I will justify the reasons and give a workaround later in the article, but before that I would like you to spend a little time self-analysing your venture by answering a few questions. If you want, you can skip those and move to the end. But, I highly recommend otherwise.
First Question: Is your business an online or offline business. (Every business has both sides, but the question is whether majority of the business will be online or offline)
Second Question: Is it a delayed cash or instant cash startup. (This is the most important question according to me)
Third Question: Is it a stable startup or a growth startup. (Stable startups are ones which make good money for the founders and a small team, but don’t have a wide application for achieve global scale)
Fourth Question: Does it require massive capex (Capital Expenditures)
Ok Done?
Now the reason I asked you these questions is because they are imperative when deciding equity shares. I’ll elaborate as follows:
First Question: If it’s an online startup, you probably will have to focus on a more technical staff. Getting a good technical team on Equity is a little easier for an online startup than for an offline one. This is because the technical guys will get a lot more exposure for their work and become popular in their community. On the flipside it you want to “Hire” technical staff for an online venture, it’s probably going to be too damn expensive for you.
For offline startups are easier to “Hire” employees for work, but getting technical co-founders for creating a one pager website is obviously foolish. Getting non-technical co-founders with area expertise is a big challenge over here because most of them will be employed in well-paying jobs in a competitive industry. So getting them on board will be a whole lot tougher.
Second Question: Delayed Cash startups are ones which make money after a long development delay, much like my startup Qpeka which is an online reading and publishing platform. Here cash is to be made on large scale, which is very distant. Instant cash start-ups are where you start making money from the word go. That is similar to my other venture My Cute Office which is a cloud office concept for helping freelancers, startups and professionals get an affordable office space close to their homes to start their businesses. Here there is no focus on expensive technology, no long gestation periods and business can be started just through a good network. In fact I just have a one pager website and it’s more than enough (for now at least)
The reason this is important is, when you are looking at a long business development cycle, you have to keep in mind that the team may not remain intact for long. We started Qpeka with 8 co-founders and are currently at 4. So to sustain, you need to have A) more co-founders than you actually need in the beginning, because many will quit, B) agreements in place with the other co-founders to deal with various contingencies such as their leaving.
With Instant Cash Startups, it’s wiser to pay interest to your investors than to give them equity stakes, since you will be making money. Offer them 15% if required + try paying off the principal from your cash flows. (I know easier said than done)
Third Question: Stable Startups are usually those which will make good money (enough to make employees and the founder happy). However, these achieve market saturation early because of the niche which they aim for. In such startups, getting investors is a bit easier, but taking investor capital could be risky as the investor may have hopes of making more money which may drive you away from managing your business.
Growth Startups is where you aim for the Pie in the Sky. They are inherently risky like Qpeka is. But the rewards once you reach there seem big. Best of Luck if you are planning one like this. These are also typically difficult to get funded, and you will usually say to any money you see coming whether from co-founders or investors, no matter what the stake you need to give. But as I mentioned before getting back the shares you let go is not easy. However, if you decide to give any equity because you need the money, ensure you discuss the exit arrangements beforehand. This is because in all probability you are going to require cash in the future as well and if these investors don’t agree to an exit, you may end up seeing yourself as a minority shareholder.
Fourth Question: Capex (Capital Expenditure is one time expenditure that usually burns your pocket and your legs along with it). These are usually the most difficult. Unfortunately most tech start-ups fall in this category, since costs pile up as you have a development period. Do a proper due diligence of the inflows before you start a venture which requires massive Capex. Usually you need really good luck to get a co-founder to put in all the money for the Capex. Also, if you need special expertise for the technology, getting a co-founder becomes even more difficult.
In all the above, always note that when getting a co-founder later is always better. Try to do as much as you can yourself, but don’t think of going solo the whole way. Co-founders always help and big time.
Now once you have got the basics in place, let’s discuss the main part:
DECIDING CO-FOUNDER PERCENTAGES
I can become all philosophical and say some prophecy showed us how we should divide our shares. But I would be lying.
Equal is the worst possible answer, since we all know – Not everyone works equally” and “Not everyone has the same needs”. Also there is “No guarantee about the future”.
So, we actually had to come out with an extremely complicated calculation for deciding the percentages. This helped us a lot during the phase where many co-founders left the venture. (Please note this was for Qpeka – An online, delayed cash, growth start up with large capex costs. This is where most tech-based businesses fall).
Before deciding to allot the shares, we first listed the criteria for us to decide who should get what. We listed it as follows:
- Capital – This is the amount of money which is being put in.
- Time and Effort – This is the efforts made by the team members and the time they put in.
- Opportunity Cost – This is the sacrifice by the team members when choosing to work on Qpeka.
- Idea – This is for the ideas and inputs given by the team members in improving the concept.
