| Business Basics for Engineers by Mike Volker |
EQUITY: Dividing the Pie
Contact: Mike Volker, Tel:(604)644-1926, Fax:(604)925-5006Email: mike@risktaker.com
I'd rather have a small piece of a big pie than a large piece ofnothing! (M. Volker)
Why Do You Need a Partner?
If you are very bright, very tenacious, and financially well endowed, thenyou can start a company which you own in its entirety and in which youcan hire a bright, capable, highly motivated and well-paid management team.However, if you do not fit this description entirely (I might add that,if you do not possess at least one of these attributes, you might wantto re-think starting your own business), then you will likely have to bring"partners" into your company by giving them equity, i.e. some share ownership.Obviously, investors who bring money to fuel the growth of your companydeserve some ownership. Similarly, key people who join you on your team,or who start the company with you, will want some form of ownership ifthey are making a valuable contribution for which they are not being fullypaid in cash. Others who contribute their skills, experience, ideas, orother assets (such as intellectual property) may be given shares in yourcompany in lieu of being paid in cash.How do you deal in New Partners?
Valuation is the issue. What is the new partner's contribution worth inrelation to the whole pie? At that moment in time, what is the companyworth and how is that worth determined? Bringing in new shareholders alwaysmeans "dilution" to the existing shareholders. If a new investor is toreceive a 10% stake in the company, then a shareholder who previously held40% of the equity, will now hold 36% (i.e. 90% of 40%). You never actuallynever give up your shares when new people are dealt in. You simply issuemore shares (the same way governments print money). Issuing more sharesis what causes the dilution. If you have 100 shares and you want to givesomeone 10%, you'd have to issue 11 new shares (11/111 x 100 = 10%, approximately).Unless you are greatly concerned about control issues, each time youdilute you should be increasing your economic value. If you dilute yourownership from 40% to 36%, you still hold the same number of shares, butthe per-share value should have increased. For example, if you entice TerryMathews (of Newbridge and Mitel fame) to your board by paying him 10%,it is quite likely that your shares will double or triple in value (i.e.market value for sure and hopefully also intrinsic value because of strengthenedleadership). If your 40% was worth $1 million, your resulting 36% may nowbe worth $3 million!
If you bring in a new VP of Marketing and give her 5% as a signing bonus,how do you know that her contribution will be worth 5%? How do you measuresomeone's reputation? Unless the person is well known or has a proven record,it may not be so easy. That's why vesting (described later) may be appropriate.
There is only one way to bring in new partners: carefully and with deliberation.A partner may be with you for life. It may be more difficult to terminatea business partnership than it is to obtain a marital divorce. So thinkabout it!
Who Should Get What?
What percentage of the company should each partner in a new venture receive?This is a tough question for which there is no easy answer. In terms ofpercentage points, what's an idea (or invention or patent) worth? What's5 years of low salary, sweat and intense commitment worth? What is experienceand know-how worth? What's a buck worth? "Who should get what" is bestdetermined by considering who brings what to the table.Suppose Bill Gates said he'd serve on your Board or give you some help.What share of the company should he get? Just think about the value thathis name would bring to your company! If a venture capitalist thought yourcompany was worth $1 million without Gates, that value would increase several-foldwith Gates' involvement. Yet, what has he "done" for you?
Often, company founders give little thought to this question. In manycases, the numbers are determined by what "feels good", i.e. gut-feeling.For example, in the case of a brand-new venture started from scratch byfour engineers, the tendency might be to share equally in the new dealat 25% each. In the case of a single founder, that person may choose tokeep 100% of the shares and build this venture through a "bootstrapping"process, in order to maintain total ownership and control by not dealingin other partners. It may be possible to defer dealing in new partnersuntil some later time at which point the business has some inherent valuethereby allowing the founder to maintain a substantial ownership position.
The answer to the question "who should get what" is, in principle, simpleto answer: It depends on the relative contributions and commitments madeto the company by the partners at that moment in time. Therefore,it is necessary to come up with a value for the company, expressed in eithermonetary terms or some other common denominator. It gets trickier whenthere are hard assets (cash, equipment) contributed by some parties andsoft assets (intellectual property, know-how) contributed by others. Let'slook at a some examples for illustration.
