Are Private Individuals Who Invest Their Own Money In Potentially Hot New Companies

Business Nuts for Engineers by Mike Volker

Disinterestedness: Dividing the Pie

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

E-mail: mike@risktaker.com

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I'd rather have a small piece of a large pie than a large slice of nothing! (K. Volker)

Why Do You lot Need a Partner?

If you are very bright, very tenacious, and financially well endowed, so you tin can start a company which you own in its entirety and in which you lot can rent a bright, capable, highly motivated and well-paid management team. Even so, if yous practise non fit this description entirely (I might add that, if you lot do not possess at least one of these attributes, yous might want to re-think starting your own business concern), then you will likely have to bring "partners" into your visitor by giving them disinterestedness, i.east. some share buying. Apparently, investors who bring coin to fuel the growth of your company deserve some ownership. Similarly, fundamental people who join you on your squad, or who start the company with yous, volition want some class of ownership if they are making a valuable contribution for which they are not being fully paid in greenbacks. Others who contribute their skills, experience, ideas, or other avails (such equally intellectual property) may be given shares in your company in lieu of being paid in cash.

How practise you lot deal in New Partners?

Valuation is the effect. What is the new partner'south 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 disinterestedness, will now hold 36% (i.e. ninety% of 40%). You never actually never requite upwards your shares when new people are dealt in. You simply event more shares (the same way governments print money). Issuing more than shares is what causes the dilution. If you lot take 100 shares and you want to give someone x%, you'd take to event xi new shares (11/111 x 100 = 10%, approximately).

Unless y'all are greatly concerned most control issues, each fourth dimension you lot dilute y'all should exist increasing your economic value. If you dilute your ownership from 40% to 36%, you nonetheless hold the same number of shares, just the per-share value should take increased. For example, if you entice Terry Mathews (of Newbridge and Mitel fame) to your board past paying him x%, information technology is quite probable that your shares will double or triple in value (i.due east. market value for sure and hopefully as well intrinsic value because of strengthened leadership). If your 40% was worth $one 1000000, your resulting 36% may now be worth $3 million!

If you bring in a new VP of Marketing and requite her v% every bit a signing bonus, how do you know that her contribution will exist worth 5%? How do you measure someone's reputation? Unless the person is well known or has a proven record, it may non be and so easy. That's why vesting (described later) may exist appropriate.

At that place is only one mode to bring in new partners: carefully and with deliberation. A partner may be with yous for life. It may be more than difficult to terminate a business organization partnership than it is to obtain a marital divorce. So call up about it!

Who Should Get What?

What percent of the company should each partner in a new venture receive? This is a tough question for which at that place is no piece of cake reply. In terms of percentage points, what's an thought (or invention or patent) worth? What'south v years of low salary, sweat and intense delivery worth? What is experience and know-how worth? What's a cadet worth? "Who should get what" is best adamant by because who brings what to the table.

Suppose Beak Gates said he'd serve on your Lath or give you some help. What share of the company should he get? But call up about the value that his name would bring to your company! If a venture backer idea your visitor was worth $1 million without Gates, that value would increment several-fold with Gates' involvement. Nevertheless, what has he "done" for yous?

Often, visitor founders give petty thought to this question. In many cases, the numbers are determined by what "feels proficient", i.east. 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 go on 100% of the shares and build this venture through a "bootstrapping" process, in order to maintain total buying and control by not dealing in other partners. It may be possible to defer dealing in new partners until some later on time at which bespeak the concern has some inherent value thereby allowing the founder to maintain a substantial ownership position.

The reply to the question "who should get what" is, in principle, simple to answer: It depends on the relative contributions and commitments fabricated to the visitor by the partners at that moment in time. Therefore, it is necessary to come up up with a value for the company, expressed in either budgetary terms or another common denominator. It gets trickier when in that location are hard assets (cash, equipment) contributed by some parties and soft assets (intellectual property, know-how) contributed past others. Allow's look at a some examples for illustration.