But, before that we had to decide the length of the project. We decided that it would take us at least 2 years to develop a self-sustaining product. (Currently we are a year and a half through). Such a long period meant that we had to find a way to change equity ratios.
So, there were 2 major challenges in this, 1. To measure the criteria. 2. To be able to change the equity based on the team’s performance.
Before we tackled these problems, we first had to form a company. A company is an ideal form of organisation when you are dealing with 3rd parties, since it has an independent identity from it’s investors and shareholders and also helps build more trust.
Step 1 – Qpeka was a long term project, and we decided to contribute capital quarterly and issue equity too quarterly. This period depends on the start up and how they want to raise money.
Step 2 – To measure the criteria, we first derived relative values of each of these. So let’s say “Effort” was very important and “Money” was secondary. We therefore decided to give, Effort a total value of say 100 and money a total value of say 75 (for the Rs. 100000 being brought in by the partners. Actual figures are obviously different). Now “Idea” according to us was the least important since ideas count for nothing without execution. So we decided to give it a value of 25. “Opportunity Cost” was a special benefit for those who were giving up their day jobs for the venture. We gave it half the value of the time and effort i.e. 50. (This can also be calculated using the salaries foregone by each co-founder and compared with the amount of money being contributed to arrive at the relative value eg. If for the quarter capital raised is Rs. 10000 for a value of 75 and salary foregone by the co-founders is say Rs. 50000, the value can be 37.5.)
So we now had the total values as under:
Capital – 75
Time and Effort – 100
Opportunity Cost – 50
Idea – 25
Total – 250
Step 3 – Now with these figures in mind, we should start dividing each of them between the co-founders. You are free to choose more heads if you want, eg. you may chose to have a portion for the equity for bringing in and managing clients or give different values for each head depending on your preference and situation. Nevertheless, the next step is much more important.
Step 4 – The most important step is to divide these figures among the partners. Assuming there are 4 co-founders A, B, C and D. Of these let’s assume that A and B are contributing to the capital in the ratio of 1: 2 while also doing their day jobs and helping the venture in their part time. C and D are working on the venture full time but do not contribute capital. D withdraws a salary from the venture but C does not. The idea was thought of by A and C. Now with this case in mind the way we divided it was as under:
Capital 75 – In ratio to the amount actually contributed by A and B i.e. 25 and 50 respectively
Time and Effort 100 – A and B are part time and are assumed to put in 1/4th of the time of C and D. Therefore the ratio is 1:1:4:4. So when split the values are 10, 10, 40, 40 for A, B, C and D respectively.
Opportunity Cost 50 – C and D have left their jobs for working full time on this. But D draws a salary equivalent to his last company, so he should not get any benefit, and C shall get the entire benefit from this. Thus 50 is transferred to C
Idea 25 – The major contributions and the structure of the business was designed by A and C, hence they should be given the benefit equally, which is 12.5 and 12.5 respectively.
Total 250 – The total figures for A, B, C and D from the above come to 47.5, 60, 102.5, 40 and in percentages this comes to 19%, 24%, 41% and 16%.
But percentage of what? Now that the company was in place, we had to issue shares. The face value of shares (the price mentioned on the certificate, market value can be substantially higher) we issued was equal to the amount we had contributed. So for the Rs. 100000 we raised we issued equity worth Rs. 100000. But instead of dividing it between the co-founders equally, the ones working their asses off got more stake, which is quite implied.
Now for the next quarter we repeated the same exercise, but to keep the values in proportion to the last issue, we decided to derive the value of the capital first. Since say we had to raise Rs. 2 lakhs in the second quarter which is 2 times the amount raised in the first quarter, the value of capital was now 75 *2. All other values were proportionately determined. If there are no new ideas, then it can be made 0 in the next quarter. Also, if opportunity cost loses its importance or if all full-time co-founders draw salaries, you can accordingly reduce its value. Once you get the percentages for that quarter, issue new shares for the amount you have raised and divide it amongst the co-founders in that percentage.
Rinse and Repeat, till you get a Washing Machine in form of an investor.
So that’s about it. Just keep in mind, that even though you need to determine the percentages at the beginning of the quarter, keep a clause that these can be revised by the board at the end of the quarter depending on actual performance and you should be safe.
If not on a registered document, at least get these details on mail. Oral contracts are hard to prove.
But as time progresses cash becomes more important if you have a high burn rate. At that time however, if your product is not in place, you may have to shell out more equity for the money being put in, since now it’s riskier. But then again that is the co-founders call.
This is how we tried to ensure that the division was equitable among our co-founders and touch wood has had a really great impact in keeping our team together. Even the co-founders who quit keep in touch with us owing to the fact that they accept this equation.
I happen to be a CA too, so if you need any help in your startup don’t hesitate to write to me at abhishekbarari@qpeka.com
You can also find me on Twitter @AbhishekBarari and on Facebook too.
Also don’t forget to check out Qpeka and My Cute Office.