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ENTREPRENEURSHIP 2, 2.07 (V) 2.6 Allocating Equity Among Team Members (1)

This session is on Allocating Equity Among Team Members. Let me start by giving you an example. And then I'll explain what equity is and how to allocate it. This is the founding team of a leading mobile phone provider in China called Xiaomi. And Xiaomi was founded by eight individuals. That was a really dream team that came from the Silicon Valley elite from companies like Microsoft and Google. And the founder, the CEO, sitting in the middle here is Jun Lei who is now a celebrity in China. When these eight people came together, they had to figure out what did they bring to the table, and how would they share the rewards if they eventually became successful. That's the essential challenge in allocating equity in the start up team. By equity, we mean an ownership or profit interest in the new enterprise. Most new ventures involve several key team members, and there's an interest, there's some value in having those team members share in the ownership of the venture. That's usually valuable for several reasons. First, it's typically required by outside investors. Outside investors want to know that the management team shares their incentives to create an enterprise of tremendous value. It also allows the enterprise to pay the team members with profit interest, or shares, as opposed to with cash. Cash is typically the most scarce resource for the new venture. And lastly, many individuals who were attracted to entrepreneurial ventures are also motivated by the possibility that if they're really successful they might get an outsize financial reward and that's only possible if you have equity in the new venture. Now to explain what equity is, I need to explain the concept of a capitalization table which usually just goes by the term cap table. A cap table is simply an accounting of the shares of the company and who owns them. I'm going to show you just a very typical although somewhat simplified cap table. Typically, the founders would own some chunk of shares. Here, I've shown the founders owning 500,000 shares, which represents half of the shares that are authorized, so they own half of the shares, or 50%. There's usually some reserved shares for key team members who are hired after the founding event. So for instance, this might be the vice president of marketing, or the vice president of sales, and in this case I've shown 100,000 shares reserved for those key employees or 10%. There's usually then something called an option pool, which investors require that you set aside for compensating future employees. And so many of you have probably heard of someone joining a tech start up and getting options or stock options. And stock options come out of this pool of shares. That's usually required by the investors, before they'll put money into a new venture. Now just as a somewhat arcane aside, options usually are, just as that term implies, an option to purchase shares, as opposed to an outright grant of the shares. That difference is really mostly relevant for the tax treatment, and in countries like the United States, where a grant of shares might be taxed as ordinary income. In order to avoid that, most companies will allocate options to employees which don't normally suffer from being taxed at the time they're issued. And then the last category of shares is the shares allocated downside investors. In this case, I've shown that as 300,000 shares representing 30% of the shares that are authorized. So this is a cap table. Now I'm going to go through each of the lines here and just say a few words about how they're established, how they're allocated. And then we're going to turn to that top row, which is the founders' shares, and how to allocate those shares across the founders. Let's start with the outside investment. Now the outside investment, the number of shares allocated to outside investment, is determined by two things. The first thing is how much money the investors put into the company, and the second is, what the value of the company is before the investors put their shares in, and that's a term you've probably heard, called valuation. And in particular, the pre-money valuation. That is, what's the value of the company, what's the imputed or implied valuation of the company before the investors put any money into it. So just in this example, let's assume that the company arrives at a valuation, usually in negotiations with it's investors of $700,000 US that's before any new money is put in. Then the investors invest $300,000 so now what the company has, is it has $700,000 in value. That was the value it had before it got the money. And it now has $300,000 in the checking account, and so its total value is now $1 million. And because the investors provided 300,000 of the total value of $1 million, they own 30% of the company, so that's how that number is calculated. The second issue here is how to allocate the option pool. The option pool, just by convention, is usually established to be about 10% of the shares that are outstanding. And that's usually just a requirement of the investors. The investors want you to set aside some shares so that you can compensate future employees, give them some incentive to increase the value of the company. It's usually established by negotiation. Those shares may or may not be issued in the future, but they have to be shown on the cap table. And if you've ever heard someone discussing cap tables, talking about share price on a fully diluted basis, for instance, that notion of full dilution means that you assume that all of those options were issued, and you use those shares