Slicing Pie: Fund Your Company Without Funds
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You might think I would have learned from this mistake. Nope. Not long after I had another idea for a new company and bounced it off a few developers. I tried to entice them into doing the development work by offering them pie. They are Grunts so they happily agreed. Again, I made the mistake of slicing the pie before the pie had been baked.
When I realized that the technology component was much smaller than I had anticipated I realized I had offered too much pie for development. Now I have developers who think they own a huge hunk of my concept and neither of them have done any work whatsoever! That project is now stalled for two reasons: First, I sliced the pie in advance and now I have to renegotiate with them and, second, I stopped working on the project because it gave me the idea for this book!
I will not make this mistake again!
Vesting and Options
Vesting is a popular hedging method for those who slice the pie before baking it. Vesting is a structure under which your equity is granted according to a certain schedule. For instance, the company may give you 2,000 shares in the company with 100 shares vesting at the end of each month. At the end of the eighth month you would own 800. At the end of 20 months you would own all 2,000 shares. After that you have to either get nothing or negotiate more shares.
People figure if they slice up the pie and allow it to vest over time they create a safety net if the Grunt doesn’t work out. The problem is that you have to predetermine the amount of pie a Grunt will receive which means you are also trying to predetermine the value of that pie. This just doesn’t work during the Gap phase of a startup. However, as a company matures the value is more concrete and a vesting program can work nicely.
Companies like vesting because they think it helps retain employees. The employee has to stay a certain number of months, for instance, before their equity vests. If the employee leaves they stop vesting.
Vesting and options are legitimate solution for slicing pie and it works reasonably well. Later in this book I’ll tell you how to talk to your lawyer about setting up Grunt Fund-style vesting.
Along with vesting, it is customary for businesses to use options rather than actual equity. Options allow the Grunt to reap the financial rewards associated with equity, but avoid some of the tax implications. When you use options you are essentially keeping track of how you will slice the pie when it’s time to eat. It keeps the pie whole and it keeps your knife clean.
A Note about Vesting
When appropriate, the rules outlined in this book can serve as the basis for a vesting schedule. This will help address potential tax issues that arise from issuing equity. More later on this…
After it’s Baked
Sometimes entrepreneurs anticipate the problems with slicing pie before baking the pie so they decide to slice the pie after they bake it. This is even worse than doing it in advance. Now that the pie is baked and has some value there will be a Grunt feeding frenzy with every Grunt trying to get the biggest piece they can get. And, to make matters worse, they are starving! They haven’t been fed yet!
Some friends of mine once started a bike shop. They all put time and energy into it and, lo and behold, they made money!
So they had a pile of cash and none of them knew what to do with it. Who did it belong to? Did they keep it in the company or split it up? Some guys did more work than other guys, plus some had spent some of their own money for marketing materials.
One guy owned all the tools and the stand. One guy was a member of the bike club and a lot of the members were customers. After much ado, they chickened-out and split the money evenly. They all felt burned. The business was over.
When you slice a pie after it is baked you are forced to make judgment calls on each other’s contribution. You have to recreate what worked and what didn’t work while you were baking the pie. Everyone has a different point of view so nobody agrees.
Sometimes a herd of Grunts will do a little bit of work, like writing a business plan, before they start thinking about slicing the pie. So, the pie starts baking and they start seeing the value and they all want their piece. Again, you get a feeding frenzy and a herd of disgruntled Grunts.
Whether you’re slicing pie before or after it’s baked you run a high risk of getting burned or burning someone else. It is a tightrope, even if you have the best intentions.
Sometimes entrepreneurs find the right answer because they have enough experience to know what they will need, sometimes they luck out, and sometimes the pie grows so big so fast that nobody cares (like during the dot-com bubble).
However, you can’t always count on these things to work in your favor and good companies with good Grunts often ruin their chances for success when they make the inevitable bad choice.
Fixed-Splits
Whether people divide the pie before or after it’s baked they exacerbate their problems by using a fixed split (also called “static”). Today, nearly everyone on the planet does this. A fixed split means that once the pie is sliced the percentages remain fixed until there is a new negotiation. In spite of the prevalent use of fixed-splits, they always create problems of fairness (no exceptions).
You shall soon learn about a new method called a “dynamic” split which allows the ownership percentages to properly adjust without the need for stressful renegotiation. The advantages over a fixed split will be abundantly clear by the time you finish reading this book in a few short, enjoyable hours.
