Slicing Pie for Startup Business Centr

today we have a great webinar by Mike Moore so I am going to actually turn this over to my and we can get into the webinar today Mike take it away thank you very much I appreciate you having me today we're gonna talk about a concept that I call slicing pie which has to deal with how startup companies divide up equity during the early days of their startup and say it's an area that it's very important to me and a lot of owners struggle with it and this is a relatively unknown way of approaching it not because they haven't been used before because of the mechanics of this type of equities but are not widely understood so hopefully today we'll get through slow mechanics and you can use it in your own startup so the first question I want to pose to our listeners and even listen to this is why we start startup companies in the first place why we go about doing this what's the point of this effort and when I think about it you know people think they're gonna do some hard work on a concept or idea they believe in and it's gonna be fun along the way and they're going to a big payout later so most people that are starting growth oriented startup companies feel this way about their business they know it's gonna be hard they know it's not going to be a slam dunk most the time but they know that they're gonna care about the process and they're gonna enjoy doing it and hopefully they're gonna find people along the way that they can enjoy doing the business with along the way and maybe they'll go public people get purchased maybe they'll make a lot of money for cash flow but whatever the reason they hope that there'll be some kind of payout for their hard work later on so this is the typical mentality of someone starting a company especially a girls company um but the problem is we don't know what our payout is going to be um I don't know any startup companies that can accurately predict exactly what they're gonna make when their company is successful um it's a big big big unknown so as entrepreneurs you move with a lot of faith and we make a lot of assumptions about our business on what might happen and we kind of act on those assumptions in ways that rational people in big businesses would not dare act on and when we act on those those assumptions we make some choices about what we think our company's going to be worth and what the different people are going to provide to that company to make it worth something and most companies today that majority use what's called a fixed equity split in a fixed equity split is one where you go in fifty-fifty with a partner you have an idea and you find someone's gonna help you say alright we'll split everything right down the middle 50/50 or maybe even partners this is one of the most typical ways a company will start in today's economy it's also one of the most dangerous we can also do 60/40 split or maybe you have 80/20 split because it's mostly your idea and the person says to be a little bit of work you think it will require that much so whatever happens you might think that if we do 50/50 now and in the future we'll get 50% of the rewards whatever those rewards happen to be and people think that's fair but what if something changes in your startup company what if you do all the work you go in fifty-fifty with a partner and you wind up doing all the work instead of that partner you thought they were going to participate being gay Genet but they weren't that's a very typical scenario especially in a college an MBA setting where student teams will get together for a quarter or two and then they'll get jobs and move on to other things but they walk out the door owning a big chunk of somebody's company what if you want to bring in somebody else if it's bringing somebody else you your your equity still know no longer works do you keep up your equity or does your partner give up their equity or how do you calculate it but if your partner wants to quit that personally the day after you do your equity split the person can quit and walk out through or half your equity well what if you want to quit does it fair that you keep your equity or should somebody else get your equity back or what what happens in those scenarios there's millions of things that can happen in a startup company that inevitably do startups are extremely volatile places to work they're extremely volatile activities and the rate of change that they go through especially during the formative months is very dramatic and there's millions of things that can change in a fixed equities but simply does not reflect the those changes what if somebody dies in your company this I've seen this before where the two partners be working together and the partner will die and it might take years to realize any value does the 50% partner that died deserve the equity is their family deserve that equity the company even though that the partner was in it was unable to participate in success of the company there's just lots of questions that need way of handling them and today what we do is we go back in to renegotiate what our equity splits are we go back to our partner and we say listen or I crease but isn't right or want to bring somebody else in and there are a few activities that any business can engage in that are more damaging than renegotiation of anything renegotiation means we were wrong we thought something was gonna happen and it didn't happen so we have to renegotiate the term so it was happier and usually after that it was less well-off it was less happy even if you get more out of negotiation you're still make your partner's will resent you for it so renegotiations the most damaging things you can do in your kind of startup company so we want to avoid a renegotiation possibility at all costs what it boils down to when these changes happen is that things aren't fair anymore where the partner leaves and they keep 50% of your equity it's not fair well it's no longer fair it's no longer fun so your startup become stressful this to be abused it starts becoming politicking and greedy and people start stabbing each other in the back and it takes the fun out of a startup company in a very real tangible way in many cases that that lack of fun can actually destroy a startup company and I've seen time and time again where the partners just decide that cannot reconcile their differences and they split their they split split ways and the company is actually destroyed so if it's not fair it's not fun and we want to keep startups fun so people remain engaged and passionate and excited about what