image

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

If you need to hire a sales person, sales people are often paid very differently than, say, software engineers in different industries. And so it allows you to use their market value in similar roles, perhaps currently or in the past, to establish the value of the inputs they're bringing to the startup. However there's a challenging issue here, which is, those who were providing the cash to the venture rarely want $100,000 of their cash to be $100,000 of sweat. They've view the sweat as a little bit of sort of what we might call funny money. It involves some sort of soft calculations, and so for that reason, there's often an adjustment that values a dollar of market value of sweat at less than a dollar value of cash. And let me give you the arguments for that. The argument is basically that $100,000 of sweat is worth less than $100,000 of cash. Here are the three main arguments for why that might be so. First, often people don't quit their jobs, and so what they're really doing is they're using their free time to work on the startup. And people often value their free time at less than they value their salary or their wages. And not only that, they're often not giving you their best hours. They're not giving you the same hours they're giving in their day job. And so that's one logic for valuing the sweat. It's perhaps slightly lower than the cash. The second argument, it's a little bit of an arcane tax argument. But cash investments are made with after tax dollars. So when you invest $100,000, those are your hard earned dollars after you paid taxes on them. The sweat is usually calculated on a pre-tax basis. So for that reason, investment's after-tax, sweat is pre-tax, you need some adjustment. And then the last reason that sweat is often valued at a lower rate than cash is that cash is king. Cash is usually the scarce resource in the startup, so cash is the hardest thing to come up with. Sweat, less so, and so for that reason, we often value cash at more than we value sweat. So let me walk you through a typical calculation, how to value these inputs, and how to end up with the allocation. So let's imagine we have three partners, founding partners, Claire, Huijing, and Sanjay. These are our three partners, and Claire actually had the original idea. And so Claire brought the opportunity and the idea to the party. She brought the others together to say, hey, let's go work on that. And so we're going to put a value on that opportunity identification. And somewhat arbitrarily, because I haven't even said what this venture is. I've just put the value of $100,000 here. This piece is going to be a negotiation among the partners. What is really the opportunity worth relative to the sweat and cash that we're putting in? I put in $100,000, but obviously if Claire had invented a cure for cancer and had a patented molecule, we would value it at much more than $100,000. And if all she did was buy people coffee and say, hey, I've got this idea for a taxi hailing app for a phone we might say eh, Claire, that's not really worth much. So this is just a representative example where we value the original idea at $100,000. Okay, let's now look at the sweat piece, and the way I've shown it here is I've assumed that Claire has foregone $120,000 in wages. She's putting in $120,000 of her sweat. Huijing has put in $60,000. Sanjay has also put in 60,000. And this is typically, not just the sweat that's been put in to date, but also a commitment of sweat, typically for some period into the future. Often until the first financing comes in, and people can start to be paid salaries. And then if you look at the next column, the after discount column, what I've done is to apply a 50% discount to those market values of the sweat, in order to come at an equivalent cash value to that sweat. Again, the 50% is the result of a negation. It's a value that I've often used. I think it's about right, but you're going to have to work that out with your partners. And then, the last category of input is cash. Again, it's very hard to start something without putting at least some cash in. I've shown here, the founders putting in quite a bit of cash. So they put in 60, 70, $80,000 in cash here. Claire put in $40,000. Huijing put in $25,000. Sanjay put in $15,000. And of course, cash, a dollar of cash is worth a dollar of value, a dollar of cash, almost by definition. So, putting that together, you can see the percentage ownership that corresponds to each of the three categories of inputs for each of the three founders. And we could add those up to estimate what fraction or to calculate what fraction each founder owns. So for instance, Claire would have 33.3% plus 20% plus 13.3% which, let's see, rolls up to 66.6%. It would be Claire's interest, would be the fraction of the original founder shares that Claire would have a claim on. All right, so that's an example of the arithmetic that can be done before any new money has come in to the enterprise. Now, if the idea of filling out a spreadsheet like this with your founders really starts to make your stomach turn, then there actually some softer ways to have this negotiation. I'm going to show you an example that I used in a recent venture where we thought, where it just made a little friendlier to move some geometric shapes around on a graph. So what we did was to say, there are various kinds of roles and inputs that are going to be required in this new venture. Those are represented here by the columns. You can see the left most column is the idea. The right most