The Minefield
Obviously there are startups all over the place who have successfully handled equity allocation issues in their company. Nearly all of them that I’ve ever heard about slice the pie before or after the value is created. In these cases I can virtually guarantee that at least one of the participants felt mistreated or participants didn’t recognize the inequity because they didn’t know better
Either way, these are landmines that will eventually explode. The first problem will explode slowly as animosity festers within the organization. The second problem will explode violently when the participants wake up and realize they have been mistreated. Or maybe not…
Maybe the company does so well that they all choose to focus on the success and be happy with what they did receive. Most successful startups get through the early days in spite of their equity allocation problems. They have to, there is no other way.
In my experience, unfortunately, many good ideas do not last because of how the pie is sliced during the nascent stages of the company’s existence.
For every company that successfully navigates the minefield, there are a bunch of companies that don’t make it because they can’t get past the interpersonal problems of equity allocation.
We need a way to prevent problems before they happen.
We Need a Solution
The fundamental problem with using equity as compensation is that equity (pie) has no actual value. It is highly subjective so, lacking a concrete model, entrepreneurs try to assign an actual value. This is virtually impossible at the startup stage— anything can happen. If actual value is so unclear then what is clear? The answer is relative value.
While it’s impossible to calculate actual value, it is rather simple to calculate relative value. We can use relative value to solve the problem.
In order to solve the problem we must find a method for slicing pie that is easy to understand and:
Rewards participants for the relative value of the ingredients they provide
Provides motivation for them to continue to provide more ingredients
Allows founders to fairly add or subtract participants to or from the company
Is flexible in the face of rapid change
Good news. A solution exists. It is called a “Grunt Fund”. A Grunt Fund accounts for the relative value of the individual Grunts’ inputs so that when it’s equity-allocation time it’s clear who gets what.
Chapter Two:
The Grunt Fund
Rather than slicing pie before the pie is baked or after the pie is baked
and risk creating a herd of disgruntled Grunts, a Grunt Fund allocates equity while the pie is being baked by allocating equity based on the relative, theoretical value of the ingredients at any given time. Ta-da!
This provides the basis for the dynamic equity split that I mentioned in the last chapter. Yes, this means that on any given day the pie could be sliced differently. The percentage of pie for each person during the Gap phase remains fluid and changes from day to day. However, to keep things simple, we provide pie instead of actual equity. “Pie” is simply a promise to allocate actual equity when the time comes. (You can think of “pie” as an acronym for Promise to Issue Equity, but you don’t have to.)
Some people think this fluidity is strange and it makes them uncomfortable. When you think through it logically, however, you will see that it makes perfect sense and solves a lot of problems. However, I am aware that it may seem weird at first. After all, it does break conventional wisdom; but, isn’t that what being an entrepreneur is all about?
When you use a Grunt Fund you allow Grunts to essentially earn pie over a period of time (during the Gap) based on the theoretical value of the ingredients they provide. So, at any given point in time the allocation among Grunts will vary. This fluidity reflects the ever changing needs of the business as it grows.
To implement a Grunt Fund, follow these simple steps:
Appoint a Grunt leader
Assign a theoretical relative value of the ingredients provided by the various Grunts
Calculate the possible equity whenever you need to based on the percentage of value contributed by each Grunt
A Grunt Fund makes some people uneasy. They like to know what they’re getting into and they like the I’s dotted and T’s crossed. That’s fine. If this is you then don’t use a Grunt Fund-get a job instead.
A job will pay you a fixed salary and you can be around other people like you. Those who can’t handle the risk and ambiguity that comes with a startup are better off in a predictable career with a predictable salary. There’s nothing wrong with that. I myself have opted for the job option more than once.
If you are a Grunt, however, you will see that a Grunt Fund is the easiest and most equitable way of slicing the pie.
The Discovery of the Grunt Fund
In his book, The Founder’s Dilemmas, Harvard professor Noam Wasserman provides an outline of the perils of bad equity splits and cites the importance of dynamic splits. A reader of an early draft of Slicing Pie brought it to my attention and I was very happy to have found some validation for the concept based on some reliable research. Before I read that book I had never heard of the term “dynamic split” before. Wasserman covers a number of other pitfalls that can sink a startup so it’s high on my list of recommended reads.
A Grunt Fund is a method for creating a dynamic split for your company’s equity.
I first discovered pieces of a Grunt Fund when I started a company several years ago on a shoestring budget. I had spent almost a year trying to get the business off the ground. I briefly made the mistake of trying to slice the pie before it was baked when I teamed up with a classmate to enter a business plan competition. My teammate went on to other things after the competition (we won).
Before long, it became clear that I needed help baking the pie and had to find some Grunts. I had no money to pay anyone and I had no idea when I would be able to pay them. So, I made an agreement with each of them that laid the foundation for the Grunt Fund.