in the calculation of share price. The next piece is the equity allocated for key team members. This would typically be vice president of marketing, for instance, vice president of sales. The number of shares here is usually established by the market conditions, that is what you have to offer to be able to attract the right people to your team, and also to some extent when they joined the venture. So if these are very late hires, after the company is already up and running and quite valuable. You might need relatively few shares here. But if it's right at the beginning, typically a fairly large number of shares have to be allocated to retain and attract the key members of your team who aren't necessarily founders. All right, that's all background that leads us up to this key question which is a of those 500,000 shares that are shown here in the cap table as going into the founders how do we determine, how many of those shares each member of the founding team actually receives? So let's turn to that question. As background I want to show what typically the founding shares look like before and after financing. So often at the very beginning of the enterprise or after the founding team has worked on it for a little while is when you actually establish, you assign the equity to the founding team. And let's just say for the sake of argument that shown here on the left, we valued what we have when we start the company at about $300,000. Now, at the time of investment we have the cap table as I showed previously. And I showed the value of what the founders began with plus the equity for key employees plus the option pool for future employees plus the equity purchased by investors. Now notice that in this example I've shown that the value of the company at the time of founding was about $300,000, but by the time investment came in, if the team is doing its job, it's actually increased the value of what it has, of what it started with. And that's why I show that line moving up. And so the value they started with was about $300,000. At the time of financing it, the time that CAP table was computed, the value I estimated at $500,000. Now of course, this is just an illustrative example. The specific numerical values for your company will differ widely. And so, you should think of this just as an example, to walk through some of the arithmetic. So now I want to go back to that founding moment when the founding team is sitting there looking at what they have and saying okay, how do we divide this up? Now, if you think about it, what should determine how those assets or how those shares are divided among the founding team? Well, it's really, what did the founders bring to the table? What assets did they bring to the party? And those assets you can think about as occurring in three different categories. The first category would just be the original idea. Who came up with the idea and developed the opportunity and perhaps developed alongside that some intellectual property? Maybe a product design, maybe an algorithm, maybe some market research. Some original intellectual property that formed the genesis of the raw opportunity. That's the first category of assets that founders bring. The second category is what we call sweat, and that's short for sweat equity. And sweat simply means the effort that the founding team will put into the venture without cash compensation, and so that's why we call it their sweat. They're earning equity in the venture through their sweat, they're not being paid cash and instead they're being paid in effectively a share of the future profits or future value of the company. And then the third category is cash. And no matter how you slice it, the founders almost always have to reach into their pockets, or put some money on their credit card, and come up with some money to get the venture started. It's usually not the bulk of the money required to capitalize the business, but there's almost always some cash requirement, and there's really no choice but for the founders to come up with it themselves. Now, of course there are no real algorithms for precisely estimating the value of those three different inputs for every situation. There is still some bargaining and some negotiation that's involved among the founding team members in order to come to an outcome. But, these are the basic principles. What did everybody bring to the table and what was the value of what they brought to the table? So now I want to go into a little more detail on how to actually calculate that, and really how to think about it. To do that, we really need to talk about the sweat. The sweat is one of the things that's hard to value, and I want to give you the approach that I've taken in several new ventures, and I've seen others take it as well. I think it works quite well. And it essentially starts with, what's the market value of the labor that the founders will be devoting to the enterprise? So, for instance, let's imagine that someone is quitting their job. And they're quitting their job, let's say, as a product manager working at a relatively large company. And let's say they were being paid $100,000 per year, in that job. If they then devote a year of their time, then logic would suggest that that's worth $100,000. The market has just paid them $100,000 per year for similar kinds of services and now they're going to perform those services for a new venture without receiving cash. And so logically, that should be worth about $100,000. So, that's the notion of using the market value of services in order to establish what is the sweat really worth. And that allows you to accommodate the fact that different people actually have different market value.