1. Professor Goldblum has developed a new product for decreasing thecost of automobile fuel consumption. He decides that in order to bringthis innovation to market, he will need a business partner to help himwith a business plan, and then manage and finance a new company formedto exploit this opportunity. He recruits Sam Brown, aged 45, who has agood record as a local entrepreneur. They agree that Sam will get 30% ofthe company for contributing his experience, contacts, and track recordplus the fact that he will take a $50K/year salary instead of a "market"salary of $100K for the first two years. Furthermore, they agree that Samwill commit his full-time attention to the firm for 5 years and that shouldhe leave, for whatever reason before the full term, he would forfeit 4%of the equity for each year under the 5 year term. The Professor takes60% for contributing the intellectual property and for providing on-goingtechnical advice and support. The Professor "gives" the University a token10% because according to University policy, the University is entitledto "some share" of his intellectual property because of its contributionof facilities even though, under its policy, the intellectual propertyrights rest with the creator. Although these numbers are somewhat arbitrary,they are seen by the parties as being fair based on the relative contributionsof the parties. As a taxpayer, one might suggest that the University gotthe short end of the deal, but that's a moot point.
2. Three freshly graduated software engineers decide to form a new softwarecompany which will develop and sell a suite of software development tools,bearing in mind the paucity of software talent plaguing the industry. Theyall start off with similar assets, i.e. knowledge of software, and comparablecontributions of "sweat equity". Heidi takes on the role of CEO of thenew venture and they divide the pie as to 40% for Heidi (because of hergreater responsibilities) and 30% each for the other two. They are happycampers for now. Some time later, they decide to recruit a seasoned CEOwith relevant experience and bring in a Venture Capital investor to fundthe promotion of their then-developed and shipable suite of software products.They will then have to wrestle with the issue of what their company isnow worth and how much ownership they will have to trade for these newresources. This will be determined by the venture capital suitor(s) inlight of current market investment conditions and the attractiveness ofthis particular deal.
3. Four entrepreneurs who have recently enjoyed financial windfallsfrom their businesses, decide to get into the venture capital business.They decide to form a company with $10 million in investment capital. Harryprovides $3 million, Bill provides $2 million, and the other two each provide$2.5 million. How much of the new company will each of them own? (Thisisn't a trick question.) For assets as basic as cash, it is easy to determine"fair" percentages.
In the case of the second example above, we have a situation in whicha company is established and has some value by virtue of its products andpotential sales in the market. The company's Board decides to bring inan experienced CEO (this also makes the venture capitalist happy) to developthe business to its next stage of growth. Although it may be possible tohire such a person and pay him/her an attractive salary, it probably makesmore sense to bring in such a person as more of a partner than a hiredhand. In this case a lower-than-market salary could be negotiated alongwith an equity stake. One way of doing this is to apply the differencebetween market rate and the actual salary over a period of time, say 5years, to an equity position based on a company valuation acceptable tothe founders. If a venture capital investment has been made or is beingnegotiated, this may set the stage for such a valuation. For example, Louisewas earning $125,000 per year working as the CEO of an American company'sCanadian operations. She agrees to work for $75,000 per year for 5 years.She is essentially contributing $250,000 up front (in the form of equitythat does not have to be raised to hire her). If the company has been valuedat $2 million, she ought to receive something in excess of 10% of the company.However, her shares would "vest" over 5 years meaning that each year shewould receive one-fifth of the shares from "escrow". She would forfeitany shares not so released should she break her commitment or should heremployment be terminated for cause. In this example, Louse's salary isreally $125,000 per year but she is investing a portion of this in thecompany's equity (on a tax-advantaged basis, I might add!).
For more mature companies and especially for publicly-listed companies,it is possible to provide managers with incentive stock options as an additionalincentive in the form of a reward if the company performs well and if thestock price reflects this performance. However, this is not the same asownership and should be viewed as part of a salary package.
Important Point: Don't confuse equity (i.e. investment and ownership)with income (i.e. salary)!
Shares vs Percentage Points
Sometimes people will get hung up on percentage points. For example, ifa new company is created which consists of many people, it may not be possibleto divide that fixed 100% into 20 or 30 meaningful chunks of 10%. It justwon't work. Some people may receive only 3% and may feel slighted by whatappears to be an insignificant amount (although I sure would like to havehad 1% of Microsoft when it got started). It's too bad that only 100 percentagepoints are available. However, there is no limit on the number of shareswhich can be issued. So, let's issue 10 million shares and give our 3%person 300,000 shares. We all know that someday these shares might be worth$5, $10, or $50! Work it out! It suddenly becomes more palatable.So, how many shares should be issued? Small public companies usuallyhave between 5 and 15 million shares outstanding. Larger public companiesmay have 100 million or more shares issued. Private companies, large orsmall, have fewer shares issued - anywhere from 1 to perhaps a few million.The number is not really important for private companies because theseshares do not trade in a public market. When companies go public, i.e.list their shares for trading, there are often stock splits such that 5or 10 new shares are traded for each existing share in order to give acompany a "normal" number of shares and a "normal" price range.
