Basics
for
Engineers
by Mike Volker
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Business
Basics for Engineers by Mike Volker |
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!
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)!
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 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.
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.
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.
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.