column is the cash. And there's some other inputs described as effectively as the phases of the creation and growth of the enterprise. That's the additional columns. And then we put the team members as the rows. And all we did was simply put a square, a triangle, or a small square in the cell to reflect people's relative beliefs about the road of contribution of each of the partners to each of the phases of the development of the enterprise. Now of course you can put numbers in the cells but this is sort of as they say a little friendlier way to have the discussion. We actually found that in this particular instance, the team members converged remarkably quickly. There was remarkable agreement on who came up with the idea, who's put in the cash, who's going to do this, who's going to do that, and this was actually a nice way to facilitate that discussion. You can probably imagine that once you had this kind of representation of the relative contributions, you then need to do some arithmetic to convert this into some actual numerical percentages. There are a couple of issues that often come up, when you actually go to make this happen in practice. The first issue is that sometimes a team member doesn't work out as planned. That might be because they don't do what they actually committed to do. It might be that the team doesn't get along. It might be that you decide you really need a different person on the team. And of course one of the problems is, if you've allocated shares right there on the first day, you are essentially stuck with that share holder forever, and that can be quite awkward. So, typically the way it works is that you issue the shares but the shares don't vest, meaning the share holder doesn't actually have The full title and interest in the shares, until some time has elapsed. Usually, that time period is somewhere between three and six months, before the first vesting milestone. And if within that first three to six months, you realize there's going to be some problem with a team member, you can part ways without having them as a shareholder forever. The second issue that comes up is tax liability. In many tax jurisdictions and specifically in the United States, you incur a cash tax liability even for a non-cash grant of stock. So, if you get a grant of $100,000 in stock you would owe the government taxes on that $100,000, even though you never got any cash. That of course is usually a real problem for people joining a new venture, who don't have a lot of cash. So, typically there are two strategies. The first is to grant shares to the team very, very early, when you can argue they have almost no value. Often you'll argue they have a value of maybe one cent, or a fraction of a cent. And you'll go ahead and pay taxes on that stock. But, the value will be so low that there will be very little tax liability. The second approach is to issue stock options, which are not actually the stock itself, but rather the right to purchase stock in the future at some pre-specified price, usually a quite low price. So, stock options themselves are quite valuable, but the way their taxed in most tax jurisdictions is that they aren't taxed until they're actually exercised, not when they're originally issued. Now, it goes without saying that these are complicated matters, they vary by jurisdiction and so, you really need to consult with both a lawyer and an accountant as you think about these formation issues, and as you decide how to grant stock to your founding team. The last issue I want to address is how we compensate advisors, and how we allocate equity to advisors. Advisors can often add value for two reasons. First of all, advisors often have specific expertise that they can convey through meetings, discussions, introductions, emails, and so forth. And they're sort of doing real work for you and it's sort of services rendered, but advisors also help you by lending reputation and credibility to the venture. And it's only fair that you compensate them for both of those things. Both for their reputation, you're going to put them on your website and in your investment documents typically, and for the actual services that they perform. And the way I like to think about this is to think about what is the economic value of these services that are being delivered. And what's the value relative to the other inputs that are being provided at the same time, that is the cash and sweat of the founders? So, let me just give you a sample calculation. Let's imagine that you retained an advisor, that advisor is committed to spending four days over the next year at a value of $5,000 per day. After all, these are typically quite well paid people with quite a bit of deep expertise. So, that would give you about $20,000 of value that was contributed. Let's also imagine that the value you impute to their enhancing your credibility is perhaps $15,000, that is what's you're be willing to pay to be able to list them on your website and put them in your investment documents to convert some credibility on what you're doing. So, that would give you a total value of $35,000. Then if you believe that logic and if you believe those inputs then that adviser should received equity worth approximately $35,000, just the same as the equity of a cash investor who would invest $35,000 or of the founding team who would give $35,000 of input. This calculation's worth doing, but I do want to point out that there are some norms in venture backed start ups and advisors typically end up owning about a quarter of a percent to 2.5% of the equity, that's per advisor.