The number of shares which you will issue when you first start out shouldbe determined by how many partners you wish to have. If only a handful,then you could simply issue 100 shares with the percentage points beingequivalent to the number of shares. It might make you and your partnersfeel better to increase this number by a few orders of magnitude. That'sOK, too. If you have many partners, it helps to have many shares - evenif only for psychological reasons.
Novice entrepreneurs may think, "Gee, it would be nice to own 5 millionshares in a company." True, but it may cause complications if you havetoo high a number. For example, if you start with 10 million shares andthen deal others in so that you end up with 15 million shares and thenyou decide to go public, resulting in over 20 million shares, this maybe too large a number and you may have to do a roll-back or consolidation(see next paragraph).
Stock Splits and Stock Rollbacks
You have probably heard of a "stock split". This happens often with publiclytraded companies when their share prices become "too high". Microsoft,for example, has split many times. That's why Bill has 270 million shares.Microsoft does this when the share price appears too expensive for theaverage investor. After all, who wants to pay $500 for one share? If yousplit 2 for 1, then the price per share would be $250, but if you split5 for 1, the price per share would now be $100. When companies split theirshares, they do so simply by exchanging new shares for old shares withall the shareholders.Stock rollbacks or share consolidations as they are sometimes calledare the reverse of stock splits - but with one notable difference. Whena rollback is done, 1 new share is issued for 2 or 3 (or whatever the Boarddecides) old shares. However, the new shares are issued under a new corporatename meaning that the company must change its legal name. Often the changeis minor, such as from Acme Corp to Acme Inc or from Acme Corp to Acme2000 Corp. This is done so that the new shares are not as likely to beconfused with old shares. This is not the case for splits, assuming thatshareholders will want to trade in their old shares for new shares whereasin the case of consolidations shareholders will not be eager to trade theirold for their new.
Why a rollback? If a share price is too low, the company may appearlike a "penny stock" or nickle-and-dime outfit. So, if a stock is tradingat $.10 per share a 1 for 10 rollback, will give the stock a more respectabledollar appearance. Also, if a smaller, more junior company has 500 millionshares outstanding (which can happen), it may be better, for market reasons,to have a tigher "float" (i.e. number of issued shares trading on the market).
In terms of what is appropriate, here are some ballpark numbers to consider.Private companies, closely held (i.e. few shareholders) would have a smallnumber of shares, regardless of their size. Private sompanies with a largernumber of shareholders (say up to 50) could have a few thousand or evena few million shares issued. Small public companies (with annual salesbelow $10 million) such as those trading on a junior stock exchange, likeVancouver, would have between 5 and 10 million shares issued. Senior companies(with annual sales in excess of $100 million) such as those trading onToronto, might have more than 50 million shares issued. The really mammothcorporations with sales in the billions of dollars will likely have morethan 100 million shares issued. Microsoft has about 600 million sharesissued as at March, 1997.
Implications of Ownership
Ownership means sharing risks and sharing rewards. It implies a certaindegree of control (i.e. risk management) insofar as the shareholders appointthe management team and it implies a sharing in the value of the company- however measured (i.e. profits, the net worth, market value, etc). Theseare two distinctly different concepts. The astute entrepreneur might askherself if she wants to be a wealthy, independent owner or if she wantsto be a very busy manager! Most owners, especially founders appoint themselvesas the senior managers. And, they have this right. But, I'd rather be richthan busy or poor. The most important aspect of share ownership is thatas the value of the company increases, one's share of the value also increases.Bill Gates doesn't really have billions of dollars. What he has is a fraction(one-quarter, roughly) of a business worth many billions of dollars. Yourrisk is the investment you put in, other forgone opportunities, and possiblyreputation (if the deal sours). But the reward may be unlimited. That'swhy equity is so attractive. It is not uncommon for a founder of a hightech venture to own a million shares (which cost him very little in theform of cash) and see these shares appreciate to a value of several milliondollars in a relatively short time frame. There are literally thousandsof examples of this - Gates being the most prominent one.Ownership does not imply any additional obligations nor liabilities.Once an equity stake is purchased, or "vested", it belongs to the ownerforever. It also entitles the owner to vote for the company's board ofdirectors, its governing body. Depending on the relative shareholding,a shareholder may have very little control as in the case of a large publiccompany or very substantial control as in the case of a small company inwhich he has more than 50% of the votes or in which he may have less than50% of the votes, but still have great influence by virtue of a shareholders'agreement.
