Business Basics – Equity: Dividing the Pie

Business 

Basics 

for 

Engineers 

by Mike Volker

EQUITY: Dividing the Pie

Contact: Mike Volker, Tel:(604)644-1926, Fax:(604)925-5006

Email: [email protected]

I’d rather have a small piece of a big pie than a large piece of
nothing! (M. Volker)

Why Do You Need a Partner?

If you are very bright, very tenacious, and financially well endowed, then
you can start a company which you own in its entirety and in which you
can 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 want
to 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 company
deserve some ownership. Similarly, key people who join you on your team,
or who start the company with you, will want some form of ownership if
they are making a valuable contribution for which they are not being fully
paid in cash. Others who contribute their skills, experience, ideas, or
other assets (such as intellectual property) may be given shares in your
company 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 in
relation to the whole pie? At that moment in time, what is the company
worth and how is that worth determined? Bringing in new shareholders always
means “dilution” to the existing shareholders. If a new investor is to
receive a 10% stake in the company, then a shareholder who previously held
40% of the equity, will now hold 36% (i.e. 90% of 40%). You never actually
never give up your shares when new people are dealt in. You simply issue
more shares (the same way governments print money). Issuing more shares
is what causes the dilution. If you have 100 shares and you want to give
someone 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 you
dilute you should be increasing your economic value. If you dilute your
ownership from 40% to 36%, you still hold the same number of shares, but
the per-share value should have increased. For example, if you entice Terry
Mathews (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 strengthened
leadership). If your 40% was worth $1 million, your resulting 36% may now
be 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 measure
someone’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 terminate
a business partnership than it is to obtain a marital divorce. So think
about 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 of
percentage points, what’s an idea (or invention or patent) worth? What’s
5 years of low salary, sweat and intense commitment worth? What is experience
and know-how worth? What’s a buck worth? “Who should get what” is best
determined 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 that
his name would bring to your company! If a venture capitalist thought your
company was worth $1 million without Gates, that value would increase several-fold
with Gates’ involvement. Yet, what has he “done” for you?

Often, company founders give little thought to this question. In many
cases, 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 by
four engineers, the tendency might be to share equally in the new deal
at 25% each. In the case of a single founder, that person may choose to
keep 100% of the shares and build this venture through a “bootstrapping”
process, in order to maintain total ownership and control by not dealing
in other partners. It may be possible to defer dealing in new partners
until some later time at which point the business has some inherent value
thereby allowing the founder to maintain a substantial ownership position.

The answer to the question “who should get what” is, in principle, simple
to answer: It depends on the relative contributions and commitments made
to 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 either
monetary terms or some other common denominator. It gets trickier when
there are hard assets (cash, equipment) contributed by some parties and
soft assets (intellectual property, know-how) contributed by others. Let’s
look at a some examples for illustration.

1. Professor Goldblum has developed a new product for decreasing the
cost of automobile fuel consumption. He decides that in order to bring
this innovation to market, he will need a business partner to help him
with a business plan, and then manage and finance a new company formed
to exploit this opportunity. He recruits Sam Brown, aged 45, who has a
good record as a local entrepreneur. They agree that Sam will get 30% of
the company for contributing his experience, contacts, and track record
plus 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 Sam
will commit his full-time attention to the firm for 5 years and that should
he 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 takes
60% for contributing the intellectual property and for providing on-going
technical advice and support. The Professor “gives” the University a token
10% because according to University policy, the University is entitled
to “some share” of his intellectual property because of its contribution
of facilities even though, under its policy, the intellectual property
rights rest with the creator. Although these numbers are somewhat arbitrary,
they are seen by the parties as being fair based on the relative contributions
of the parties. As a taxpayer, one might suggest that the University got
the short end of the deal, but that’s a moot point.

2. Three freshly graduated software engineers decide to form a new software
company which will develop and sell a suite of software development tools,
bearing in mind the paucity of software talent plaguing the industry. They
all start off with similar assets, i.e. knowledge of software, and comparable
contributions of “sweat equity”. Heidi takes on the role of CEO of the
new venture and they divide the pie as to 40% for Heidi (because of her
greater responsibilities) and 30% each for the other two. They are happy
campers for now. Some time later, they decide to recruit a seasoned CEO
with relevant experience and bring in a Venture Capital investor to fund
the promotion of their then-developed and shipable suite of software products.
They will then have to wrestle with the issue of what their company is
now worth and how much ownership they will have to trade for these new
resources. This will be determined by the venture capital suitor(s) in
light of current market investment conditions and the attractiveness of
this particular deal.

