by Mike Moyer
According to Carl J. Schramm, former president and CEO of the Ewing Marion Kauffman Foundation, "Entrepreneurs give security to other people; they are the generators of social welfare." The country needs entrepreneurs, the world needs entrepreneurs. Without them not much would happen.
In spite of the exciting life and important role of entrepreneurs, most people never become entrepreneurs. To most people the life is too risky. Most people can’t handle the ambiguity. Most people are afraid of failure. Every entrepreneur fails more often than they succeed.
Good Lessons and Bad Lessons
Failure is how an entrepreneur learns. In the startup life there are lessons that help you become a better entrepreneur and lessons that force you to become a worse entrepreneur. Good lessons are those that stem from failure related to how you and your team ran the business.
Good lessons improve an entrepreneur’s chances for future success. If you created a product that nobody wants, you will have learned to listen to customers in the future. If your marketing didn’t work you will learn to communicate better in the future. If your employees leave you, you will learn to be a better manager in the future. If you run out of money, you will learn to better manage cash in the future.
If a competitor comes out of nowhere and hands you your butt on a plate, you will learn to be more mindful of the market in the future and create a brand that will insulate you from the competition.
In fact, just about any failure that comes in the normal course of creating a business will ultimately make the entrepreneur stronger. She will learn to be a better predictor and a better responder in the future. In the startup world, this kind of failure begets success. These are good lessons.
Bad lessons, on the other hand, decrease an entrepreneur’s chances for success. They generally stem from failure related to getting burned by your partners.
Being an entrepreneur requires a great amount of trust and confidence. It requires bold moves and big ideas that change the way people think about life. When entrepreneurs become less confident and less trusting effectiveness diminishes. When they get burned by their partners they do learn, but they learn bad lessons. They learn to spend more time covering their own butts. They learn to spend more time and money writing contracts and agreements. They learn to move more slowly and take fewer risks. They learn to be less like entrepreneurs and more like everyone else.
It is demoralizing when entrepreneurs are burned by people they thought they could trust. It saps their confidence. They feel stupid and become bitter. Worse yet, their families lose confidence in them and become less supportive.
Inasmuch as failure is inevitable for entrepreneurs, getting burned is also inevitable. However, getting burned doesn’t have to be part of the equation and I believe there are very positive and productive ways to mitigate the long-term damage.
Equity-A Root Cause
Unfair equity allocation is a root cause of perceived mistreatment that can destroy relationships. In some cases founders deliberately take advantage of their partners, but in most cases the problem is accidental. The founder makes mistakes and it appears as if they burned their partners even though that wasn’t the intent. As in the case of the disgruntled millionaire example, the intent of the founder was to treat everyone fairly. However, because of a few bad decisions early on, there was a perception of deliberate injustice.
Partners and Equity
When two or more people form a partnership it is because they want to share the risk of a new venture. If I hire you to clean my house, we are not partners. I am your employer and you are my employee. If I ask you to be my partner it implies we are going to work together in some way to build value and reap the benefits later on. For instance, I can partner with you to clean someone else’s house and we can split the money somehow.
The problem is that because we get paid when the job is complete, we work for nothing until it’s over. So, as we clean we are essentially building equity in an asset (clean house) that will eventually be converted to cash when the owner of the house pays us. The owner gets the clean house and we get our money. So the question is, how much do we each get?
“How much do we each get?” is the most dangerous question of all business questions. It causes more problems than any other question I have found. It is most dangerous in situations where the contribution of the individual has a material impact on the outcome.
Here is what I mean: in the above example, the housecleaning partners have to figure out how to split the money. This decision, more than any other decision they will make, will determine the ongoing quality of their relationship. Doing this right is really hard.
Let’s say we decide to “keep it simple” and split the money “50/50”. I show up with a bucket full of cleaning supplies that cost me about $15, you show up with nothing. I work hard for three hours cleaning the kitchen and the bathrooms and you sweep the hall. The job pays $50. I get $25 which, after I subtract the cost of the supplies, nets me $10. You get $25—all profit for hardly any work. Hmmmm…this doesn’t seem fair. (By the way, 50/50 splits are extremely common and extremely problematic.)
Let’s say we decide to determine the split after we get paid. I think I deserve $10 for the supplies, plus $5 for my time in getting the supplies, plus $5 for getting the gig and $10 an hour for my work. So, after three hours of work I think I should get the whole $50. You think that compensating me for my supplies is fair, but you also think it’s only worth $1 because there are supplies left over. Plus, you want $20 an hour because you have more cleaning experience than I do. At the end of the day we have an issue that can’t be solved very amicably.
So what happens? In either case the relationship deteriorates and we will either have to solve our differences or split up.
