Brad's Books and Organizations

Books

Books

Organizations

Organizations

Hi, I’m Brad Feld, a managing director at the Foundry Group who lives in Boulder, Colorado. I invest in software and Internet companies around the US, run marathons and read a lot.

« swipe left for tags/categories

swipe right to go back »

Finance Fridays: Getting Started – Allocating Equity and Founder’s Investment

Comments (52)

Finance Friday’s gets off the ground with today’s post by introducing you to an imaginary startup, the entrepreneurs that we’ll being following throughout the series, and their first challenges: splitting up the founders’ equity and addressing the case where one of the founders provides the initial seed capital for the business.

We felt like we needed to put some groundwork in place using a case-study like approach, rather than just jumping into looking at balance sheets, income statements, and cash flow statements. Hopefully, by the time we are done, we’ll all have some new friends and a lot of knowledge. Let’s get started.

Jane and Dick worked together at Denver Health, the nation’s “most wired” hospital according to Hospitals & Health Networks Magazine. They have seen first-hand the impact technology can have in the medical field through exposure to a number of Denver Health IT initiatives. Through a series of conversations, Jane and Dick have come up with the idea to develop a social network tailored to the medical community. Through an online platform, doctors, nurses, and administrators would be able to assist each other with complicated diagnoses, collaborate on research studies, and find and fill job openings. After sharing the concept with a number of colleagues and receiving enthusiastic support for the idea, Jane and Dick built up the confidence to quit their day jobs and launch a business together.

Jane and Dick each brings a similar level of skill and capability to the business, making it easy for them to agree to a 50/50 equity split. While they could both go without salaries for a year, Dick had no extra money to invest in the business. However, Jane was in a position to invest some of her savings into the startup. How could they treat Jane’s cash investment in the business in a way that was fair to both of them?

Jane could have covered expenses from her personal account for now, keeping track of the receipts, with the plan of letting an accountant sort it out later. After all, they needed to focus on building their product, right?

Fortunately, Dick and Jane had both read Dharmesh Shah’s piece on avoiding co-founder conflict in Do More Faster and knew it was important to address co-founder issues – including how to handle co-founder investments – from the start. They also knew that it was important to set up proper accounting systems from the beginning and that paying for bills out of your personal bank account and having an accountant sort it out later for you seemed like a recipe for future pain.

Jane and Dick had several options, including structuring this as a debt transaction where Jane simply loaned the money to the company, or as convertible debt transaction where Jane’s investment would convert into equity in the next round. But they worried that future investors would frown on that or wouldn’t give Jane credit for the investment at a later date, since they might consider it as part of Jane’s contribution to her original ownership position of 50%.

That narrowed the possibilities down to an equity transaction, which would in turn require a conversation about valuation. Jane and Dick briefly considered a valuation based on the next external financing round, perhaps applying a discount. For example, if the first round of external investment values the company at $2 million post and, prior to that, Jane had invested $50,000, then with no discount, Jane’s investment would earn her 2.5% of the company ($50k/$2M = 2.5%). If they agreed on a 20% discount, then Jane would be entitled to 3.125% of the company ($2M * (1-20% discount) = $1.6M; $50k/$1.6M = 3.125%).

At this stage it wasn’t clear when (or even if) the first round of external financing might occur or what it might look like, which made agreeing on a discount just as difficult as agreeing on a valuation, while adding complexity. After a tense conversation about this, Jane and Dick decided to go out for a beer and try to resolve the equity allocation issue once and for all.

Jane indicated that the most she could invest in the company before they would have to seek other sources of capital was $50k. Dick hated to think that he would be diluted by more than 20% of his stake over $50k and proposed that Jane receive 10% incremental equity for her $50k. Jane felt comfortable with receiving 10% for $50k, but no less, so they agreed on a $450k pre money valuation of their startup.

There are a number of ways Jane and Dick could have executed the equity transaction. The simplest would be if they agreed in the founders documents that they would both commit full-time to the business, Jane would contribute an initial $50k, and they would split the equity 55/45 in favor of Jane.