1. Professor Goldblum has adult a new product for decreasing the cost of automobile fuel consumption. He decides that in guild to bring this innovation to market, he will demand a concern partner to aid him with a business program, and then manage and finance a new company formed to exploit this opportunity. He recruits Sam Brown, aged 45, who has a good record equally a local entrepreneur. They agree that Sam will get thirty% of the visitor for contributing his experience, contacts, and track record plus the fact that he will take a $50K/year bacon instead of a "market" salary of $100K for the outset two years. Furthermore, they agree that Sam will commit his full-time attending to the firm for 5 years and that should he leave, for any reason before the full term, he would forfeit 4% of the equity for each year under the 5 year term. The Professor takes lx% for contributing the intellectual belongings and for providing on-going technical communication and support. The Professor "gives" the University a token ten% because co-ordinate to Academy policy, the University is entitled to "some share" of his intellectual property considering of its contribution of facilities even though, under its policy, the intellectual holding rights residual 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. Every bit a taxpayer, i might advise that the University got the brusk end of the deal, but that'southward a moot point.

two. Three freshly graduated software engineers decide to class a new software company which volition develop and sell a suite of software development tools, bearing in mind the paucity of software talent plaguing the industry. They all get-go off with like assets, i.e. knowledge of software, and comparable contributions of "sweat disinterestedness". Heidi takes on the role of CEO of the new venture and they separate the pie as to 40% for Heidi (because of her greater responsibilities) and 30% each for the other two. They are happy campers for at present. Some fourth dimension later, they decide to recruit a seasoned CEO with relevant experience and bring in a Venture Majuscule investor to fund the promotion of their then-developed and shipable suite of software products. They will then accept to wrestle with the outcome of what their company is at present worth and how much ownership they will take to merchandise for these new resource. This will be adamant by the venture capital suitor(southward) in lite of current market investment conditions and the attractiveness of this detail deal.

3. Four entrepreneurs who take recently enjoyed financial windfalls from their businesses, decide to get into the venture capital letter business organisation. They decide to course a company with $10 million in investment upper-case letter. Harry provides $three million, Bill provides $ii 1000000, and the other 2 each provide $2.5 meg. How much of the new visitor volition each of them own? (This isn't a trick question.) For assets as basic as greenbacks, it is like shooting fish in a barrel to determine "fair" percentages.

In the case of the 2d example above, we have a state of affairs in which a company is established and has some value by virtue of its products and potential sales in the market. The visitor's Lath 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 place salary could be negotiated along with an disinterestedness stake. One way of doing this is to apply the difference betwixt marketplace 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 majuscule 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 yr for v years. She is essentially contributing $250,000 upwardly forepart (in the course of equity that does not accept to exist raised to hire her). If the company has been valued at $2 meg, she ought to receive something in excess of 10% of the company. Even so, her shares would "belong" over 5 years meaning that each year she would receive one-fifth of the shares from "escrow". She would forfeit whatsoever shares not and so released should she suspension her delivery or should her employment be terminated for crusade. In this example, Louse's salary is actually $125,000 per year merely she is investing a portion of this in the company's equity (on a taxation-advantaged basis, I might add!).

For more mature companies and especially for publicly-listed companies, information technology is possible to provide managers with incentive stock options equally an boosted incentive in the form of a reward if the company performs well and if the stock price reflects this functioning. Withal, this is not the same equally buying and should exist viewed as role of a salary package.

Important Point: Don't confuse equity (i.e. investment and ownership) with income (i.eastward. salary)!

Shares vs Percentage Points

Sometimes people will get hung upwardly on percentage points. For example, if a new company is created which consists of many people, it may non exist possible to divide that fixed 100% into twenty or xxx 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 similar to have had 1% of Microsoft when it got started). It's also bad that simply 100 percent points are available. Withal, in that location is no limit on the number of shares which can exist issued. Then, permit'south issue ten million shares and give our 3% person 300,000 shares. Nosotros all know that someday these shares might be worth $five, $10, or $50! Work it out! It suddenly becomes more palatable.