Sometimes you luck out. If we both brought our own supplies and we both did our fair share of the work we would both be happy with $25. As long as we keep doing our fair share, life is good. But what if you get sick? What if I get tired of cleaning houses? What if I stop caring? What if your sister wants to join us? What if, what if, what if?
Partnerships are fragile relationships. Many of them fail because of the partners’ inability to answer the question of how much do we each get?
Equity Allocation
Equity is ownership in an asset. An asset is something that produces cash or can be converted into cash by selling it at a later date. (Nobody wants equity in a liability which is something that consumes cash.) So when you own equity in something you have a right to the future cash it produces. It’s pretty simple-right?
The problem with equity is that it can be very difficult to value because most of us can’t predict the future. Some of us are better at it than others, but at the end of the day the future is all based on assumptions. Businesses operate on a complex set of assumptions, some of which are grounded in historical trends. Startup businesses are pretty much all wild guesses.
If I own a lemonade stand how much is it worth? The stand itself and the supplies may have cost $100, but that doesn’t mean I can sell it for $100. If it’s hot I may be able to sell $100 worth of lemonade, but that doesn’t mean it’s not going to rain.
So, I have to make some assumptions. I’m going to assume that I can sell the equipment and supplies for about what similar stands are selling on Ebay.com- $50 for the stand and $20 for the supplies. Next, I check the weather and it gives a 20% chance of rain. So, I’m going to take that into account and bet that I’ll make $80. I’ll use up the supplies so they won’t be around to sell later. I’ll call the stand worth $50 + $80 or $130. That’s how much the stand is worth in the next 24 hours. As you can see, there are a lot of factors. If I want you to be my partner, we’re going to have to work through these scenarios and agree on which one we like. There are no guarantees. I may not be able to sell on Ebay, it might rain, or I might get robbed-who knows?
Let’s say I don’t own the stand. You do. Then it doesn’t matter how much it’s worth as long as I get paid
what I earn. But, sometimes you will want to pay me based on the performance of the business which is a combination of my sales skills plus your equipment. You could pay me on commission, but you would rather reinvest the money into the business.
One way to get me to work without giving me cash is to allocate some of the equity to me. You are allocating a percent of the rights to the future cash the business generates either by selling lemonade or by selling the stand and supplies.
By accepting equity instead of cash I am assuming the risk that I might never get paid. So, I’m going to accept equity (future cash) that I believe will be worth more than what I would otherwise get paid now (current cash). Figuring this out, even for a simple lemonade stand, is complicated.
This book outlines a simpler, more accurate and more fair solution that doesn’t require a complex set of assumptions or a crystal ball. This doesn’t have to be a guessing game.
How I Hope You Will Use this Book
This book is designed to help alleviate that awkward little conversation that, if handled improperly, can create a rift in your little blossoming company that may never be overcome. It is designed to create a common understanding between you and your partners and your early employees. It is designed to help you make the right decisions at the get-go.
I hope, that when you bring on a new person or partner or vendor, you will hand them a copy of this book and say, “here, this is how we’re going to split the equity until we raise our first round of financing.” Bang—the awkward conversation is addressed and tackled.
Using this book as a guideline for how you will pay people with equity in your company will save you a lot of time and a lot of anxiety. It will reward you and your team for hard work and, in the long run, it will make sure everyone gets what they deserve. That’s it, simple as pie.
Boy, I wish someone had handed me this book when I joined or started probably a dozen businesses over the past twenty years. That would have saved me a lot of headaches.
I’ve created this book because I wanted a book I could hand to someone before they got involved with one of my businesses. I needed this book to solve my own business problems. In fact, as I write, I have two businesses on my mind that are facing exactly the issues that this book is designed to address. I figured I can hash it out separately with each one of them or I can write a little book about it and share it with you.
Pie A La Mode
House Cleaning
To see the solution to the housecleaning problem, visit SlicingPie.com and click on the Pie à la Mode or scan the code.
Will work for pie.
Chapter One:
Slicing Pie
Allocating equity, otherwise known as “Slicing the Pie” is tricky. And, as we’ve discussed so far, it can not only cause irreparable damage to otherwise important business relationships, but also it can prevent an otherwise good business from even getting started in the first place. In order to understand how to slice the pie, you first need to understand a few things about the pie itself. Unlike apple pies, equity pies can grow and grow and grow.
All Pie is Created Equal
In the beginning, all pies are worth nothing. They start out as just an idea. Some guy is sitting at his desk or on the subway, or in bed, or in the car, or in the shower, or on a plane, or in the hall, or at lunch or somewhere else and his mind wanders; he thinks about a problem and a clever solution.
