One of the most complex issues to deal with when starting a startup is the division of shares. If we work alone, have funds, and decide to hire consultants, the problem doesn’t arise. But a company that wants to have hopes of growth cannot do without a team of motivated people with a common goal.
There’s one thing that leading startup experts agree on: dividing up shares in the simplest way, i.e. equally, is certainly the wrong way.
David S. Rose – The Startup Checklist
The founder (or founders) should assign shares commensurate only with the contribution to the company. Partner A is the one who came up with the business idea, but Partner B has the necessary skills and experience to implement the idea. Partner C has put in the blood and sweat, working 20 hours a day to maintain the set goals and Partner D has a network of contacts that can be a key aspect to the success or failure of the company. Not to mention Partner E
who put in a lot of money to keep the project going.
How to compare and value the various contributions?
It is not at all easy and there is no magic formula to do it. What is certain is that money is measurable, everything else is not. Consequently, either you translate everything into money or you don’t get out of it.
“A better system,” says David S. Rose in his book: The Startup Checklist, “is to separate the two aspects of the ‘sweat’ everyone has put into the new venture. These are critical differences that carry with them different economic attributes.”
Entrepreneurial value and market value
The first aspect is the entrepreneurial value of
the founder(s). It is what happens if someone starts a new business and creates value. If you fund a company, start with an investment round and raise funds for a $2 million valuation, then the entrepreneurial value of the work and effort required to get to that point is $2 million. The value created has nothing to do with the effort it took. You may have worked 18 hours a day, seven days a week, for 5 years (in which case the value of your effort is $8.70 per hour) or you may have created that value through a brilliant plan, perfect planning and a team that you put together and motivated in just two weeks of relaxed work. (In which case the value of your effort is $25,000 per hour).”
The second aspect is the market value
i.e. how much would it cost to pay people who have the skills needed for that job? If the same result was obtained by paying 2 thousand euros to a professional, well that is the commercial value of the effort.
Once a company has been founded and evaluated, the sweat equity after that phase will normally be compensated according to the market value (replacement cost number), i.e. the salary that the person would have earned if he/she had been paid, plus an extra 25-50% in recognition of the fact that that person took the risk of not being paid at all if things had gone wrong.
Dividing the shares of a startup – Our guide
The division of the shares of a startup
founders or among the subjects who take over later can be a critical moment in the young life of your business idea but… as such it is good to face it with the right awareness, in order not to overlook what is one of the most important elements in the creation of a new company (and, indeed, also one of the elements that creates the most frequent disputes in the constitutive structure of the startup).
In order to deal with such a relevant issue, we have chosen to prepare an in-depth analysis that will allow you to understand
- how to divide the company shares correctly and without creating discontent among the founders
- what are the criteria you could use to divide the shares of your startup company
- how not to make more frequent mistakes when dividing the startup’s shares
Let’s start now!
Division of the startup’s shares among the founders
Let’s start by addressing one of the fundamental issues of this in-depth study. That is, how to divide the shares of the startup between the founders
How to do it in the most correct way? And how to avoid that the role of each can be valued rightly?
The answer is simple and complex at the same time.
It’s simple, because all you have to do is identify an allocation criterion and then apply it to the startup’s assets.
It is complex, because it is difficult to find a criterion that can attribute the right merits to everyone.
In fact, what often happens is that among the founders of the startup all claim to have the most merit for the business idea and, therefore, aim for a greater share than the other co-founders.
Therefore, even before talking about numbers, it is a good idea for the founders to find the right agreement on what element should be used for the division, between
- contribution in terms of time during the birth of the startup
- economic value in terms of capital and other equity contributed to the startup
- entrepreneurial experience, image and skills provided in the project.
Once the criterion has been identified, it will be possible to proceed with the division of the startup’s shares in a more precise way, avoiding headaches and misunderstandings typical of this phase of incorporation and startup.
But what is the most advisable criterion? What is the one you should follow to get a satisfactory result?
What criterion to follow to divide the shares of the startup
Let’s say right away that there is no criterion necessarily better than others and that everything will depend on the nature and characteristics of your startup
If, for example, in the startup it is mainly the work of the people that matters, rather than the capital, then probably a suitable criterion to divide the shares of the startup will have to be the number of hours that are devoted to the project.
In fact, if two people participate in the startup with the same capital, but one commits full time and one part time, it might be useful to give the one who commits full time a larger share.
Of course, it is always good to remember that the commitment of the founders could change over time, and that a person who today is committed full time could tomorrow become more actively involved in the management of the company.
For this reason, it is a good idea to formalize through a clear agreement what activities the person who has received a larger share must guarantee, for how long, and what could happen in the case of a decrease in commitment or abandonment of the startup.
The criterion of economic value also deserves special attention. Intuitively, the co-founder of the startup who invests the most also deserves a larger share but… with caution: often the equity injected into the startup is small compared to the debt capital the company will acquire in the first years of life, thus making the co-founders’ contribution rather marginal compared to their own balance sheet.