Dick and Jane have now successfully navigated their first finance challenge: dividing up the founders’ equity, including an investment from one of the founders. A few key lessons from today’s post are:

  1. Invest the time upfront to get the founders’ documents right. This will save a lot of pain down the road. This includes agreeing on how you will handle personal investments in the business, but it also includes many other topics such as founders’ vesting schedules and voting rights.
  1. Every time you put money in the business it represents some form of debt or equity transaction. You can introduce complicated mechanisms for handling these transactions (e.g. warrants or discounts). However, there is a lot to be said for keeping things simple during the early stage of a startup. It helps control transaction costs in terms of both time and money.
  1. You could inject more cash into the business on an as-needed basis. However, this is distracting, even if you are raising the money from yourselves. Each cash injection effectively represents a new round of financing, which can get messy. Try to minimize the frequency of transactions by investing enough money each time to get you to the next key milestone for your business.

Next week, we will address how Jane and Dick put proper accounting systems in place. Oh, and you’ll notice that they don’t yet have a name for their company. They’ve told us they are open to suggestions.

  • http://www.omnea.com Alex Murphy

    Nice to meet Jane and Dick.  Splitting equity is an important discussion, a close second may be to decide on how to split equity in the event one of them wants to leave.  Reverse vesting, etc … perhaps a future post?

    Congrats on getting this underway, I am sure it will help many people along the way!

    • http://www.feld.com bfeld

      Yup – good suggestion on talking specifically about vesting.

      • http://twitter.com/stevereis Steve Reis

        what about a simple promissory note?  really low transaction cost and avoids the valuation discussion.

        • http://www.omnea.com Alex Murphy

          You can do a simple shareholder loan (recommended if each founder is putting in equal share) but in this situation one of the parties didn’t want to put in at risk capital (and $50k over the other is a big difference) you need to handle it in a way that gives the person more at risk more equity.

        • http://www.feld.com bfeld

          Correct, but in this case as we tried to explain Jane and Dick didn’t want to have the investment as a note outstanding for a couple of reasons. One of them was that Jane was worried her first round investors wouldn’t respect the note and force it to be converted into equity anyway since this just happened to her friend Michael in his company.

    • James Mitchell

      If a co-founder wants to leave in the first couple of years, two things should happen:

      1. They should lose all of their equity.

      2. Their balls should be cut off. (I don’t know what an equivalent penalty for Jane would be.)

      There is nothing worse than a co-founder who finks out on you. Startups are much too tolerant of people who do. The idea that someone can work at a startup for 13 months and have any equity at all is totally ridiculous. (Assuming they were not laid off.)

  • http://twitter.com/jim_shook Jim Shook

    Is a range of $400-$500k a reasonable starting point for pricing equity of a company that is mostly in the idea stage? Assuming founders aren’t serial entrepreneurs with prior successes?

    • http://www.feld.com bfeld

      It varies a lot – you’ll see valuations between lower numbers and much higher number (e.g. $10m). Ultimately, it’s a negotiation and up to the entrepreneurs to figure out what’s fair. 

      The easiest way for experienced founders, who have some money, to deal with this is for each of them to contribute an equal amount, or a pro-rata amount of their ownership if they don’t have equal ownership, since then the valuation doesn’t matter.

  • Ryan Lackey

    I’d be a little wary of contributing $50k to buy common stock which is under an RSPA (basically vesting).  You could get bounced on day 2 to day 364 on most standard terms and end up with nothing.

    $50k might be below the threshold where a 2 person company needs to worry about doing a note or preferred for that financial contribution, but if it were more like $500k contribution by one of the founders, that would seem to be a lot better handled as founder shares + investment with two separate instruments.

    • http://www.feld.com bfeld

      I agree. In our case, we decided to deal with it in a more simple form since it’s only $50k. 

      On approach is to make sure some of Jane’s shares are vested up front. The founders have control over the vesting and can decide that some portion (5% – 10%) should be vested on day 1 to compensate for the case investment. Almost all investors will respect this.

    • James Mitchell

      Vesting should apply only for shares earned through one’s labor. If one pays for shares, there should never be any vesting.