3. Four entrepreneurs who have recently enjoyed financial windfalls
from their businesses, decide to get into the venture capital business.
They decide to form a company with $10 million in investment capital. Harry
provides $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? (This
isn’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 which
a company is established and has some value by virtue of its products and
potential sales in the market. The company’s Board decides to bring in
an experienced CEO (this also makes the venture capitalist happy) to develop
the business to its next stage of growth. Although it may be possible to
hire such a person and pay him/her an attractive salary, it probably makes
more sense to bring in such a person as more of a partner than a hired
hand. In this case a lower-than-market salary could be negotiated along
with an equity stake. One way of doing this is to apply the difference
between market rate and the actual salary over a period of time, say 5
years, to an equity position based on a company valuation acceptable to
the founders. If a venture capital investment has been made or is being
negotiated, this may set the stage for such a valuation. For example, Louise
was earning $125,000 per year working as the CEO of an American company’s
Canadian 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 equity
that does not have to be raised to hire her). If the company has been valued
at $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 she
would receive one-fifth of the shares from “escrow”. She would forfeit
any shares not so released should she break her commitment or should her
employment be terminated for cause. In this example, Louse’s salary is
really $125,000 per year but she is investing a portion of this in the
company’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 additional
incentive in the form of a reward if the company performs well and if the
stock price reflects this performance. However, this is not the same as
ownership 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, if
a new company is created which consists of many people, it may not be possible
to divide that fixed 100% into 20 or 30 meaningful chunks of 10%. It just
won’t work. Some people may receive only 3% and may feel slighted by what
appears to be an insignificant amount (although I sure would like to have
had 1% of Microsoft when it got started). It’s too bad that only 100 percentage
points are available. However, there is no limit on the number of shares
which 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 usually
have between 5 and 15 million shares outstanding. Larger public companies
may have 100 million or more shares issued. Private companies, large or
small, have fewer shares issued – anywhere from 1 to perhaps a few million.
The number is not really important for private companies because these
shares 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 5
or 10 new shares are traded for each existing share in order to give a
company a “normal” number of shares and a “normal” price range.

The number of shares which you will issue when you first start out should
be determined by how many partners you wish to have. If only a handful,
then you could simply issue 100 shares with the percentage points being
equivalent to the number of shares. It might make you and your partners
feel better to increase this number by a few orders of magnitude. That’s
OK, too. If you have many partners, it helps to have many shares – even
if only for psychological reasons.

Novice entrepreneurs may think, “Gee, it would be nice to own 5 million
shares in a company.” True, but it may cause complications if you have
too high a number. For example, if you start with 10 million shares and
then deal others in so that you end up with 15 million shares and then
you decide to go public, resulting in over 20 million shares, this may
be 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 publicly
traded 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 the
average investor. After all, who wants to pay $500 for one share? If you
split 2 for 1, then the price per share would be $250, but if you split
5 for 1, the price per share would now be $100. When companies split their
shares, they do so simply by exchanging new shares for old shares with
all the shareholders.

Stock rollbacks or share consolidations as they are sometimes called
are the reverse of stock splits – but with one notable difference. When
a rollback is done, 1 new share is issued for 2 or 3 (or whatever the Board
decides) old shares. However, the new shares are issued under a new corporate
name meaning that the company must change its legal name. Often the change
is minor, such as from Acme Corp to Acme Inc or from Acme Corp to Acme
2000 Corp. This is done so that the new shares are not as likely to be
confused with old shares. This is not the case for splits, assuming that
shareholders will want to trade in their old shares for new shares whereas
in the case of consolidations shareholders will not be eager to trade their
old for their new.

Why a rollback? If a share price is too low, the company may appear
like a “penny stock” or nickle-and-dime outfit. So, if a stock is trading
at $.10 per share a 1 for 10 rollback, will give the stock a more respectable
dollar appearance. Also, if a smaller, more junior company has 500 million
shares 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 small
number of shares, regardless of their size. Private sompanies with a larger
number of shareholders (say up to 50) could have a few thousand or even
a few million shares issued. Small public companies (with annual sales
below $10 million) such as those trading on a junior stock exchange, like
Vancouver, would have between 5 and 10 million shares issued. Senior companies
(with annual sales in excess of $100 million) such as those trading on
Toronto, might have more than 50 million shares issued. The really mammoth
corporations with sales in the billions of dollars will likely have more
than 100 million shares issued. Microsoft has about 600 million shares
issued as at March, 1997.

