It seems like not a day goes by without someone posting somewhere on the Internet a question asking how to split the equity in their startup between a founder and co-founders, then with employees, next with investors, and so on through each round funding. Splitting up the shares in a company requires first and foremost attributing a value to the company. Not an easy task at any point in time. However, even more so, when you are just starting out.
Not long ago, I posted an answer to just such a question based on the ROKC ™ Method which was quickly picked up by Mr. Randall Reade, a Board member of Washington DC Tech Fund, Executive VP of Washington DC ArchAngels, and President of Global Tech Exchange, we found our point so enlightening that he asked us to diffuse it as widely as possible.
“Yes, I like that idea! You should spread it around more. And you are correct — it can be difficult to determine a valuation, especially when there is no revenue. Most startups just assume a $1M valuation, and it’s at least a yardstick to go by. But you are correct — many times there is no value.”*
Well Randall, here you are.
The ROKC ™ Method states, a business exists because it owns and/or controls an asset – which we refer to as the “Key Component” – that is used their products/services which customers will seek to acquire because it gives them a competitive advantage in achieving a specific outcome. Therefore, a company valuation can be broken down into elements: the value of the Key Component, and the value of the economic activity that generates the Return On Key Component, or ROKC. Likewise, the Method states that a business will continue to exist as long as the ROKC is higher than the Cost of Capital. Consequently, when valuing a business at the idea stage the business owner has neither the Key Component nor the economic activity making it impossible to attribute a value. Similarly, most early stage businesses may have only the Key Component but not an economic activity making it equally challenging to determine a value. This is why we recommend using a more non-traditional approach: the consortium, otherwise known as a contractual Joint Venture.
A consortium is basically a contract between parties – individuals or legal entities – who come together to achieve a specific goal, which can be work on a common project or jointly provide a service, by way of example. The contract details how the parties will work together and divide up the benefits. It is not a legal entity so it does not have any of the administrative burdens required by law. The consortium is ideal for early stage companies because it is light and creates the conditions for focusing on building the business instead of bureaucracy.
Let’s look at the example of an idea stage business before increasing the complexity. At the idea stage, there is no manifestation of the business yet, there is on Key Component or economic activity. At this stage, there is nothing to bring to a legal entity or a need to limit liabilities so why go through the hassles of creating and administering one. Even to give the idea expression there is no need for a legal entity.
For the first iteration, the “idea person” will a small team to build a prototype. Until the prototype is built there is not Key Component to place in a legal entity making this phase ideal for a consortium since there are two or more parties collaborating. It is at this stage that a contact between the parties forming the consortium can be drafted detailing each party’s role and expectations going forward. To keep things simple, we suggest each party define an hourly market comparable rate for their work and keep track of the time they spend working on the prototype. At the end of each month – or any period agreed upon – each member of the consortium validates the others so there are no conflicts at the end.
Assuming the prototype is determined to be of equal value, when forming a legal entity, each party receives an equity stake equal to the number of hours employed multiplied by their hourly rate, or can be bought out by one or more of the other members. If the prototype is given a value inferior to the time spent times the rate then a percentage based allocation is made. And, if the prototype is worth more the remainder can saved for future employees, advisors or new equity partners.
In the next phase, the prototype may actually be put to work allowing the founding team to determine the business’s market fit. This phase can require a whole series of pivots and adjustments which means more time and resources dedicated possibly by new parties. Once again, the contract can be adjusted to take into consideration each new party and their expectations allowing the work to continue before creating a legal entity.
“The consortium approach has the added value of seeing what you have and can do BEFORE the expense and trouble of founding a company. Focus on the product first, and the determine whether this product and the team can generate revenue. If the answer is no, then why waste all that time and money? If yes, then you can always put it together.”*
As long as the parties to the consortium do not require a limit to their liabilities beyond what they already have entering the economic phase should not be a problem.
So when you launch your next startup, please consider the value of creating a consortium between those who will be collaborating and cooperating with you instead of how to divide a pie which is worth nothing.
*Quotes are Randall Reade.