Determining Ownership Among Founders and Investors
Different risk exposures should mean different equity positions.
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Q: How do you determine ownership shares for founders and passive investors in a new company?
A: Typically, all shareholders will have equal risk exposure: One share equals one unit of ownership, and each slice of the company has the same potential for liability as every other slice. But in some cases, the entrepreneur who will be actively managing the business has agreed to cosign or personally guarantee certain contractual and/or debt obligations that the enterprise will incur.
For example, I recently discussed this with a client who said he would be personally liable for the balance of his new company's facility lease and certain contractual fees with his main supplier. If the business went under, he would have to pay the outstanding balance on the remaining months of rent for the building as per the lessor's terms for the original 36-month contract.
In addition, his key supplier agreed to allow this new company to pay certain licensing-distribution fees over 48 months, rather than in a lump sum at contract inception. If the new firm hits economic difficulties, the supplier has the principal entrepreneur's personal guarantee to continue making those payments to fulfill the original contract. These two personal obligations are not required of any of the other shareholders in the firm. The situation then calls for some type of formula to allow the entrepreneur-owner to receive additional shares in the company to represent the added risk exposure to his or her position.
The solution to this issue is not that difficult to remedy. A mechanism must be agreed to by which the additional risk exposure can be translated into incremental value to the individual shareholder(s) with these potential personal liabilities that might have to be paid out-of-pocket should the company cease operations. The formula I use with my clients is to first establish the maximum amount of money a certain shareholder could be required to pay in the event the business fails.
In the case of the example mentioned above, the reality is that this maximum loss amount is only good on the first day of operations, because if the business closed on that day, the one owner would be liable for the entire rental lease on the building and the entire four years' worth of licensing fees to be paid. Three to four years from now, the original rental lease will be ready for conversion to a new lease and/or a new facility, and there will only be a few months left on the licensing agreement.
Somewhere between these two extremes is a total dollar-value risk that represents a "reasonable" potential exposure for the lead entrepreneur/shareholder. The best way to decide on that value is to:
- Show the entire continuum of potential personal losses, from the maximum amount down to zero--the place where all the risks are ended due to the passing of time without the business failing.
- Assign the time frames to each of these points in the life of the firm.
- Decide on the odds that the business would fail at that point in time. Typically, the earlier time periods have higher likelihoods of failure. This decreases as time passes, but there are scenarios where the firm could easily pay its bills in the first six months to a year, but the best chance of failing is during the second year, or something like that. These have to be looked at based upon the market, management team, potential buyers, suppliers and other unique factors to the business.
- Calculate the weighted average of the potential liabilities. For example, you might think there's a 20 percent chance of failure at six months, with $150,000 total exposure at that point in time; a 50 percent chance of failure at 14 months, with $100,000 of potential loss; and about a 30 percent chance for failure at the two-year anniversary, with a $50,000 risk exposure. Twenty percent of $150,000 + 50 percent of $100,000 + 30 percent of $50,000 equals a weighted average risk exposure loss of $98,000 at 15.4 months into operations. (Do the same calculation on the time periods as well.) You might end up agreeing with all the other shareholders on $100,000 (rounding up) or $90,000 (negotiated downward). But whatever figure you decide upon, that personal guarantee represents additional value from that person. It's like additional capital added to the firm to cover these potential losses.
- Add in the weighted risk exposure figure, once all the tangible capital contributions are tallied. That's a fair representation of the total value allocated to the company by the shareholders. If the total funds invested are $250,000 and the additional personal guarantee is another $100,000, it's like having $350,000 appropriated to the company. Perhaps assign $1 per share for 350,000 shares and then distribute shares accordingly. The lead entrepreneur will receive additional pro-rated shares because of the additional capital at risk when compared to the other shareholders who do not have this risk in their positions.
Be prepared to negotiate this with the other capital providers, but in the end the logic should be clear to everyone that you have more personal capital at risk than they do, and should therefore receive additional shares to represent those funds.
David Newton is a professor of entrepreneurial finance and head of the entrepreneurship program, which he founded in 1990, at Westmont College in Santa Barbara, California. The author of four books on both entrepreneurship and finance investments, David was formerly a contributing editor on growth capital for Industry Week Growing Companies magazine and has contributed to such publications as Entrepreneur, Your Money, Success, Red Herring, Business Week, Inc. and Solutions. He's also consulted to nearly 100 emerging, fast-growth entrepreneurial ventures since 1984.
The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.