Implications of Ownership

Ownership means sharing risks and sharing rewards. It implies a certain
degree of control (i.e. risk management) insofar as the shareholders appoint
the management team and it implies a sharing in the value of the company
– however measured (i.e. profits, the net worth, market value, etc). These
are two distinctly different concepts. The astute entrepreneur might ask
herself if she wants to be a wealthy, independent owner or if she wants
to be a very busy manager! Most owners, especially founders appoint themselves
as the senior managers. And, they have this right. But, I’d rather be rich
than busy or poor. The most important aspect of share ownership is that
as 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. Your
risk is the investment you put in, other forgone opportunities, and possibly
reputation (if the deal sours). But the reward may be unlimited. That’s
why equity is so attractive. It is not uncommon for a founder of a high
tech venture to own a million shares (which cost him very little in the
form of cash) and see these shares appreciate to a value of several million
dollars in a relatively short time frame. There are literally thousands
of 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 owner
forever. It also entitles the owner to vote for the company’s board of
directors, its governing body. Depending on the relative shareholding,
a shareholder may have very little control as in the case of a large public
company or very substantial control as in the case of a small company in
which he has more than 50% of the votes or in which he may have less than
50% 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, but
I sure do have a lot of smart people working for me!”. This person understood
the 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 start
off being worth only the incorporation expense. As soon as people, money
and assets are added or developed, a company will appreciate in value.
If the management team comes up with a breakthrough technology, that may
be worth millions of dollars! The development of products and customers
adds value. The management team itself is worth something by virtue of
its aggregate experience, skill, contacts, etc. Value is best measured
in terms of potential, not in terms of historical earnings or financial
track record – but in terms of future performance possibilities. Value
increases both through internal actions and growth as well as through external
contributions (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 deserve
to enjoy enormous gains because they are the ones who are bold enough to
take the initial risks. An “angel” investor who provides a University faculty
member with a small amount of start-up funding, say $50,000 to prepare
an invention for exploitation, may easily deserve 10 or 20% of that business.
After a concept is more fully developed, this initial position may be viewed
as a “steal”, but then again, most such “steals” end up being worthless
deals!

It is both unhealthy and unrealistic for an entrepreneur to begrudge
the stake held by his or her early backers. Sometimes there is a tendency
towards seller’s remorse. For example, an entrepreneur who sells 20% of
his firm for $50,000 may feel cheated one year hence when a serious investor
is willing to pay $500,000 for 20%. This is flawed thinking. Without that
intial $50,000, this company may never have survived its first year. In
this illustration, the founder initially had 100%, then 80%, then ended
up with 64%. The angel had 20%, then ended up with 16%. The rich investor
ended up with 20% – at least until the next round at which time they will
all again suffer a dilution. Ideally, as time marches on, the value of
the company increases dramatically such that subsequent dilutions become
less and less painful to existing stakeholders. Sometimes, when milestones
are not achieved, the early investors and founders must swallow a bitter
pill by enticing new investors with large equity positions with major dilutive
consequences. But, that’s business!

The value of a business is best ascertained by what an investor is willing
to 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 business
reasons) is willing to pay for it.

It is prudent management philosophy to always be thinking in terms of
making a business attractive to such suitors by building a solid foundation
and by nurturing and growing it. The business should always be in a condition
to sell it.

Other Alternatives

Let’s be creative. You don’t always have to give up shares in your company
if you can’t pay cash. Also, it gets messy (from a corporate governance
perspective) having too many, especially small, investors. You might be
able to negotiate a deferred payment arrangement, possibly with interest.
If you need to acquire a tangible asset, you can likely obtain bank or
third-party financing. For soft assets like intellectual property, you
could consider entering into a royalty arrangement, i.e. for every unit
sold embodying said intellectual property, you pay a 5% royalty on sales
to the provider of the asset. And remember, equity is expensive. Giving
someone a 5% stake, means that that party owns 5% of your firm’s net worth
and 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 makes
sense. But, unfortunately, all the “percents” have to add up to 100. That’s
why it’s nice to be able to issue 10 million shares. It sounds a lot better
to own 100,000 shares in the next hot software deal, than to only own a
mere one percent!

At the time you sell some or all of your shares in the company, remember
that it is dollars which you put into your bank account, not percentage
points.

Copyright
1997 Michael C. Volker

Email:[email protected] –
Comments and suggestions will be appreciated!

Updated: 971015