Founder's Equity - Explained
How is Equity Distributed to Company Founders?
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Table of ContentsHow is Ownership Distributed to Company Founders?How to Split Ownership Between Co-Founders?IllustrationFinal Thoughts
How is Ownership Distributed to Company Founders?
At the beginning of the life of any business venture, the business has no resources. It is, in fact, a legal shell that must be filled. Founders are generally the sole source of assets in a startup venture. That is, the founders undertake the task of assembling resources necessary to carry out the business value proposition. These assets are transferred to the ownership and control of the business entity. In return for assets invested, the founders receive shares of ownership of the business entity.
Back to: Business Transactions
Thus far, I have used the word assets to include all value that is transferred to the business. These assets generally consists of financial capital. In addition to funds, however, founders may contribute various other types of value to the venture. For example, founders may contribute:
- Ideation (or contribution of the original business idea, product or service model);
- Work Product or Effort (i.e., equity shares as salary or other compensation);
- Physical Assets (Equipment, Office Space, Inventory, Raw Materials, etc);
- Intellectual Property (Rights to technology, brand name);
- Reputation and Connections (personal relationship, such as with vendors, suppliers, lenders, capital investors, etc.).
Each of these founder contributions has distinct value to the business that is helpful or necessary for carrying out the business value proposition. The contribution of these items may give rise to an allocation of ownership interest (e.g., shares of stock) that represents its value to the corporation. In addition, this transfer to the corporation necessary entails a translation of the specific value into a monetary figure (i.e., it is given a dollar value).
The financial value of such contributions is often difficult to determine. Nonetheless, the team will have to decide what number of total shares to allocate to the contributor for each contributed resource. Each share has a prescribed monetary value (either based upon the par value of the shares assigned in the articles of incorporation or based upon some business valuation method).
The allocation of shares for the value contributed may lead to unequal ownership and control among the founders. Naturally, this may lead to dissension within the team.
Back to: Entrepreneurship
How to Split Ownership Between Co-Founders?
As discussed in previous lecture, the founders of the business provide the initial infusion of assets to fund the business. Allocating the shares of ownership interest in the business between founders can be difficult. Allocation of ownership is based on any number of factors, but it primarily concerns the value of assets contributed to the business.
Back to: LAW, RISK, and TRANSACTIONS
As such we propose this systematic method for allocating ownership interest in the new venture to founders.
Step 1: Take the total number of founders and allocate 100 shares to each founder.
- Example: A = 100 / B = 100 / C = 100 / D = 100
- Note: This initial step assumes that everyone who is considered a founder is equally interested in being owners of the business. This also assumes that no value has yet been contributed to the business venture. The next step will involve the addition of a percentage of shares based upon contributions of value.
- Step 2: Identify major elements of value that will or could be contributed to the business:
- Prior Work Contributed
- Note: This includes the effort put into the business concept, product, service model, etc.
- Example: It may include: ideation or coming up with the idea; developing a prototype; researching the concept for feasibility; or any other initial effort prior to the formation of the business entity.
- Future Pledge of Work to Contribute
- Note: This includes the role that the individual will assume in the venture, the requirements of that role, and the value of the role to the operations or success of the business.
- Example: Defined roles such as CEO, CFO, CMO, Sales and Business Development, etc. Consider full-time vs part-time status as a consideration for the amount of effort the individual will be required or able to invest in the business. Lastly, consider the value of that role to the business, either operationally or strategically. For example, an individuals expertise or know-how may be absolutely necessary to the business. Even if one founder may work harder or dedicate more time in her business role, another founder may be indispensable to the business achieving its strategic objectives. As such, you must account for this in the allocation of ownership interest.
- Physical Assets;
- Note: This includes any form of tangible asset contributed to the business.
- Example: Think of equipment, real estate, inventory, raw materials, etc.
- Intangible Assets;
- Note: Intangible assets include intellectual property and reputation assets.
- Example: Intellectual property means any assets subject to patents, trademarks, copyright, or trade Secrets. It also includes property rights secured in domain names and state-registered, entity names. Reputation assets include any benefits derived from personal brand or resource connections (such as suppliers, vendors, lenders, equity investors, etc.).
Step 3: Calculate a percentage increase for each element of value contributed to the business venture:
- Example: (These are not the real percentages. This section provides a method. You should adjust the percentage to meet your business needs.)
- Prior Work Contributed:
- Idea: Add 2-25% (in this case 10 shares) to the originator or split between originators.
