Unwrapping Episode 3: How Divide an Imaginary Pie

Introduction

In this episode, Alex puts the quest for funding equity aside while he considers the division of that ownership or equity before new investors are introduced. This issue is brought to the forefront when Alex adds a new team member, Matthew

Listen to Episode 3: How To Divide an Imaginary Pie

Why Share the Pie at All?

What is are some of the reasons to increase the founding team? One good one is that investors recommend it: Michah Rosenbloom tells Alex, “I would much rather bet on two people or three people than a single founder. Now, not to say, if you look at our wall of, you know, companies here. There are single founders that we’ve bet on, but I think startups are a team sport. Like the probability of success, in my opinion, goes up. And, frankly, I think it would be more satisfying to you because you’d have someone to share it with.”

Entrepreneurship Founding is Lonely

Another reason is that being a sole founder can feel very isolated. There is no one there to validate or refute your thinking. It can be discouraging. Clearly, Alex (and his wife) were feeling it was the right time to increase the team. It just feels like, all of a sudden, I’m just like, “What am I doing? Who am I”? I don’t know……I was just so lonely.”

Why is splitting up equity so hard?

Alex knows that adding someone to his team means giving up some ownership. He also knows that this involves figuring out just how much to give up. It turns out that for almost all entrepreneurs, this is a difficult conversation. First of all, it is very, very personal. When Alex says he thinks to Matt that it is time to have a “conversation of where we see this relationship going” you feel like you are listening to two people who are dating trying to figure out if they are getting married. Once you get past the awkward, personal nature of the conversation, you run into the next difficulty: unclear decision rules. As Alex puts it:  “When you’re in early stages, like I am, there are lots of people out there who you rely on for help, for mentoring: my cousin who went to business school, the parent of a friend’s girlfriend, an acquaintance’s acquaintance. Some of these folks are happy to help. Others want to help but are expecting to be compensated with equity. Maybe. Or maybe not. It’s never really spoken of. There was literally no right answer to the question of how much to offer a partner to entice him into the company. The result is Alex’s hesitant speech in starting the conversation: Well, so, so…so I definitely…so I feel like there’s like a….I think…I don’t want to …. While there are some resources online to talk about equity splits, there is truly no hard and fast rule about how new members of the founding team are awarded a share of equity.

Why Does Do Pie Slices Matter?

If, as Alex points out, the company is not yet worth anything, why does the split matter? A little thing called dilution. It’s all well and good for Alex and Matt to decide on a 60/40 split, but what happens when they need to hire more members of the team? They will expect equity unless you can pay them a market wage rate. Then investors come onto the scene, adding money to the pot in exchange for ownership.   Each new draw on equity has to come from the existing ownership, so over time, the partners are sure to see their share diluted. A highly simplified example based on an Excel tool built by Neo founder, Gil Constable, shows how quickly dilution happens.
  1. Setting up the Pie. The two founders start at 60/40 and start by giving up some equity to hire the first two employees and engaging an advisor. The hit to each is relatively minor.
Table 1. Company Equity Division Before Investment
Holder Shares %
Founder 1 600 60.00%
Founder 2 400 40.00%
0 0.00%
0 0.00%
Total Shares 1,000.0 100.0%
Holder Shares %
Founder 1 600 59.11%
Founder 2 400 39.41%
First hire 7 0.69%
Second hire 5 0.49%
Advisor 3 0.30%
Total Shares 1,015.0 100.0%
 
  1. First Investment – Family and Friends Round. The founders come up with a justifiable estimate of $450,000 for the company. The family adds $50,000 and the owners also decide they will need to set aside 10 shares for future hires.
Table 2. Dilution after Family and Friends Round
In 1000s Percent
Family and Friends Invest $50 10.0%
PreMoney Valuation $450
Post $500
Holder Shares %
Family 114 10.0%
Founder 1 600 52.7%
Founder 2 400 35.1%
First hire 7 0.6%
Second hire 5 0.4%
Advisor 3 0.3%
Employee Options Pool Starter 10 0.9%
Total Shares 1,139 100.0%
 
  1. Angels take a slice. After a few months of operations, the owners convince an angel investor to put in a half million in exchange for 20%. Notice that the newer valuation has to be justified and now is $2.5M on a post-money basis. Valuation is fundamentally a matter of negotiations, with each side looking at revenues, growth prospects and the achievements of various milestones.   Another 150 shares are set aside for the employee Option Pool 1, to be used for new members or to incentivize existing members of the team in a later round.