And then, how many shares should be issued? Minor public companies usually take betwixt five and 15 million shares outstanding. Larger public companies may have 100 million or more than shares issued. Private companies, big 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 non trade in a public market. When companies become public, i.e. list their shares for trading, there are ofttimes stock splits such that five or ten 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 lot volition event when you first start out should be determined past how many partners y'all wish to take. If only a handful, then you could simply issue 100 shares with the percentage points being equivalent to the number of shares. It might brand you lot and your partners feel better to increase this number by a few orders of magnitude. That'southward OK, too. If y'all have many partners, information technology helps to take many shares - even if only for psychological reasons.

Novice entrepreneurs may think, "Gee, information technology would be overnice to own 5 one thousand thousand shares in a company." True, but information technology may crusade complications if yous have likewise high a number. For case, if yous start with 10 million shares so bargain others in then that you cease up with xv meg shares and so you make up one's mind to get public, resulting in over 20 million shares, this may be too large a number and you may have to exercise a roll-back or consolidation (see next paragraph).

Stock Splits and Stock Rollbacks

You take probably heard of a "stock split up". This happens often with publicly traded companies when their share prices become "too high". Microsoft, for example, has split many times. That's why Pecker 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 1 share? If you lot split 2 for 1, and then the toll per share would be $250, just if you lot dissever v for ane, the price per share would at present exist $100. When companies split their shares, they do so simply past 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 divergence. When a rollback is done, 1 new share is issued for 2 or iii (or whatever the Lath decides) old shares. Notwithstanding, the new shares are issued under a new corporate name pregnant that the visitor must change its legal proper name. Often the change is minor, such as from Superlative Corp to Tiptop Inc or from Meridian Corp to Peak 2000 Corp. This is done so that the new shares are non equally likely to be dislocated 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 besides low, the visitor may appear like a "penny stock" or nickle-and-dime outfit. So, if a stock is trading at $.10 per share a one for ten rollback, will give the stock a more respectable dollar advent. Also, if a smaller, more than junior visitor has 500 meg shares outstanding (which can happen), it may be better, for market place reasons, to have a tigher "float" (i.e. number of issued shares trading on the market).

In terms of what is appropriate, hither are some ballpark numbers to consider. Individual companies, closely held (i.e. few shareholders) would accept a small number of shares, regardless of their size. Individual sompanies with a larger number of shareholders (say up to 50) could accept a few one thousand or even a few 1000000 shares issued. Small public companies (with annual sales below $10 million) such as those trading on a inferior stock exchange, like Vancouver, would have between 5 and 10 million shares issued. Senior companies (with almanac sales in excess of $100 million) such as those trading on Toronto, might accept more than fifty 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 1000000 shares issued as at March, 1997.

Implications of Buying

Ownership means sharing risks and sharing rewards. Information technology implies a sure caste of command (i.eastward. risk management) insofar as the shareholders engage the direction team and information technology implies a sharing in the value of the company - all the same measured (i.e. profits, the net worth, market value, etc). These are two distinctly unlike 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 director! Most owners, specially founders appoint themselves every bit the senior managers. And, they have this right. But, I'd rather exist rich than decorated or poor. The well-nigh important attribute of share buying is that as the value of the company increases, one'south share of the value also increases. Bill Gates doesn't really have billions of dollars. What he has is a fraction (i-quarter, roughly) of a business worth many billions of dollars. Your take a chance is the investment you lot put in, other forgone opportunities, and perchance reputation (if the deal sours). Only the advantage may be unlimited. That's why equity is so bonny. It is not uncommon for a founder of a high tech venture to own a million shares (which cost him very petty in the course of greenbacks) and see these shares capeesh to a value of several one thousand thousand dollars in a relatively short fourth dimension frame. There are literally thousands of examples of this - Gates being the most prominent ane.

