’s equity interest of 29.43%.
What If We Don’t Know All Deliverables?
Occasionally, founders will raise a concern that they only know what contributions have to be made in the short term in order to get to the minimum viable product. After the first few months, they have no idea what must be accomplished.
In this situation, services contributions can be broken into two components:
- Deliverables of known services, and
- A time period for labor after those deliverables are provided.
The value of the deliverables for the known services are determined. The balance of the founder contribution comes from the founder working for the startup full- or part-time without salary or at a reduced salary.
Of course, the deliverables might change because of a pivot in the business model. To address this possibility the stock grant agreement can provide for an automatic change from deliverables to working without salary.
Starting Point for a Discussion
Dividing equity isn’t purely mathematical. But these calculations provide a reasonable starting point and objective basis for a discussion that focuses on the startup, where the founders want it to go, and what it will take to get there. Rather than a top-down approach to equity allocation, a value-based allocation of equity is a bottom-up approach that focuses on the individual business. The founders will find that this vital conversation becomes much easier and that a proper allocation of equity will help avoid problems in the future.
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