Table 3. Dilution after an Angel Investment

Angel Invest $500 20.0%
PreMoney Valuation $2,000
Post $2,500
Holder Shares %
Angel Investor(s) 322 20.0%
Family 114 7.1%
Founder 1 600 37.2%
Founder 2 400 24.8%
First hire 7 0.4%
Second hire 5 0.3%
Advisor 3 0.2%
Employee Options Pool Starter 10 0.6%
Employee Option Pool 1 150 9.3%
Total Shares 1,611 100.0%
 
  1. Enter the Vultures. The so-called “A Round” (Table 4) is funding that comes from a venture capitalist fund, interested enough to put in $2.4M with a post-money valuation agreed upon of $10M. The decision is made to enrich the Option Pool again, this time with 220 shares.

Table 4. Dilution after First Venture Round

A Round $2,500 25.0%
PreMoney Valuation $7,500
Post $10,000
Holder Shares %
A Investor 610 25.0%
Angel Investor(s) 322 13.2%
Family 114 4.7%
Founder 1 600 24.6%
Founder 2 400 16.4%
First hire 7 0.3%
Second hire 5 0.2%
Advisor 3 0.1%
Employee Options Pool Starter 10 0.4%
Employee Option Pool 1 150 6.1%
Employee Option Pool 2 220 9.0%
Total Shares 2,441 100.0%
 
  1. More venture. Next comes the “B Round (Table 5) , in which another $4M is added, and the post-money valuation is $20M. Note that the round comes from both B players (venture fund) the A players, who get a chance to “re-up.” Again, the employee option pool is increased. Along the way, everyone else gets diluted. The founders have gone from 60%/40% to about 20% /13%

Table 5. Dilution after First Venture Round

B Round $4,000 20.0%
PreMoney Valuation $16,000
Post $20,000
Holder Shares %
B Round 623 20.0%
B Investor 455 14.6%
A Investor re-up 168 5.4%
A Investor 610 19.6%
Angel Investor(s) 322 10.3%
Family 114 3.7%
Founder 1 600 19.3%
Founder 2 400 12.8%
First hire 7 0.2%
Second hire 5 0.2%
Advisor 3 0.1%
Employee Options Pool Starter 10 0.3%
Employee Option Pool 1 150 4.8%
Employee Option Pool 2 220 7.1%
Employee Option Pool 3 50 1.6%
Total Shares 3,114 100.0%
 