Want to learn a language?


Learn from this text and thousands like it on LingQ.

  • A vast library of audio lessons, all with matching text
  • Revolutionary learning tools
  • A global, interactive learning community.

Language learning online @ LingQ

If you need to hire a sales person, sales people are often paid very differently than, say, software engineers in different industries. And so it allows you to use their market value in similar roles, perhaps currently or in the past, to establish the value of the inputs they're bringing to the startup. However there's a challenging issue here, which is, those who were providing the cash to the venture rarely want $100,000 of their cash to be $100,000 of sweat. They've view the sweat as a little bit of sort of what we might call funny money. It involves some sort of soft calculations, and so for that reason, there's often an adjustment that values a dollar of market value of sweat at less than a dollar value of cash. And let me give you the arguments for that. The argument is basically that $100,000 of sweat is worth less than $100,000 of cash. Here are the three main arguments for why that might be so. First, often people don't quit their jobs, and so what they're really doing is they're using their free time to work on the startup. And people often value their free time at less than they value their salary or their wages. And not only that, they're often not giving you their best hours. They're not giving you the same hours they're giving in their day job. And so that's one logic for valuing the sweat. It's perhaps slightly lower than the cash. The second argument, it's a little bit of an arcane tax argument. But cash investments are made with after tax dollars. So when you invest $100,000, those are your hard earned dollars after you paid taxes on them. The sweat is usually calculated on a pre-tax basis. So for that reason, investment's after-tax, sweat is pre-tax, you need some adjustment. And then the last reason that sweat is often valued at a lower rate than cash is that cash is king. Cash is usually the scarce resource in the startup, so cash is the hardest thing to come up with. Sweat, less so, and so for that reason, we often value cash at more than we value sweat. So let me walk you through a typical calculation, how to value these inputs, and how to end up with the allocation. So let's imagine we have three partners, founding partners, Claire, Huijing, and Sanjay. These are our three partners, and Claire actually had the original idea. And so Claire brought the opportunity and the idea to the party. She brought the others together to say, hey, let's go work on that. And so we're going to put a value on that opportunity identification. And somewhat arbitrarily, because I haven't even said what this venture is. I've just put the value of $100,000 here. This piece is going to be a negotiation among the partners. What is really the opportunity worth relative to the sweat and cash that we're putting in? I put in $100,000, but obviously if Claire had invented a cure for cancer and had a patented molecule, we would value it at much more than $100,000. And if all she did was buy people coffee and say, hey, I've got this idea for a taxi hailing app for a phone we might say eh, Claire, that's not really worth much. So this is just a representative example where we value the original idea at $100,000. Okay, let's now look at the sweat piece, and the way I've shown it here is I've assumed that Claire has foregone $120,000 in wages. She's putting in $120,000 of her sweat. Huijing has put in $60,000. Sanjay has also put in 60,000. And this is typically, not just the sweat that's been put in to date, but also a commitment of sweat, typically for some period into the future. Often until the first financing comes in, and people can start to be paid salaries. And then if you look at the next column, the after discount column, what I've done is to apply a 50% discount to those market values of the sweat, in order to come at an equivalent cash value to that sweat. Again, the 50% is the result of a negation. It's a value that I've often used. I think it's about right, but you're going to have to work that out with your partners. And then, the last category of input is cash. Again, it's very hard to start something without putting at least some cash in. I've shown here, the founders putting in quite a bit of cash. So they put in 60, 70, $80,000 in cash here. Claire put in $40,000. Huijing put in $25,000. Sanjay put in $15,000. And of course, cash, a dollar of cash is worth a dollar of value, a dollar of cash, almost by definition. So, putting that together, you can see the percentage ownership that corresponds to each of the three categories of inputs for each of the three founders. And we could add those up to estimate what fraction or to calculate what fraction each founder owns. So for instance, Claire would have 33.3% plus 20% plus 13.3% which, let's see, rolls up to 66.6%. It would be Claire's interest, would be the fraction of the original founder shares that Claire would have a claim on. All right, so that's an example of the arithmetic that can be done before any new money has come in to the enterprise. Now, if the idea of filling out a spreadsheet like this with your founders really starts to make your stomach turn, then there actually some softer ways to have this negotiation. I'm going to show you an example that I used in a recent venture where we thought, where it just made a little friendlier to move some geometric shapes around on a graph. So what we did was to say, there are various kinds of roles and inputs that are going to be required in this new venture. Those are represented here by the columns. You can see