they're doing and changing the world so fairness is a lot more fun so what we need in the dynamic in the equity space is a program of allocating equity in our start-up allocating future profits of our startup that's perfectly fair to all participants we want to reward people for the contributions they make in a company in a fixed equity split we anticipate what contributions they might make but now there's a program that will actually allow us to reward people for the contributions they actually do make we also need to provide ongoing motivation to continue contributing to a startup company if we go 50/50 in a business the minute I get my equity allocation I've been paid so my motivation to work can be different based on what I think is gonna happen in the future so if I think that you're gonna do all the work and make the company success I'm going hang out without my help then I won't be very motivated to work we also need a program that will accommodate changes of the team to make up the team and program it's flexible the changes the Facebook rapid change of the company so as our company changes we need to be flexible but as people come and go in our team which inevitably happens we have to be able to accommodate them in a very meaningful way a very fair way so we need a program that does all these things that program is called a dynamic equity split a dynamic equity split is one that will accommodate changes in the startup company and unlike a fixed equity split it changes throughout the formation stages of a company so that people could make sure that they're getting what they deserve out of the company and they don't make any guesses about the future it's impossible to guess what our company is going to be worth even the smartest savviest entrepreneurs this cannot determine what their company to be worth in the future so we don't we can't base our predictions or equity splits on future predictions of what might happen we need to make base them on what actually does happen in a dynamic equation it allows that to take place so you worked now hard now and we get exactly what we deserve later not short of what we deserve when the ballpark of what we deserve we should get exactly what we deserve in the share of your reward should be in direct proportion to what you've contributed so your share of the company your ultimate equity that your company that you get out with a company splits earlier or gets gift sold or starts distributing profits your share of what you get should reflect exactly what you contributed to that company if you contribute 50% of what it takes to make the company success you should get 50% of what the company's what to expect the company's success if you contribute 10% you should get 10% if you contribute 60 9.2 percent you should get 60 9.2 percent no rational person is gonna argue with the fact that being rewarded in proportion to what you put in is fair now lots of people would like to get a lot more than they put in and that's what we're going for we're going we're hoping that you're 60 9.2 percent is worth a lot more than you your time and energy is worth a lot more than you actually put in we want your success but when it comes to dealing with your partners you don't want to succeed at their expense it's okay to be unfair with the competition it's okay to beat the competition down but it's not okay to beat your partner's down you want to make sure you have a program that reflects the value that everyone is bringing to the table not just you and in typical scenarios that's just not the case because when it's perfectly fair it'll continue being fun you know that you're aligned properly with your partners and investors and participants you will continue to enjoy the company without having to suspect someone's out to get you or suspect someone that's getting more than they deserve but think some of these being too lazy well think someone's doing more than their fair share of the work you want things to be perfectly fair because they'll stay fun until you can have a nice exit so the concept I want to describe to you the execution model I want to describe is called a grunt fund a grunt are these little animals which are also people who are willing to do the hard work that it takes to get a company off the ground everything from marketing the company to cleaning the toilets to calling customers to doing the billing anything it takes to get a company a foreground as grunt work and that's what grunts - so most startup companies are made up of these people who are willing to do just about anything not in exchange for money all the time in exchange for some of the equity they'll turn into value someday so grunt fund is the model that I propose that people use to implement dynamic equity split there are lots of ways to implement dynamic equity splits this is my model and your model might be different I like this model because it's very concrete it's very fair it's very clear how it works so I'm gonna take you through how it works right now the first thing in a grunt fund as you sign a leader that you can trust second thing is right you had you assign a theoretical value to the various inputs provided by each participant and I'll do over that in a minute how that works in the last step is you determine someone's percentage of ownership by dividing their individual value of what they contributed by the total value of what everybody contributed and that will give you the exact percent of the shares you deserve in that company so that's the basic calculation that works for so the two critical components are determining the total value of the firm and the individual value value of the firm so step number one get a trustworthy leader it doesn't always go without saying need you to hire only work with people you can trust one typical scenario is that people will get into new companies and they'll do a lot of legal work upfront they'll do a lot of agreements they'll do a lot of corporate structure and kind of but covering legal agreements if you have to start off with your team with a lot of legal agreements you're probably not working with the right team I always encourage people to hire lawyers to do influent the basics even with the basic level of liability corporate structures the basic agreements but you want to spend your money and your time and energy growing a company not on protecting yourself from what might happen the future so you want to work with people you can trust and the reason you want trust is leaders because they will generally hold the equity and tell it's appropriate to issue