A third criterion, mentioned above, comes into play: the competence and image of the co-founder. There is, of course, nothing to prevent an entrepreneur who already has long experience in the sector or who wishes to make a greater commitment in terms of visibility from receiving a larger share.
Our advice is to use all three of the above requirements to arrive at a more effective and shared allocation.
Mistakes in a startup
‘s share allocation
If the above is sufficiently clear, the misqualification of a startup’s less suitable share allocation criteria should also be – accordingly. That is, what are the most common mistakes that are made in this delicate phase of the establishment of the company?
The first, and most common, is to limit oneself to an equal division of shares. Mind you, there’s nothing wrong with dividing the shares equally (for example, 25% of the shares to each of the four partners) but… are we sure it’s always right?
Instead, try to think – following the above principles – about what is really fair for your startup, and what might not be considered fair by the other partners. Any unclear division of shares could lead to discontent that, sooner or later, will come to the fore and have repercussions on the management of the company.
A second mistake which is often made is exactly the opposite of the first mistake which we have summarised here. That is, to carry out an excessively disparate division of the shares, which goes to favour one or more partners, to the detriment of other co-founders.
Well, be careful not to make too many disparities in treatment. Even if one co-founder has a prominent role compared to the others, you should still avoid that “minority” co-founders have such marginal shares that they feel left out of the company’s destiny. Also, their commitment and active participation in the company may grow as the months go by, so reducing them to an overall stake of less than 10% or 5% may make them feel left out.
Another mistake you could fall into is over-rewarding ideas. Sometimes a co-founder feels entitled to ask for a particularly valuable share in the startup’s capital just and exclusively because he had the intuition, the business idea.
Be careful, though. Ideas are important, but startups are not just made of ideas. Therefore, try to give due credit to those who came up with the business idea, but reward above all those who are making commitments and capital.
Splitting Equity: a practical guide to splitting the shares of the startup
In this second part of our insight we want to get much more concrete about this dilemma, helping you to divide the shares in a reliable and orderly way. By sharing this path with other co-founders, you will certainly create the right basis for a splitting operation that is well shared by all.
Evaluate the start
Before even understanding how you can divide the startup’s shares among the various co-founders, you need to do a calculation of the value of your startup
, keeping in mind that pre-money valuation is one thing and post-money valuation is another. The difference lies in whether or not the entrepreneur has received funding: the pre-money valuation will therefore be the valuation of the startup before the financial support, the post-money valuation will instead be the valuation of the startup after the financial support.
Without going into too much depth (we’ll talk about this in a separate article), the difference is certainly not marginal.
Having said that, to determine how much your startup is worth there are methods that are often called upon to arrive at a reliable and effective final result. For example, the Berkus method proposes scoring five risk factors
- basic idea
- product technology
- strategic relationships
- production and sales risk.
Then there’s the Venture Capitalist method, which is based on calculating ROI, the value of the company at the time of sale, and the post-money valuation. As you can well imagine, this is where you have to start from: only once you have calculated the value of your startup you can in fact think about how to distribute and share.
The Demmler method
Frank Demmler has worked on a model that he explains in the post:
The Founders’ Pie Calculator and that I tried to report as faithfully as possible
According to Demmler, the following factors must be considered
It’s fair to say that without the original idea, the business wouldn’t be there. But it’s also fair to accept that a successful business is made up of 1% inspiration and 99% perspiration.
Drawing up an initial roadmap requires a lot of effort and time. It requires great skills of organization, synthesis and above all the ability to produce a document that can tease banks, investors and anyone we want to involve in the venture. The plan is a necessary element to the start of the business, but often the real value is in the execution that goes against the plan itself.
Experience in the sector
What level of knowledge do you and your industry partners have that underpins your business? Knowing the market and having a portfolio of useful contacts can dramatically increase the likelihood of success and increase the speed of growth. If not, you will need to pay to have these assets on your team by hiring someone and paying them dues.
Commitment and risk
In an American breakfast of eggs and bacon, we can safely say that the chicken is involved in the dish, but it is the pig that has put everything into it. Similarly, if among the founders there will be those who throw themselves in headlong, risking everything themselves, and those who stand on the sidelines waving their hands. A distinction in these terms should be made.
Who does what? Who stays up at night to make ends meet? Analyzing each area of contribution is the first step in designing an appropriate division of shares. The next step is to assign an appropriate value to each factor by assigning each member to a factor and doing the math based on that. The result will give you a reasonable starting point on the division of shares.
Example of a division of shares according to Frank Demmler’s scheme.
Demmler’s scheme demonstrates how complicated it is to divide the value pie among the founders of a startup. It takes time and every action must be reasoned with the utmost care. Otherwise, we will only find out too late that there are partners who are dissatisfied with their allocated shares and have spent all their time nursing grudges instead of being positive.
Many companies have failed because of this very reason.
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