the left most column is the idea. The right most column is the cash. And there's some other inputs described as effectively as the phases of the creation and growth of the enterprise. That's the additional columns. And then we put the team members as the rows. And all we did was simply put a square, a triangle, or a small square in the cell to reflect people's relative beliefs about the road of contribution of each of the partners to each of the phases of the development of the enterprise. Now of course you can put numbers in the cells but this is sort of as they say a little friendlier way to have the discussion. We actually found that in this particular instance, the team members converged remarkably quickly. There was remarkable agreement on who came up with the idea, who's put in the cash, who's going to do this, who's going to do that, and this was actually a nice way to facilitate that discussion. You can probably imagine that once you had this kind of representation of the relative contributions, you then need to do some arithmetic to convert this into some actual numerical percentages. There are a couple of issues that often come up, when you actually go to make this happen in practice. The first issue is that sometimes a team member doesn't work out as planned. That might be because they don't do what they actually committed to do. It might be that the team doesn't get along. It might be that you decide you really need a different person on the team. And of course one of the problems is, if you've allocated shares right there on the first day, you are essentially stuck with that share holder forever, and that can be quite awkward. So, typically the way it works is that you issue the shares but the shares don't vest, meaning the share holder doesn't actually have The full title and interest in the shares, until some time has elapsed. Usually, that time period is somewhere between three and six months, before the first vesting milestone. And if within that first three to six months, you realize there's going to be some problem with a team member, you can part ways without having them as a shareholder forever. The second issue that comes up is tax liability. In many tax jurisdictions and specifically in the United States, you incur a cash tax liability even for a non-cash grant of stock. So, if you get a grant of $100,000 in stock you would owe the government taxes on that $100,000, even though you never got any cash. That of course is usually a real problem for people joining a new venture, who don't have a lot of cash. So, typically there are two strategies. The first is to grant shares to the team very, very early, when you can argue they have almost no value. Often you'll argue they have a value of maybe one cent, or a fraction of a cent. And you'll go ahead and pay taxes on that stock. But, the value will be so low that there will be very little tax liability. The second approach is to issue stock options, which are not actually the stock itself, but rather the right to purchase stock in the future at some pre-specified price, usually a quite low price. So, stock options themselves are quite valuable, but the way their taxed in most tax jurisdictions is that they aren't taxed until they're actually exercised, not when they're originally issued. Now, it goes without saying that these are complicated matters, they vary by jurisdiction and so, you really need to consult with both a lawyer and an accountant as you think about these formation issues, and as you decide how to grant stock to your founding team. The last issue I want to address is how we compensate advisors, and how we allocate equity to advisors. Advisors can often add value for two reasons. First of all, advisors often have specific expertise that they can convey through meetings, discussions, introductions, emails, and so forth. And they're sort of doing real work for you and it's sort of services rendered, but advisors also help you by lending reputation and credibility to the venture. And it's only fair that you compensate them for both of those things. Both for their reputation, you're going to put them on your website and in your investment documents typically, and for the actual services that they perform. And the way I like to think about this is to think about what is the economic value of these services that are being delivered. And what's the value relative to the other inputs that are being provided at the same time, that is the cash and sweat of the founders? So, let me just give you a sample calculation. Let's imagine that you retained an advisor, that advisor is committed to spending four days over the next year at a value of $5,000 per day. After all, these are typically quite well paid people with quite a bit of deep expertise. So, that would give you about $20,000 of value that was contributed. Let's also imagine that the value you impute to their enhancing your credibility is perhaps $15,000, that is what's you're be willing to pay to be able to list them on your website and put them in your investment documents to convert some credibility on what you're doing. So, that would give you a total value of $35,000. Then if you believe that logic and if you believe those inputs then that adviser should received equity worth approximately $35,000, just the same as the equity of a cash investor who would invest $35,000 or of the founding team who would give $35,000 of input. This calculation's worth doing, but I do want to point out that there are some norms in venture backed start ups and advisors typically end up owning about a quarter of a percent to 2.5% of the equity, that's per advisor.


×

We use cookies to help make LingQ better. By visiting the site, you agree to our cookie policy.