  • http://twitter.com/amicusergoest Dan Callahan

    Brad, what was the thinking behind a 20% (or any) discount? I’m missing that point.

    • Trent Hauck

      Not to speak for Brad, and I could be completely off base, but the discount probably has to do with the the amount of time and uncertainty as to if Jane will receive her money back.  There’s a lot of risk involved with a start-up and 20% seems fair for an early investment by a cofounder – an angel or VC would probably want a higher return for such an early investment.

      • http://www.feld.com bfeld

        Trent is correct. If an angel investor invested $50k at the beginning in the form of a convertible note (that would convert into equity in the next financing) there would likely be a discount of around 20% (usually between 10% and 30%).

  • http://twitter.com/V_xklsv Vineeth Kariappa

    always-be-healthy.com ?

  • http://www.omnea.com Alex Murphy

    An alternative way to structure the deal is rather than an equity contribution, they could simply divide the company 60/40 with a $60 and $40 equity contribution by each and a low par value, set it up as an S Corp, and then Jane could make a $50k shareholder loan to the company.  Since she wanted more than the 10% bump, this would give her the opportunity to get paid back some time down the road, especially if the company doesn’t need to take on an equity financing round.  Also, something to note at this stage, she gets the upside of having basis for the losses the company will incur.

    • http://www.feld.com bfeld

      Yup – agree that this is one approach (and there are others). Our goal was not necessarily to put out the best answer (as there isn’t one), but to set up a situation where we’ll have to address it on the balance sheet later in the series.

      The are two issues with your approach. One is that in a lot of cases, the next round investors will simply force the debt to either be forgiven (a taxable event) or roll it into equity / the basis. The other is that Dick would fight the idea that Jane is getting the equivalent of a participating preferred – she gets an extra 10 points, gets the tax deduction from the S-Corp, and gets her money back first because it’s debt but still gets 60% of the equity.

      In our example, Dick and Jane decided that the extra 10 points were for the cash investment in equity. Jane was happy to get an extra 10 points for her contribution of $50k. Dick was ok giving up 10 points because Jane put $50k at risk.

  • http://bizen.com Jackson Miller

    infirm.com

    It is a play off infirmary (their domain) and inform (part of the site’s purpose). The dot com isn’t available, but there is no site there so it could likely be purchased from a squatter for $10k.

  • http://www.adduplex.com Alan Mendelevich

    Great idea for the series and a great start. Thanks! I especially enjoy that it’s a case-study and not just some theoretical stuff.

    That said, doesn’t this arrangement put Jane in total strategic control and being more “powerful” than Dick for like forever? Won’t that create tension in itself? I mean she totally deserves being compensated for her financial investment, but this arrangement sounds like it would affect Dicks mood from the start. Or are there other arrangements in place to enforce equal control of the company’s direction?

    • http://www.feld.com bfeld

      It could impact their relationship, but in our example Dick acknowledged that Jane should get more of the company because of her investment. We are assuming that they talked this out over a beer and are comfortable with the equity split. 

  • http://arnoldwaldstein.com awaldstein

    A great start to a new series Brad. Pushed it out to my networks. 

  • Zach

    Brad, the split could have been 50/50 regardless of Jane’s $$ contribution, right?  My point is that while Jane and Dick negotiated the split is was basically arbitrary.  

    Also, someone recently argued with me that in your scenario Dick would actually have taxable income on the value of his shares based on the value “attributed” to the shares derived from Jane’s investment and implied valuation.  I argued “no” and that Jane’s cash investment would just increase the tax basis of her shares.   Do you agree?

    • http://www.feld.com bfeld

      Correct – the split was arbitrary. We are setting up a case where it’ll roll through the balance sheet. Plus, Dick and Jane agreed they were equal partners, but Dick acknowledged that Jane’s cash contribution should give her more of the company.

      As long as things are structured correctly and Dick and Jane both file 83-b elections you are correct. However, if they don’t structure things correctly, there could be a valuation step up issue. Any good early stage / formation attorney will get this right in the founders documents.