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This session is on Allocating Equity Among Team Members. Let me start by giving you an example. And then I'll explain what equity is and how to allocate it. This is the founding team of a leading mobile phone provider in China called Xiaomi. And Xiaomi was founded by eight individuals. That was a really dream team that came from the Silicon Valley elite from companies like Microsoft and Google. And the founder, the CEO, sitting in the middle here is Jun Lei who is now a celebrity in China. When these eight people came together, they had to figure out what did they bring to the table, and how would they share the rewards if they eventually became successful. That's the essential challenge in allocating equity in the start up team. By equity, we mean an ownership or profit interest in the new enterprise. Most new ventures involve several key team members, and there's an interest, there's some value in having those team members share in the ownership of the venture. That's usually valuable for several reasons. First, it's typically required by outside investors. Outside investors want to know that the management team shares their incentives to create an enterprise of tremendous value. It also allows the enterprise to pay the team members with profit interest, or shares, as opposed to with cash. Cash is typically the most scarce resource for the new venture. And lastly, many individuals who were attracted to entrepreneurial ventures are also motivated by the possibility that if they're really successful they might get an outsize financial reward and that's only possible if you have equity in the new venture. Now to explain what equity is, I need to explain the concept of a capitalization table which usually just goes by the term cap table. A cap table is simply an accounting of the shares of the company and who owns them. I'm going to show you just a very typical although somewhat simplified cap table. Typically, the founders would own some chunk of shares. Here, I've shown the founders owning 500,000 shares, which represents half of the shares that are authorized, so they own half of the shares, or 50%. There's usually some reserved shares for key team members who are hired after the founding event. So for instance, this might be the vice president of marketing, or the vice president of sales, and in this case I've shown 100,000 shares reserved for those key employees or 10%. There's usually then something called an option pool, which investors require that you set aside for compensating future employees. And so many of you have probably heard of someone joining a tech start up and getting options or stock options. And stock options come out of this pool of shares. That's usually required by the investors, before they'll put money into a new venture. Now just as a somewhat arcane aside, options usually are, just as that term implies, an option to purchase shares, as opposed to an outright grant of the shares. That difference is really mostly relevant for the tax treatment, and in countries like the United States, where a grant of shares might be taxed as ordinary income. In order to avoid that, most companies will allocate options to employees which don't normally suffer from being taxed at the time they're issued. And then the last category of shares is the shares allocated downside investors. In this case, I've shown that as 300,000 shares representing 30% of the shares that are authorized. So this is a cap table. Now I'm going to go through each of the lines here and just say a few words about how they're established, how they're allocated. And then we're going to turn to that top row, which is the founders' shares, and how to allocate those shares across the founders. Let's start with the outside investment. Now the outside investment, the number of shares allocated to outside investment, is determined by two things. The first thing is how much money the investors put into the company, and the second is, what the value of the company is before the investors put their shares in, and that's a term you've probably heard, called valuation. And in particular, the pre-money valuation. That is, what's the value of the company, what's the imputed or implied valuation of the company before the investors put any money into it. So just in this example, let's assume that the company arrives at a valuation, usually in negotiations with it's investors of $700,000 US that's before any new money is put in. Then the investors invest $300,000 so now what the company has, is it has $700,000 in value. That was the value it had before it got the money. And it now has $300,000 in the checking account, and so its total value is now $1 million. And because the investors provided 300,000 of the total value of $1 million, they own 30% of the company, so that's how that number is calculated. The second issue here is how to allocate the option pool. The option pool, just by convention, is usually established to be about 10% of the shares that are outstanding. And that's usually just a requirement of the investors. The investors want you to set aside some shares so that you can compensate future employees, give them some incentive to increase the value of the company. It's usually established by negotiation. Those shares may or may not be issued in the future, but they have to be shown on the cap table. And if you've ever heard someone discussing cap tables, talking about share price on a fully diluted basis, for instance, that notion of full dilution means that you assume that all of those options were issued, and you use those shares in the calculation of share price. The next piece is the equity