- Note: 10% is just an example. It may surprise people that coming up with the idea is not that valuable when it comes to awarding initial equity. The idea is simply not worth much without additional effort.
- Early Development: Add between 25-100% to each member depending on the amount of effort devoted.
- Example: Developing a prototype may be more valuable than carrying out an initial consumer test for viability.
- Future Work Contributed: Add between 25 - 200%
- Note: The individuals working in the firm may receive a salary, bonus or other compensation for their efforts. By virtue of their dedication to firm, they will demand an increased ownership percentage to assure that they benefit from the eventual success of the firm.
- Example: The CEO and individual in charge of sales may receive between 100% - 200%, while the person in charge of internal accounting and finance may only receive 25%. This comes down to the level of demand for the position or role (both in skill and effort. In such a case, those allocated to accounting, finance, compliance, etc., may draw a salary that equals or exceeds the other positions. This comes in exchange for the lower equity reward.).
- Physical Assets Contributed: Add 10 - 200%
- Note: At an early stage, assets contributed can be very valuable. You have to look at the value of assets (or $ of funds contributed) in comparison to a reasonable valuation for the business. A pre-revenue business is generally not worth much. This may change if the business has some form of competitive advantage (such as a strong patent). Soon into operations, however, the value of early contributed assets quickly diminishes as the business grows. That is, the value of contributed assets or funds compared to the growing value of the business diminishes. Hence the expression, early equity investment is expensive.
- Intangible Assets Contributed: Add 5 - 300%
- Note: The value of contributed intellectual property varies dramatically with the type and nature of the property.
- Example: Contributing a strong patent that effectively eliminates direct competition in the space is very valuable. A weaker paten or trademark to a brand name that is unsubstantiated has very little value.
- Idea: Add 2-25% (in this case 10 shares) to the originator or split between originators.
- Note: Never subtract value. Each potential founder is given a starting point of equal ownership in a business that currently has no value. We use the metric 100 because it is a round number that makes calculation of percentage increase very easy. Remember, you only include individuals who are founders and will be involved in the contribution of value to the business.
- Prior Work Contributed:
To illustrate the above calculations, let's use the case of Adam (A), Bill (B), Carla (C), and Dana (D). The initial division of equity is equal between the founders. The company is a technology product that fills a void in the automated, B2B, customer marketing space. Adam came up with the idea and brought it to Clara (+5%). Clara and Adam worked together on functionality and design (+25% each). They approached Bill to code the initial program. Bill is very talented and they could not afford to pay him, so they agreed to award him in equity (+25%). They quickly needed to raise money and looked to Dana. With no patent awarded, no revenue, and no clients, Dana made a high-risk, friends & family loan of $50,000 (+200%). Dana has a strong reputation as a smart entrepreneur and investor. He brings a wealth of contacts in the industry and his strong personal finances allows for opening a line of credit to the business +200%). Adam and Clara have quit their jobs and will work on the business full time as CEO and Head of Marketing & Sales, respectively (+150 each). Bill will continue to work part-time for the business on maintaining and de-bugging the code (+10%). Adam and Clara jointly file for patent protection and transfer all intellectual property rights to the business.
Adam = 100 +5 + 25 + 150 + 100 = 380 shares
Bill = 100 + 25 +10 = 135 shares
Clara = 100 + 25 + 150 + 100 = 375 shares
Dana = 100 + 200 + 200 = 500 shares
The above results may surprise you. Adam and Clara are roughly 27% owners. It should be expected that their ownership is roughly similar, but 27% seems low. Dana, on the other hand, owns 36% of the business and she is doing very little. Bill provided all of the technical knowledge (which would have been prohibitively expensive), has about 10% of the business. The fact of the matter is Dana held all of the early risk. Further, it is her reputation that makes the business possible. Early investors often come out even better than Dana in this scenario. Until Adam and Clara quit their jobs, they really had nothing to cement them together as majority owners. This should illustrate that until a business has revenue or significant competitive advantage, it is not as valuable as it may seem. Bills situation should illustrate the alternative to being able to pay highly competent individuals early in the life of the business.
The allocation of ownership interest in the business is closely tied to the level of control, authority, or influence of the shareholders. As such, it is an emotional hotbed. This effort can be a real milestone for the business. Make certain that this allocation does not cause issues that will cause long-term dissension that could thwart achievement of the business goals.