      • http://about.me/liuzehua Liu Zehua

        Even though it’s arbitrary, the explicit mention of $50k for 10% in the face of $450 pre-money valuation makes me feel like mathematically it should be 55/45 ?

        Pre-money, Dick and Jane both had  50% and with a 10% $50k investment coming, both 50% got diluted and became 55/45. Is this calculation correct?

      • http://about.me/liuzehua Liu Zehua

        Even though it’s arbitrary, the explicit mention of $50k for 10% in the face of $450 pre-money valuation makes me feel like mathematically it should be 55/45 ?

        Pre-money, Dick and Jane both had  50% and with a 10% $50k investment coming, both 50% got diluted and became 55/45. Is this calculation correct?

        • http://www.feld.com bfeld

          It’s a good point and I can see that 60/40 is confusing in this context. I’ll go update the post.

    • James Mitchell

      Whether Dick’s receipt of shares is a taxable event depends.

      First, Dick and Jane could issue their labor shares first, and one month later Jane purchases her money shares.

      Second, Jane could purchase preferred stock. (This would kill an S election, however.)

      Third, Jane could make a loan and they just agree that she initially gets more shares.

      As a practical matter, the odds of the IRS going after someone for this are very low. You read about those cases in the newspaper but those cases are really the outliers.

      What you do not want to do is a 209A valuation. It’s simply too expensive at this stage of the business.

  • Mac

    say ahhhh .com

  • Pingback: Reblog – Finance Fridays | ithacaVC

  • James Mitchell

    About having the accounting systems set up from the beginning — In the ideal world, definitely. But if you want a kluge temporary solutions, you can set up a business checking account (with debit cards), and simply keep track of each expense and cash receipt as it is incurred. Later on, when you have time to do it right, write a really good chart of accounts (you do it or have an accountant do it), set up QuickBooks, and then you can place each item in the proper category.

  • Bashaman

    Dija Healthcare – Dick Jane Healthcare :) ..great start..look forward to the next posts

  • Mel S.

    Brad, great series concept.  Excellent initial execution.  I mid-wife biotech startups in MD, DC and have let my network in on your blog and series.  Thanks for creating it.

    Speak DNA ?, Inc.

  • Mel S.

    Brad, great series concept.  Excellent initial execution.  I mid-wife biotech startups in MD, DC and have let my network in on your blog and series.  Thanks for creating it.

    Speak DNA ?, Inc.

  • eahiv

    Wow, this entry came out really great. Looking forward to next week’s!

  • Yusuf Baykal BOZKURT

    At this stage it wasn’t clear when (or even if) the first round of
    external financing might occur or what it might look like, which made
    agreeing on a discount just as difficult as agreeing on a valuation,
    while adding complexity. After a tense conversation about this, Jane and
    Dick decided to go out for a beer and try to resolve the equity
    allocation issue once and for all.
     http://www.yusufbaykalbozkurt.com

  • http://pulse.yahoo.com/_7AFVJMQBKGKXVXYE5NTMA353Q4 Space Planner

    Clearly Jane loves Dick.

    • Rich

      I expect it’s more that Jane is an entrepreneur. She is willing to provide money to help the business get started and feels Dick offsets her weaknesses so his inability to provide funds is not a concern.

  • Ulf

    Name suggestions: MedTouch, MedSpeakSee, CommuniMed, MedAll (no need to keep caps)

  • Pingback: Allocating Equity and Founder’s Investment | Accounting and Small Business /Beverly Shares

  • Rich

    I know this post is about finance, but I have to mention a couple things:

    “After all, they needed to focus on building their product, right?”

    No, they should start by building customers. Jumping into product development before finding customers and funding puts their company in a compromised position. There are way too many microISVs failing these days because they were started by techies who wanted to do some coding instead of build a business. I think 8 out of 10 startups are failing and it’s because many people aren’t starting a business they are starting a software project.

    “…a $450k pre money valuation of their startup.”

    It’s foolish to think the startup has any value at this point. Their business is currently a concept and all it has is what it hopes to generate in future revenues. The $50K Jane is willing to invest is not truely an investment and she is not buying anything. She is providing money to buildout the concept. I know she needs to record the money transfer into the company, but that’s really all that’s going on at this point.