So clever, in fact, that he begins to think it would make a great business. The more he thinks about the clever idea, the more convinced he becomes that there is money to be made. He gets excited. And, before long, he is convinced that he is only a few short years away from early retirement.
If you remember nothing from this book, remember this: all pies, and therefore equity, are worth nothing when they are first created. Pies are essentially ideas and ideas are pretty much worthless in the beginning.
All too often a would-be entrepreneur is so convinced that her idea is going to be “the next big thing” that she locks it away, telling no one for fear it will be stolen. I’ve seen it time and time again. Someone will allude to a great idea and get all weird and secretive when you ask them about it.
I once knew a guy who kept an idea for a new kind of paintbrush secret for years. Finally, after much prodding, he told me about it. “Cool,” I said. I told him that I knew some guys who could help develop it a little further and he agreed to let me talk about it. The next week I came back with a working prototype of the brush and it worked exactly as described.
Now all he needed to do was manufacture it, buy inventory, create a fulfillment operation, create a brand, marketing plan, build a sales force, raise money and a million other things that the idea needed in order for it to become valuable. I guess he didn’t want to do those things because the idea still remains a prototype, locked in a closet somewhere. By the way, I’m not trying to be critical here. Like most people he has better or more important things to do than build a paintbrush company from scratch.
Occasionally companies pay for ideas; however, payment is generally in the form of a royalty payment with some kind of advance. Royalties recognize the importance of an idea in a startup by providing payments upon the successful implementation of the idea. I’ll cover how to use royalties later, just keep in mind that rarely, if ever, does a company pay, in advance, for a back-of-the-napkin concept alone. The idea has to have a little meat on the bones in the form of a market analysis, prototype, business plan, or patent. In these cases they aren’t buying the idea, they are buying the opportunity of which the idea is a part.
Ideas, if you must assign a value to them, are worth about a dime a dozen. They don’t become worth anything until they get baked into pies. Next, if after baking the pie, you find that people are willing to pay for the idea and you find that you can produce it for less than they are willing to pay, then (and only then) have you built value.
Sure there are stories about the guy who invented the little plastic thing pizza shops use to keep the box from squishing the pizza that made millions.
Or, you’ve heard the one about the woman who invented the “thingamabob” and retired to Hawaii. Those stories are either urban legends or exceedingly rare. Either way odds are they won’t happen to your idea.
How Pie is Valued
Putting a value on a company (pie) is much more art than science. For established companies, investors use a variety of tools. The most popular indicators of value have to do with cash flow, revenue and earnings.
People buy pies because they are assets or the buyer thinks it will become an asset. An asset is something that produces income.
The value of the pie is based primarily on the amount of income it is able to generate. Because the future is uncertain there is a lot of speculation with regard to future income generation so the value of a pie can vary dramatically based on who is looking at it.
If your company does not generate income you may be able to estimate a resale value based on the underlying assets of a company such as buildings, machines, inventory, etc. This is useful when the company doesn’t currently generate income or if the owners think the income is less than the resale value.
Most of the early-stage deals I know of focus on income vs. assets. Especially for tech companies that usually don’t have any real assets.
Cash-Out
At any given time, your company is worth whatever you can sell it for. If my lemonade stand consistently generates $1,000 profit per year I may decide that, rather than waiting a year to get the $1,000, I’d rather have some money right now.
So, I find someone who thinks that they would like to run a lemonade stand for a living and take home $1,000 per year or more if they think they can hawk lemonade better than I can. I tell them that the company is worth $5,000 because I think the market will not change much or even improve (global warming might make people thirstier) over the next five years so profits should stay the same. They think the market will change (Jamba Juice down the stre
et) and so they offer $3,000. I say okay. They just bought my pie for $3,000. I take the money and run.
In this case they just bought the whole pie from me and I cashed-out, meaning I took the money out of the business. The pie now belongs to someone else. My share of the pie is 0% and the buyer’s share is 100%. This transaction is also known as an “exit”.
Investors are always talking about exit strategies because they want to know how they are going to cash out of the business and take a return on their investment. In fact, all equity owners want to know the circumstances under which their equity will be cashed out.
Cashing-out is also useful when you want to disconnect someone from the business. If I own 90% of the business and you own 10% of the business and we agree that the value of the business is $100 I could give you $10 and take your shares. Thus, you turned your shares into cash and are now cashed-out.
It is not uncommon to cash-out shareholders who have small amounts of equity and are no longer involved in the business.
Cash-In
In many (most) cases a company will want to raise working capital. In this case they want to sell a part of the pie but keep the cash in the business and retain part of the ownership themselves. This is a very typical scenario. When you put cash in a business in exchange for equity it helps set a benchmark for the company’s value. Whatever the investor paid for equity is a generally considered a good indicator of what the rest of the world will say it is worth.