I told each Grunt that I was trying to raise money for the business and I was making a case for a $1,000,000 pre-money valuation. I wanted to sell 50% of the company to investors for $1,000,000. I told them to keep track of the hours they spent working at the company and we agreed on an hourly rate for each person.
When I finally raised the money I converted the hours they worked into equity as part of the $1,000,000 valuation. In other words, if an employee worked 100 hours and we agreed to a $100 hourly rate, they would be given equity worth $10,000 of the $1,000,000 or 1%. For the most part, it worked. Everyone got their fair share. It wasn’t perfect because I had allocated an unfair percentage to myself, it wasn’t intentional, I just didn’t know better. (The company lost the funding about a year later so it ultimately didn’t matter.)
In all of my experiences, that method worked the best. It was an early building block of a Grunt Fund. Ever since then I’ve been refining the model so it can adapt to a variety of circumstances. I try to cover all the bases because holes in the model can lead to disagreements among Grunts.
The Grunt Fund Explained
In order to get a better grasp on how a Grunt Fund works, here is a little more detail on the steps and how to calculate the theoretical value.
Step One: Appoint a Leader
All companies need a single leader. Someone has to call the shots. This doesn’t mean they don’t listen carefully to the other Grunts, it just means they need to step up to the plate and make decisions when no one else will or make the final call on split decisions.
Most of the time picking a leader isn’t that hard. Many businesses start because one person got an idea and shared it with others. The person who cares enough about the idea to go out and take action is a good choice. I’ll refer to this person as the founder. However, if the founder is smart and knows their shortcomings they may choose to assign leadership to someone with more experience or someone who can dedicate more time to the business in the beginning.
When you pick a leader you will have someone who can manage a Grunt Fund and, if needed, hire or get rid of unproductive Grunts. The Grunt Fund leader is more than someone who simply administers the fund; they are often the person who holds all the equity in the company until it’s time to allocate it to others.
Step Two: Assign a theoretical value of the ingredients provided by the various Grunts
Each and every contribution a Grunt can make can be assigned a theoretical value that will allow you to calculate its importance relative to other contributions. The Grunt Fund leader will assign these values (with the help of this book) and will keep track of everything. It’s not terribly complicated and there are a number of online tools that can make it easier (time and expense tracking software).
By the way, if you’ve been paying attention, you will notice that I have emphasized the word theoretical when it comes to assigning a value to the ingredients provided by the various Grunts. This is important—very important. The contributions that Grunts make have no actual or real value, they only have theoretical value.
If you imply that there is an actual value of the ingredients you may find some of the Grunts want real money-even if you don’t have it.
Additionally, if the IRS thinks that your company actually has value they might like you to pay some taxes. This is because things can be valued at what people think they are worth. So, if you find a group of people who agree that your company’s equity is actually worth something then the IRS would be happy to treat the pie as actual income and assess taxes.
Don’t get me wrong, I’m not recommending that you dodge the IRS. Nor am I am suggesting that you and your fellow Grunts just agree that the equity has no value with a wink and a nod. What I am suggesting is that you recognize that reality of your situation is that the equity has no value.
This is a jagged little pill for many Grunts and Founder Grunts who like to think that their company is becoming more and more valuable every day. However, until you actually convince someone who has real money to buy into your business the business has no value.
Remember, unless you are using a GruntFund vesting schedule, pie represents a promise to allocate a fair share of equity when the time comes. It is not equity and it does not have value. I learned this lesson the hard way…
When I was using the early version of a Grunt Fund in the company I described earlier, I hired a programmer that logged about 160 hours at $50 per hour. He then stopped coming to work. We all wondered what happened to him.
Several wee
ks later he sent me a bill for $8,000. That’s a lot of money for a company that has no money. I had people who had worked for months without expectation of getting paid in cash. I had gone without an income for over a year and invested the bulk of my life savings.
To make matters worse, we couldn’t find any evidence that the guy did any real work. It seemed like he was working but he wasn’t there long enough to deliver anything. We found a couple of bugs on the bug log with his name on them but that’s it.
He wound up pursuing the matter with the Illinois Department of Employment Security. I had to go to arbitration to settle the matter and it was a big hassle. In the end we didn’t have to pay, but the lesson was learned.
Make it clear that Grunts, including you, are not creating actual value; you are baking a pie which is based on a theoretical value used for the purposes of calculating a percent ownership. Get it? Good…
Step Three: Calculate the possible equity whenever you need to based on the percentage of value contributed by each Grunt
Whenever anyone wants to know how the pie is sliced they can ask the leader to perform this cute little calculation for each Grunt:
Contribution of Individual Grunt
÷
Total Contributions from All Grunts
=