  1. Finally, the company is acquired, for $50M. The returns to investment are seen in Table 6.

Table 6. Dilution after First Venture Round

Exit $50,000
Value per Share ($) $16.05
Holder Ownership Return Investment Multiple
B Investor 14.6% $7,299 $4,000 1.8x
A Investor 25.0% $12,500 $2,500 5.0x
Angel Investor(s) 10.3% $5,173 $500 10.3x
Family 3.7% $1,828 $50 36.6x
Founder 1 19.3% $9,633
Founder 2 12.8% $6,422
First hire 0.2% $112
Second hire 0.2% $80
Advisor 0.1% $48
Employee Options Pool 13.8% $6,904
Total 100% $50,000 $7,050
  It is critical to have a basic understanding about dilution as the equity pie is sliced into pieces. Experienced players (like angel investors and venture capitalists) know all about dilution, but it can take others, especially the management team of founders as well as family and friend investors, by surprise. It is important to note that the example given above is very simplified, and lots of differences can occur through strategic negotiation in the terms sheets (the bullet-pointed guide regarding the deal that eventually guides the legal documentation). Players can built in “non-dilution terms” and large investors can allow founder equity to be “refreshed” using the options pool if needed to motivate key management team players. However, it is all about the balance of power in the equity negotiation, and if the current owners need the additional funding too much, the new investors have a lot of power. In the case outlined above, did the founders get a good outcome? It depends on the time it took to raise the money, their opportunity costs and their prior expectations. Getting millions of dollars sounds like an amazing outcome, but if it took 15 years to get there and a talented engineer or salesperson has the prospect of making a similar amount in a shorter period by taking a less risky career path, it may not look as inviting. One mistake new founders can make is to give away too much equity too early. Additions to the team may not work out or worse, leaving parts of the company owned by people no longer actively contributing. The company ownership may be divided up into too many tiny pieces, which is not attractive to new investors and can be expensive to deal with in terms of legal operations. (Some tools have been developed by the legal world to help with these issues and a good discussion can be found here: http://thestartuptoolkit.com/blog/2013/02/equity-basics-vesting-cliffs-acceleration-and-exits/) Is Dilution Good or Bad? One can debate whether dilution is good or bad, and the videos of Greg Galvin (founder, Rheonix) and Eric Young (Partner at Canaan) provide the two sides of the story. On the one hand, those early players bearing the most risk are often diluted beyond what they think is fair. On the other hand, investors coming into the deal provide critical capital without which the company might simply fail. WATCH Greg Galvin One problem, right, is every time you raise another round of equity, the founders are being diluted. I believe the whole system is wrong in that it does not correctly reward risk. So you start with the premise that the investors want roughly 85% of the equity and 15% for founder/employees. And then if you go through multiple rounds, even if there is some re-upping of option pools and so forth, you’re at best at 15, maybe you’re 10 or sub-10. And actually when you divvy 10 up over some reasonable quantity of employees, even if you have a $100 million+ exit which is, by most people’s definition, would be quite successful, you’re not altering their life. So that, you know, if founders kind of do the math and think about it, it’s not really that motivating. Second, as a personal investor, the financial advisors tell you, okay, you should only put a minimal part of your net worth into these high risk investments like venture funds. So kind of by definition the monies that are in the venture funds are not really at risk. This is the play money piece of it, yet they’re taking the bulk of the return. The founder, who has basically risked their career, is not benefitting proportionately to the risk they’ve taken. And then even amongst the investor classes, and this ends up creating lots of issues upon exit, the early investors who arguably took the greatest risk are typically financially disadvantaged to the latest stage investors who came in who arguably took the least risk. So that whole model that has evolved of kind of venture equity financing of startup businesses I think, is fundamentally flawed.   WATCH Eric Young So we have this discussion from time to time with entrepreneurs, usually very early stage entrepreneurs and generally individuals who have been working at their project for a little while and they’re accustomed to owning the whole thing in terms of how they make decisions and what’s gonna happen. And so obviously one of the things that we need to sort out of flush out is as well as possible when we’re making an investment in a situation that has been bootstrapped up to that point is, is there going to be a sense of partnership here? Do we understand that in terms of ultimate decision making, role of a board versus management, investors, ownership founders, etcetera that it is a partnership? And they way I like to describe it is for any entrepreneur or group of entrepreneurs who come to us who have been operating with their own corporation, they’ve accomplished certain things and it’s all theirs, they own the whole thing. Right now they have a pie and they own 100% of it. And the whole idea is if you take our money or any other institutional investors money or frankly any angel money, anybody’s money, you’re diluting yourself but for a purpose. The idea is the pie is gonna grow. So along the way the question of whether or not it makes sense to sell stock, to reduce your overall ownership in the pie, whether it’s for founders, or employees or current investors is will the addition of that resource and the dilution that everybody will encounter cause the pie to be sufficiently larger in value that we’ll all be better off. That’s the ongoing question. And you know I think when looked at it that way, when really thinking about I may own 100% of a pie today but the pie is worth ten bucks and maybe it can worth one hundred bucks. Should I take 25% dilution to get to that outcome? Okay I can understand that.  

How “In” is “In?”

What about Alex and Matt? Is the equity split fair? Matt brought expertise and energy to the team. Perhaps more importantly, Alex wanted to have a partner to help him through some choppy startup waters. Matt was not willing to be “all in” for 10% of the company, given his other opportunities. For him to be “all in” it required a bigger share of equity. You could argue that the resulting split of 60/40 was or was not fair, but only time will tell. It depends on how long the pie takes to bake, how big it grows and what other pieces of the pie have to be divvied up in order to attract talent and have enough capital to keep going forward. It also depends on the expectations and motivations of Alex and Matt. What may sound like a fair deal today might not feel that way down the line, or it might feel just perfect. Of course, the ultimate judges of fairness are the founders themselves.    

Key Takeaways

  1. Taking on a partner should be done when additional human, technology and/or financial resources are needed for the company to gain momentum.
  2. Every equity holder will see his/her share diluted as additional investment is added and it is critical for him or her to see the math in black and white so there are no surprises.
  3. Even though there may be some rules of thumb about splitting up equity, fundamentally
    1. For management team and employees, it comes down to negotiation about the contribution of each player.
    2. For investors it depends on negotiation about the value of the company (valuation).