1.2.15 Allocating Equity Among Team Members


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.
3:01
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.
4:04
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.
5:13
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.
8:50
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?
9:01
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.
9:39
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?
11:01
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. 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.
15:12
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.
17:58
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. And the specific values over that range will depend on who the advisor is and what they’re bringing. So, a relatively famous person, individual joined your team really early and puts in quite a bit of time. You’re going to need to allocate at least 2.5% of equity for that kind of engagement. On the other hand, let’s say a more, just someone with some specific expertise with maybe not much of a public reputation whose going to help you in a relatively limited way late in the process, you would expect that to be more like a quarter of a percent. So, that gives you a sense of the practical range of how advisor equity varies based on what it is they’re actually delivering.

Jim Rohn