equity you don't have to issue equity in the beginning of a company most you'll make that mistake it's very common mistake to issue all the equity before the company even gets going one person can hold on to it and clearly you have to trust that person or make sure they don't rip you off that push will manage the grunt fund and then also deal with people appropriately when they leave the herd when they leave the leave the company the next step is to assign a theoretical values the various inputs now there are lots of different inputs that someone can provide a grunt can provide to a startup company the most popular one is time they can also put relationships credit in the form of credit cards or small loans ideas are obviously an important part of a startup company small amounts of cash equipment like trucks and printing presses and ovens and things that make the company work small supplies like office supplies and equipment and laptop computers and even facilities like office space for instance so most of the time we think about time as our main input but there are lots of different things that are important and we have to have a way of assigning what I call a theoretical value a theoretical value reflects the fact that your company in the beginning is worth nothing most startup companies cannot be sold if their inception their ideas and the basic materials cannot be sold to anybody so their value is usually zero the stock is worth zero everything is zero if I spend a hundred bucks on a company the company is still worth zero I spend a thousand dollars at a company probably still worth zero if I give it my great idea it's probably still not worth a thing it's not worth anything until you can actually convince somebody that it is worth something and you're not gonna have a very good time convincing something that's worth something unless you have some prototypes and customers some subtraction and other things that show value so till that day dawns your company is worth nothing so what we need is a relative theory theoretical value the theoretical value it allows us to assign a value that's important not in terms of how much it's worth but relative to other inputs so we show you what I mean by that so time is a very popular contribution to a startup company so what I would do to calculate the theoretical value of time is I would figure out what your negotiated base salary what is the base salary of someone in your position that would be paid enough that they wouldn't have to receive equity if you just pay me for my work you don't have to give me equity so I've subtract any cash compensation I might receive from the company I multiply it by two and I multiply it by two to reflect the fact that there's a lot of risk in a startup company there's a very big risk that I will never get paid at all so to account for that risk I do a multiplier of two so anything I've put at risk when ago she ate a base salary less what I'm actually getting paid anything I put at risk I multiply by two and then I divide it by two thousand two thousand is roughly the number of hours in a year that gives me my grunt hourly resource rate order so here's an example let's say my market value is a hundred thousand dollars a year I'll be happy getting a job with no equity at a hundred thousand dollars a year and some startup guys willing to pay me $25,000 a year so I'm putting 75 thousand dollars at risk so I multiply that times two I / mm and I get the grunt alley resource rate of $75 an hour that is a theoretical value of my time it's not an actual value no one's actually paying you for that it's just a pretend Val they'll help me measure the value of my time versus somebody else's time so somebody else's time might be somebody right out of college that has no experience whatsoever their market rate might be more like $30,000 or $40,000 a year so they'll have a lower hourly resource rate because they're the relative value of their time is less than the relative value of someone's more important or has more experience let's say I was a former senior developer at Oracle Corporation well my time is much more valuable than someone who is a junior developer so this calculation helps you keep those values over time and relative check so I was getting rewarded relative to another person so next example is money money small amounts of money are is harder to come by than time it's much harder to save a thousand dollars than it is to earn a thousand dollars so I give it a higher multiplier instead of two I multiply the time the risk at four to give people extra water for putting money in this is a good way to start a company if you can just pay people you don't have to give them equity so with more cash you put in the more if the company can reserve for yourself so this is a good way their founders can keep them company for themselves I put in cash in its a multiplier that I made up because it based on my experience to reflect the relative value of cash and your startup company so everything has a theoretical value so when you have a relationship you know once if it's a common mistake to hire some of the big royal rolodex and think all those relationships are going to materialize they may not materialize it to sales or investment or anything else so I only reward those relationships when they turn into something so I would consider an unpaid commission on a sale for instance times 2 which that risk the theoretical value of that commission for ideas I would pay someone a royalty or the development hours of the idea plus costs as the theoretical value for small office supplies and staplers and paper I wouldn't give anything unless they were unreimbursed expenses which I'd put in its cash so everything is has a calculation that will help you determine how much it's worth relative to other things not actually I'm which it's worth what it's worth relative to other things so your stapler that you paid 10 bucks for has a relative value of your hours worth of time so everything has a calculation so for equipment is an interesting one if I purchased a piece of equipment for the company I would put it treat it as if it was cash times four if I owned the piece of equipment for more than eight for less than a year I would put it in as its purchase price as a fear as the theoretical value the relative value if I owned it for more than a year as a used piece of equipment I would figure out how much I could buy it on the resale market and treat it as the theoretical value of the actual resale value again it helps assign a value to the asset or the contribution