Splitting Up the Investment Pie
When you're determining ownership stakes among business founders and new investors, how do you do what's fair and equitable for everyone?
One of the frustrating dilemmas of being an entrepreneur is that no truly great idea can be implemented alone. The really great, big ideas will require a team to implement them, investors to fund them, and a passel of advisors and expert resources to guide and fine-tune your every move. And with all that, they'll each want to own a piece of your idea.
This concept of shared ownership is one of the foundations of American capitalism. It's at the root of our strength in business because, nestled within this concept, is the ability for someone to rise up and become wealthy by owning a part of something they built into a successful business. The question is, how do you determine who owns what in the beginning?
Of all the issues related to starting a new business, ownership concerns are perhaps most responsible for killing more good ideas that anything else. It's ironic, but both greed and generosity are at the heart of these failures. Greed is probably the easiest to understand: In this instance, an entrepreneur sets the value of their company so high that no investor is willing to invest and no resource is willing to help because the reward offered for doing so is so pitifully low.
Equally devastating is the entrepreneur who is so generous, they give up large portions of their company to people they believe will help them but who end up doing nothing. And once the stock is given away, it's nearly impossible to get it back (unless you're smart enough to create a buy-back clause in your agreement that allows you to buy back your stock at its original purchase price if the person fails to perform). Even when things go right, if an overly generous entrepreneur has given up more than 50 percent of their company before they need professional capital, the investors will question who really owns the company, and that fact may deter them from investing.
So is there a more rational method of "sharing the wealth" and ensuring a fair distribution? Yes, but it requires discipline and planning to make it work. Like all aspects of your business, if you're not willing to plan your work and work your plan, there'll be a price to pay. In this article, I'll share what I've learned about this subject after 25 years of working with entrepreneurs. Some of it will make perfect sense, and some of it may sound silly. But--and here's my warning label--all the ideas listed in this article have been tested and have a sound reason for their importance. If you choose not to follow some of them, be warned: There'll be a day of reckoning for your decisions!
The first thing to know is, you shouldn't worry about any of the principles I talk about in this article as long as you're able to drive the ship by yourself. The advice in this article applies to that moment when you finally realize your idea is just too big for you alone. You're going to need money and people with more (or different) expertise than what you can bring to the table. To do that, you'll need to find a way to entice them and, since you can't pay them, stock ownership in your company is all you can offer. Clearly, if they don't believe your stock will ever be worth anything, your offer of ownership won't fly. But if they can grab your vision and become true believers, they may kill to own a piece of it.
Now that you've decided you want to share the ownership, let's start by classifying four types of owners and how much we think they should get. Understand that our strategy here is to define ownership until you receive your first round of professional funding (from either angels or venture capitalists) of at least $1 million. After you achieve that goal, the issue of ownership will be out of your hands:
1. Founders. This is the person or persons who had the original idea. If you're in this group, you'll want to own 75 to 80 percent of your company through and until the first professional investment.
2. Workers. These are the members of the team you recruit who'll help you launch your company. Their goal is to add to your idea and help make it real by:
- Finishing the product,
- Helping with the business plan, or
- Doing anything else needed to help run the company.
These people may work full or part time and generally don't get paid in cash. Their total compensation is in stock, and as a rule, they can earn up to five percent of the company.
3. Key contributors. This category allows for someone to make an extraordinary contribution that significantly benefits your company, such as someone who finds and brings on board a major strategic partner who not only invests in the company but also decides to buy the product. Such important contributions should be rewarded with five to 10 percent of the company.
4. Investors. These are the people who help fund the initial launch of the company. This could include the company founder or a friend or family member. Generally, the amount of their investment is $10,000 to $50,000; in exchange, they may get five to 10 percent of the company.
The next step is to set rules for how your stock will be allocated. Once you've adopted your rule set, be sure everyone on your team understands it. Better yet, make sure these rules are translated into a legal document that's agreed to and signed by everyone on your team.
Here are some guidelines for creating your own rule set:
1. The founder's percentage should be set from the beginning. They'll get no additional stock for their sweat equity, cash infusions or significant new contributions.
2. Team members will be awarded a minimal number of shares for each documented hour of contribution (commonly referred to as "sweat equity"). Sweat equity shares will vest (become owned) by the team member after six months on the job. If they're let go before their six-month anniversary, none of the shares are owned and all are lost.
3. Sweat equity shares must be priced and allocated in such a way that the company doesn't run out of them before their first professional funding event. Otherwise, all shareholders will be diluted as the company issues more shares to cover the need.
4. The company should clearly articulate what kind of contributions they'll define as "key contributions." Anyone making a qualified key contribution will receive a special allocation of stock that will vest at the same time the company receives the benefit of their contribution. For instance, if the contribution is securing a major investor, once that investor's check clears the bank, the associated stock reward will vest.
5. The company should also institute a buy-back policy on all shares that are earned, not bought. This is simply to protect the company from people trying to score a quick hit and then leaving the company once they've scored. Buy-back provisions allow the company some period of time to buy back shares at a preferred rate and only under some very strict conditions.
6. Although valuations of very early stage companies are nearly impossible to assess, it will be necessary to benchmark a valuation for any capital investor receiving stock in exchange for their money. For instance, if $50,000 buys 10 percent of your company, then the value of your company is being set at $500,000. Compare this to what your first professional angel investment might look like: $1 million will be invested on a pre-money value of approximately $3.5 million. These numbers may not work for you, but just remember one thing: Valuations should be cumulative (that is, they progressively increase as the company ages). Therefore, if you price your company too high at one stage, you'll either not be able to sell it at all later or you'll be forced to take a significant cut in your percentage of ownership.
7. Finally, plan for what you'll have to give up when (and if) you accept money from an angel investor (usually 10 to 20 percent) or a venture capital investor (usually 25 to 50 percent). These investments will dilute what you and everyone up to this point own in the company.
Providing stock to those helping you build your company is a great American tradition. When done right, everybody wins and new millionaires are created who often turn right around and invest in the next great idea.
Jim Casparie is the founder and CEO of The Venture Alliance, a national firm based in Irvine, California, that's dedicated to getting companies funded.