    I know that all this is for illustration purposes and evals for a startup are smoke and mirrors so that we can “think” about this. But, since the United States is on the brink of defaulting it’s important for us to keep in touch with reality when it comes to business startups.

    Another thing that is important is how much thinking this post will invoke in the minds of entrepreneurs and business people who are doing or are wanting to do a startup. Great post.

  • Chris Field

    Terrific wisdom in this post’s key lessons.  I would summarize them as:  1. Do it Right, 2. Keep it Simple, 3. Be Efficient.

    Though considered and dismissed by Jane and Dick, I think a promissory note is generally the simplest and most efficient way solve the issues related to Jane’s cash investment (as suggested by Steve Reis elsewhere in the comments).  Promissory notes are also about the easiest transaction to do right.  For these reasons, I almost always would advise founders to use a simple promissory note to put cash in their company, absent specific reasons for not using a promissory note.

    In this hypothetical, the suggestion is that Jane and Dick decided against a promissory note basically because of the prospect of what future unknown investors might do.  In my view, Jane was sort of negotiating against herself with a phantom future investor, and I generally advise founders to resist doing that.  Though obviously not unheard of, in my experience, investors are reluctant to undo existing deals, particularly in a way that would dramatically affect founders in a negative way.  To the extent the value of a startup is the value of the founders, there is an alignment in the interests of investors and founders, which tends to reduce the risk of investors behaving in a way that is adverse to the founders.  Investors generally would hesitate to put their investment under the stewardship of someone who feels they’ve been taken advantage of.

    If Jane and Dick had come to me after they’d had this difficult conversation about valuation, I probably would first advise them to consider a simple promissory note and cross the “bad investor” bridge if they ever get there.  Assuming they still insisted on treating Jane’s investment as a stock purchase, I probably would suggest they consider structuring the transaction as a promissory note where Jane had the option to convert the note into XXX shares of common stock, where xxx gives her 60% ownership. It’s still a relatively simple transaction and it formally memorializes their agreement, but also preserves the possibility that Jane’s note can be repaid (assuming that is Jane’s true preference).

    Some of the reasons I like promissory notes:

    1.  Promissory notes preserve optionality.  Startups are often about solving the most pressing issues now and deferring on issues that can be dealt with later.  I admire that Jane and Dick did the hard thing here by having the difficult conversation about valuation of the company for the purposes of her investment.  But, I’m not sure it was an absolute necessity.

    2. Debtholders are repaid before stockholders, so it assures that Jane will get her money back first.

    3. Repayment of debt can be a tax efficient way to transfer value from the company back to the founder.  This is attractive in all cases, but can be especially useful in a worse case scenario where future investors force Jane to “eat” her $50,000 investment.  Having a promissory note in place makes it easier to come up with creative ways to make this bitter pill easier to swallow.  For example, Jane might be able to offer to eat the $50,000 by reducing her salary (once she has one) and replacing the lost income with repayment of her note.  The repayment could be done over time, so that it is no different to the company in terms of cash flow.  Jane comes out ahead by the amount of the income taxes on the $50,000 she would have otherwise made as salary.  Even the company saves money by reduced payroll taxes on that $50,000.

    Really looking forward to this series, Brad!

    • http://www.feld.com bfeld

      The promissory note approach works also. However, in my experience, there’s a lot more movement when early stage investors come in, especially if they are angels instead of VCs. I know of many cases where the founder didn’t get any incremental equity for the note, nor was the note paid back.

      Since we are taking a case study approach, we wanted to create a situation where the invest would impact the equity part of the balance sheet.

  • http://www.julian-carter.com Julian Carter

    Looking forward to following this

  • http://www.julian-carter.com Julian Carter

    Looking forward to this thread series

  • Raghunath

    Suggestion for name of the company: Mediassist

  • Pingback: Setting Up Your Accounting System

  • Pingback: Google Reader Starred: Setting Up Your Accounting System « Tao's Tao

  • Pingback: compare auto insurance quote

  • Pingback: search engine optimization service

  • Pingback: Brookline

Build something great with me