that keeps it balanced relative to other participants in the company so on my website slicing PI comm I have a cheat sheet which goes over all the different calculations for all the different types of inputs and you can download it for free on my website so I sleep I calm if you can't find it I will email it to you so here is an example of how this works let's say you have three people in a company a junior developer a founder and a rich uncle in this case the junior developer just brings time they spend their hours working on a project the founder brought equipment brought time and ideas to the company and the rich uncle brought gave it to companies from startup capital provided some important introductions that might turn into sales and some credit for the credit card to help fund the company so the theoretical base value is the is the sum of all the different contributions yeah junior developers time the contributions made by the founder and the contributions made by the rich uncle and that total altogether gives you a theoretical base value again it's not an actual value your company isn't actually worth this it just gives you a base for which to determine equity splits so our number one share is the value of their time divided by the entire enchilada trend number two is the value of their time and ideas and equipment divided by the total value that contributed by everybody and girl number three is what they contributed divided by what everybody contributed this will give you an exact percentage that's balanced to fair given what each person contributed so here's example how it might play out let's say the person had two thousand dollars worth of their time theoretical value worth of their time this is the junior developer number to put in four thousand dollars worth at a time it could've been the name say number of our there early resource rate might be higher maybe a fifteen thousand dollar truck and the patent that was worth $7,000 so this is the theoretical value what they contributed the investor might have put sixty thousand dollars in cash and their relationships may have turned into a sale that pays a three thousand dollar Commission so the theoretical value of the total company at this point is ninety one thousand dollars doesn't mean you can sell it for ninety one thousand dollars this means that our pretend value is ninety one thousand dollars when you divide it all out it makes perfect sense the first guy that the junior developer would own two percent of this company the founder would have twenty nine percent of the company and the money guy would have sixty nine percent of the company it's a perfectly balanced equity split given what it means contributed to the pilot 2% to the junior guy 29% for the founder and 69% for the investor now if the founder wanted to have more control over the company a more inequity their company they could have put more cash in but they didn't have the cash they need to seek outside for the cash and reward someone appropriately before so let's say we bring in a new guy a sales guy this person has a lot of good relationships they've spent some time with the company and they bring relationships in time their contribution gets batted to the theoretical base value and assuming nobody else does any more work that period we just divide up everybody's shares the same way and the program automatically adjusts to reflect that someone else providing contribution so here's that sales guide now I'm figuring can' figure out how much he deserves so here's the pie again these three guys didn't do anything this guy came in spent $2,000 at a time they entered a great big sale so now he's added $12,000 in theoretical value the company's now worth 103 thousand dollars and theoretical value and these splits have adjusted appropriately this guy these guys have less but they don't mind because now the company is worth more they have a bigger they have more poor people the payroll and the company's moving forward so now the pie looks like this everyone is adjusted perfectly and appropriately given what they've contributed so over time people are going to get what they deserve out of a company now the second problem we have with equity splits what happens when somebody leaves there are four circumstances under which someone could leave the company they can be fired for good reason meaning you didn't do your job as asked you can be fired for no good reason meaning you did your job as ask we no longer need your position so we can't keep you on the team you can resign for good reason and a good reason would be like the company moves a thousand miles away you cannot relocate your family in practical way so be a good reason to leave the company well maybe the company decided to move your position to a different position that wasn't what you signed up for that'd be a good reason to leave the company so a number of things that are good reasons to leave a company or you can resign for no good reason no good reason would be you just get sick of it you can't work for whatever reason or your guitar the company or you want to get different job or any personal reasons that aren't at fault the company's not our fault so each one of those circumstances brings different consequences when you come to person to departs the company so for instance if you're fired for good reason because you weren't doing your job or you left the company in the lurch for no good reason you should deserve to bear the brunt of the pain associated with leaving the company so we would not give you any equity for the time you put into the company we had to adjust your other inputs like the cached without the multipliers to adjust those down we would buy back anything we put into the company in cash wise and we would ask you to sign a non-compete now this is pretty harsh punishment for someone who gets fired or leaves for no good reason and it should be because if we need some retention for the company the company can't operate if you're not doing your job or if you're leaving them in lurch so it's fair to require the grieving grunt on these circumstances to bear the burden of leaving the company it's their decision on the flip side if you're fired for no good reason or you resign for good reason if the company's more at fault so the company should bear the burden of your departure in this case you'd be able to keep all the pie or the equity you were created we should be able to buy it back at the full theoretical value of the company and we did the the equity and we cannot ask you to sign a non-compete because it's not