allocated for key team members. This would typically be vice president of marketing, for instance, vice president of sales. The number of shares here is usually established by the market conditions, that is what you have to offer to be able to attract the right people to your team, and also to some extent when they joined the venture. So if these are very late hires, after the company is already up and running and quite valuable. You might need relatively few shares here. But if it's right at the beginning, typically a fairly large number of shares have to be allocated to retain and attract the key members of your team who aren't necessarily founders. All right, that's all background that leads us up to this key question which is a of those 500,000 shares that are shown here in the cap table as going into the founders how do we determine, how many of those shares each member of the founding team actually receives? So let's turn to that question. As background I want to show what typically the founding shares look like before and after financing. So often at the very beginning of the enterprise or after the founding team has worked on it for a little while is when you actually establish, you assign the equity to the founding team. And let's just say for the sake of argument that shown here on the left, we valued what we have when we start the company at about $300,000. Now, at the time of investment we have the cap table as I showed previously. And I showed the value of what the founders began with plus the equity for key employees plus the option pool for future employees plus the equity purchased by investors. Now notice that in this example I've shown that the value of the company at the time of founding was about $300,000, but by the time investment came in, if the team is doing its job, it's actually increased the value of what it has, of what it started with. And that's why I show that line moving up. And so the value they started with was about $300,000. At the time of financing it, the time that CAP table was computed, the value I estimated at $500,000. Now of course, this is just an illustrative example. The specific numerical values for your company will differ widely. And so, you should think of this just as an example, to walk through some of the arithmetic. So now I want to go back to that founding moment when the founding team is sitting there looking at what they have and saying okay, how do we divide this up? Now, if you think about it, what should determine how those assets or how those shares are divided among the founding team? Well, it's really, what did the founders bring to the table? What assets did they bring to the party? And those assets you can think about as occurring in three different categories. The first category would just be the original idea. Who came up with the idea and developed the opportunity and perhaps developed alongside that some intellectual property? Maybe a product design, maybe an algorithm, maybe some market research. Some original intellectual property that formed the genesis of the raw opportunity. That's the first category of assets that founders bring. The second category is what we call sweat, and that's short for sweat equity. And sweat simply means the effort that the founding team will put into the venture without cash compensation, and so that's why we call it their sweat. They're earning equity in the venture through their sweat, they're not being paid cash and instead they're being paid in effectively a share of the future profits or future value of the company. And then the third category is cash. And no matter how you slice it, the founders almost always have to reach into their pockets, or put some money on their credit card, and come up with some money to get the venture started. It's usually not the bulk of the money required to capitalize the business, but there's almost always some cash requirement, and there's really no choice but for the founders to come up with it themselves. Now, of course there are no real algorithms for precisely estimating the value of those three different inputs for every situation. There is still some bargaining and some negotiation that's involved among the founding team members in order to come to an outcome. But, these are the basic principles. What did everybody bring to the table and what was the value of what they brought to the table? So now I want to go into a little more detail on how to actually calculate that, and really how to think about it. To do that, we really need to talk about the sweat. The sweat is one of the things that's hard to value, and I want to give you the approach that I've taken in several new ventures, and I've seen others take it as well. I think it works quite well. And it essentially starts with, what's the market value of the labor that the founders will be devoting to the enterprise? So, for instance, let's imagine that someone is quitting their job. And they're quitting their job, let's say, as a product manager working at a relatively large company. And let's say they were being paid $100,000 per year, in that job. If they then devote a year of their time, then logic would suggest that that's worth $100,000. The market has just paid them $100,000 per year for similar kinds of services and now they're going to perform those services for a new venture without receiving cash. And so logically, that should be worth about $100,000. So, that's the notion of using the market value of services in order to establish what is the sweat really worth. And that allows you to accommodate the fact that different people actually have different market value.


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