A very successful founder once said, "I'm not really very smart, butI sure do have a lot of smart people working for me!". This person understoodthe difference between ownership and management.
What's a Company Worth? (and When?)
How is value added to a business over a period of time? All companies startoff being worth only the incorporation expense. As soon as people, moneyand assets are added or developed, a company will appreciate in value.If the management team comes up with a breakthrough technology, that maybe worth millions of dollars! The development of products and customersadds value. The management team itself is worth something by virtue ofits aggregate experience, skill, contacts, etc. Value is best measuredin terms of potential, not in terms of historical earnings or financialtrack record - but in terms of future performance possibilities. Valueincreases both through internal actions and growth as well as through externalcontributions (e.g. cash and people) which facilitate such growth.For founders and early investors, the upside potential is the greatest.In its early stages of development a company may be worth very little,especially to outsiders. All of the value may be dormant within the team- awaiting development. Those who contribute at this early stage deserveto enjoy enormous gains because they are the ones who are bold enough totake the initial risks. An "angel" investor who provides a University facultymember with a small amount of start-up funding, say $50,000 to preparean invention for exploitation, may easily deserve 10 or 20% of that business.After a concept is more fully developed, this initial position may be viewedas a "steal", but then again, most such "steals" end up being worthlessdeals!
It is both unhealthy and unrealistic for an entrepreneur to begrudgethe stake held by his or her early backers. Sometimes there is a tendencytowards seller's remorse. For example, an entrepreneur who sells 20% ofhis firm for $50,000 may feel cheated one year hence when a serious investoris willing to pay $500,000 for 20%. This is flawed thinking. Without thatintial $50,000, this company may never have survived its first year. Inthis illustration, the founder initially had 100%, then 80%, then endedup with 64%. The angel had 20%, then ended up with 16%. The rich investorended up with 20% - at least until the next round at which time they willall again suffer a dilution. Ideally, as time marches on, the value ofthe company increases dramatically such that subsequent dilutions becomeless and less painful to existing stakeholders. Sometimes, when milestonesare not achieved, the early investors and founders must swallow a bitterpill by enticing new investors with large equity positions with major dilutiveconsequences. But, that's business!
The value of a business is best ascertained by what an investor is willingto pay for it (i.e. its shares) or what a potential strategic acquisitor(i.e. an investor (or competitor) who wants to buy it for strategic businessreasons) is willing to pay for it.
It is prudent management philosophy to always be thinking in terms ofmaking a business attractive to such suitors by building a solid foundationand by nurturing and growing it. The business should always be in a conditionto sell it.
Other Alternatives
Let's be creative. You don't always have to give up shares in your companyif you can't pay cash. Also, it gets messy (from a corporate governanceperspective) having too many, especially small, investors. You might beable to negotiate a deferred payment arrangement, possibly with interest.If you need to acquire a tangible asset, you can likely obtain bank orthird-party financing. For soft assets like intellectual property, youcould consider entering into a royalty arrangement, i.e. for every unitsold embodying said intellectual property, you pay a 5% royalty on salesto the provider of the asset. And remember, equity is expensive. Givingsomeone a 5% stake, means that that party owns 5% of your firm's net worthand profits forever! So, tread cautiously.Summary
Dividing the pie is not easy. In the end, or to put it more correctly -in the beginning, it is important that all equity partners accept the deal.Each shareholder would like to own a bigger percentage - that only makessense. But, unfortunately, all the "percents" have to add up to 100. That'swhy it's nice to be able to issue 10 million shares. It sounds a lot betterto own 100,000 shares in the next hot software deal, than to only own amere one percent!At the time you sell some or all of your shares in the company, rememberthat it is dollars which you put into your bank account, not percentagepoints.
Copyright1997 Michael C. VolkerEmail:mike@risktaker.com -Comments and suggestions will be appreciated!
Updated: 971015