fair if he asked to leave the company we can't expect you not to compete if it wasn't your fault for leaving the company so again this is these are tough consequences for the company and they should be because we don't want to give companies an easy way out to fire people for no good reason or to change people's jobs so when you leave a grunt you simply subtract the contributions they made to the overall theoretical base value and recalculate their ones equity based on what the new value is so let's say we get rid of this jr. grunt you simply subtract what he put into the company and recalculate everybody shares based on the departure of that person so here's trot number one as you can see we've taken out his equity he has 0% and everybody else readjusts now they may have a bigger share of the pie at this point it's not necessarily true that they're better off however because we've lost an important player or the company is a setback when they leaves to leave somebody so just because you're a bigger percentage of that point doesn't mean you're necessarily better off if you can avoid it you don't want to have absentee owners on your company that's called dead equity and investors tend to loathe absentee owners the more you can put in place to buy stuff back the better off you're going to be and I try to limit the number of absentee owners as possible but if you have no choice you have to deal with that as part of the part of doing business okay so here's how the pie would readjust in the case so you can see ground number one is no longer part of the company and it's here's how they did it it's adjusted now if someone does continue to work for the company let's say month one is the next month goes by and these these guys continue to work for the company their share will just based on what they work so here's the next month as you can see this person's but another two more hours in this person's put more hours in and their shares just appropriately so I'll toggle back and forth you can see how that works so in this case the company's worth one hundred one thousand dollars the theoretical value everybody does more work and boom their equity changes based on our contribution so months to month day to day things will change as the company moves forward and builds value there the different points have changed so what we've got here with the dynamic equity split is a program that adjusts perfectly it's perfectly fair for people who are participating everyone's getting out exactly what they contribute it's going to reward people for their actual contributions not what we think they're gonna contribute it provides ongoing motivation to continue contributing because you continue earning or equity in the company it accommodates changes as the team as people leave and come and go to the company and it's flexible in face of graphic change so it can change on a dime depending on who comes and goes and never requires renegotiation of what anyone's worth so eventually though your get out girl grunt fund this your company will settle down and stop changing as much and turn into a real company and there's certain points at which you want to sort of freeze your equity and move forward under more traditional equity programs and the cases would be when the company starts generating real revenues if you start generating real revenues you can use those revenues to pay people you no longer have to give them equity if your cash flow becomes positive you could use the money to pay people if you get a series a investment you can use the cash to pay people and not have to give them equity anymore so you can freeze the equity and the next next one is a large theoretical based value the larger your theoretical based value gets the people reached a point of diminishing returns and you mentioned earlier that the risk goes down as you go forward the reward always goes to also goes down so the first month you might work ten hours that could be worth half the company in your twelfth month you could work ten hours you could be worth one percent of the company so it automatically just as time goes by the incremental hours are worth less and less so early hours are worth more to the company so that's the our dynamic equity split works and it keeps everything fair and square for the participants this is a concept that's not widely used today because it's not widely understood there have been some some interesting research that's been out in the past year show showing that about 70% of entrepreneurs make the potentially fatal mistake of dividing up equity early on in their company using a fixed model it's extremely devastating and people just deal with it today because that's the only way people deal with it they don't know how to do it there's no there's no practical guide for implementing dynamic split as you can see there's a lot of moving parts so I wrote grunt a slice and pie as a way to provide guidance on a practical way to implement a very very important tool for keeping your company happy and fair and keeping you focused on the visionary company and not on infighting and you know fights you can potentially have on your team so if you aren't using a dynamic split whether or not you use the slicing pie model or not I highly recommend giving it full attention until you understand it well enough to make a decision on your own people who go to fix flip model really dig some major holes that many of them could not dig out and I see that all the time with my students I see all the time and companies that I helped start if they if they've done a fixed model it's always without exception creates tension among the founders so please take a special pay special attention to how this models work and if the grunt fund model isn't the one for you and then you can devise your own but definitely use a dynamic split in your company no matter what you're done trying to do and you can reach me at my Twitter's grunt funds and on my website I have a lot of resources I have a calculator or spreadsheet you can use to calculate the equity going forward I have examples of how it works and some videos together so it's a very diplomatic program and my experience since I came out with these this concept has been pretty overwhelming accepted so I'm sorry Charlotte companies all over the world using this to their success

Channel: Mike Moyer

Views: 35,824

Rating: 4.9369087 out of 5

Keywords: Founders Equity, startup shares, dividing equity, angel investors, stock purchase agreement

Id: 3MYYPkIEyH8

Length: 29min 17sec (1757 seconds)

Published: Fri Feb 22 2013