Ownership does not imply any additional obligations nor liabilities. In one case an equity stake is purchased, or "vested", it belongs to the owner forever. Information technology also entitles the owner to vote for the company'southward 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 than 50% of the votes or in which he may have less than 50% of the votes, just still have dandy influence by virtue of a shareholders' understanding.

A very successful founder once said, "I'm not really very smart, but I certain practice have a lot of smart people working for me!". This person understood the difference between ownership and management.

What'due south a Visitor Worth? (and When?)

How is value added to a business over a period of time? All companies start off beingness worth only the incorporation expense. As shortly as people, coin and avails are added or adult, a company will capeesh in value. If the management team comes up with a quantum engineering science, 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 amass experience, skill, contacts, etc. Value is best measured in terms of potential, not in terms of historical earnings or financial track tape - just in terms of future performance possibilities. Value increases both through internal deportment and growth also equally through external contributions (e.g. greenbacks and people) which facilitate such growth.

For founders and early investors, the upside potential is the greatest. In its early stages of evolution a company may be worth very little, particularly to outsiders. All of the value may be dormant within the squad - awaiting development. Those who contribute at this early phase deserve to enjoy enormous gains because they are the ones who are bold enough to take the initial risks. An "affections" investor who provides a Academy faculty member with a small amount of start-upwardly funding, say $l,000 to set an invention for exploitation, may easily deserve 10 or 20% of that business. After a concept is more than fully adult, this initial position may be viewed as a "steal", but then once more, most such "steals" end upwardly being worthless deals!

It is both unhealthy and unrealistic for an entrepreneur to begrudge the pale held by his or her early backers. Sometimes at that place is a trend towards seller's remorse. For example, an entrepreneur who sells 20% of his business firm for $fifty,000 may experience cheated 1 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 upwardly with 20% - at least until the next circular at which time they volition all again endure a dilution. Ideally, as time marches on, the value of the visitor increases dramatically such that subsequent dilutions go less and less painful to existing stakeholders. Sometimes, when milestones are non accomplished, the early investors and founders must swallow a biting pill by enticing new investors with large equity positions with major dilutive consequences. Simply, that'southward business!

The value of a business is all-time ascertained past what an investor is willing to pay for information technology (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 exist thinking in terms of making a business attractive to such suitors by building a solid foundation and past nurturing and growing information technology. The business should always be in a condition to sell it.

Other Alternatives

Let'southward be artistic. You don't ever have to requite up shares in your company if y'all can't pay cash. Also, it gets messy (from a corporate governance perspective) having likewise many, especially small, investors. You lot might be able to negotiate a deferred payment arrangement, perhaps with interest. If you lot need to larn a tangible asset, you tin likely obtain banking company or third-political party financing. For soft assets like intellectual belongings, you lot could consider entering into a royalty arrangement, i.e. for every unit of measurement 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 five% stake, means that that party owns 5% of your firm's internet worth and profits forever! Then, tread cautiously.

Summary

Dividing the pie is non easy. In the stop, or to put information technology more than correctly - in the beginning, it is important that all disinterestedness partners accept the deal. Each shareholder would like to own a bigger percentage - that but makes sense. But, unfortunately, all the "percents" accept to add up to 100. That's why information technology's nice to be able to outcome 10 1000000 shares. Information technology sounds a lot better to own 100,000 shares in the side by side hot software deal, than to but own a mere one percent!

At the fourth dimension you sell some or all of your shares in the visitor, call back that it is dollars which you put into your bank business relationship, non percentage points.

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Copyright 1997 Michael C. Volker
Email:mike@risktaker.com - Comments and suggestions will exist appreciated!
Updated: 971015

Source: https://www.sfu.ca/~mvolker/biz/equity.htm

Posted by: chaneysnate1999.blogspot.com

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