Valuing Contributions

First, let’s look at valuing contributions to the startup. These can come in the form of cash, intellectual property, equipment, real estate, or past and future services to the startup.

Cash is easy to value. It is the other contributions that are hard. Real estate, off-the-shelf equipment, and other tangible property are the next easiest to value, as the founders can find the market value by having it appraised by expert valuers or by finding the market value of equivalent equipment or property.

Bespoke equipment made specifically for the startup and intellectual property are harder to value. Bespoke equipment has an idiosyncratic component: it is very likely worth more to the startup than it would be worth to other persons, because it was created specifically for the startup’s business and this may have to be factored into the valuation. Intellectual property can be valued using several methods: historic cost of developing the intellectual property, market comparables, real options, or discounted cash flows. It is an art rather than a science (especially when determining appropriate cost of capital or discount rates), and requires experts who understand the industry and the technology that is the subject of the intellectual property rights. When a founder is transferring intellectual property, consult an attorney who has experience incorporating startups, as there are some tricky tax issues for contributions of property that need to be handled with care if that founder is to avoid being taxed on that transfer.

Past and future services is also a difficult contribution to value. Past contributions can often be valued by considering the cost to the startup if it had to acquire comparable services in the market, e.g. how much it would need to pay to have a developer develop its application. The problem really lies in valuing future services, as there is inevitably an element of uncertainty. The product may change. The business plan may change. The roles that founders play in the business may change. A founder may leave the startup for other pursuits. All of this combines to make valuing future services an almost futile effort, even before we consider questions like the appropriate discount rate. The best that founders can do is likely to backload any equity for future contributions by using a vesting schedule that ensures that if a founder walks away from the startup he or she is not walking away with a significant portion of the equity despite not having “earned” it through the future services that he or she should have provided.

Allocating Equity

Once the founders know (or have estimated) the value that each of them brings to the startup, the next difficult question is how to allocate the equity. This is often a difficult discussion. Sometimes founders will simply split the equity equally among themselves. This may be a feasible option where each founder brings approximately the same value to the startup, but it is unlikely to be true in the majority of cases.

There is no perfect formula or method to allocate equity, but there are some rules of thumb that can help to guide founders to think about it:

• It rarely matters whose idea it was. Unless the idea involves patented technology (in which case it should be valued as stated above), it will be execution that determines the ultimate value of the startup. Don’t get hung up over whose idea it is and automatically give that person a greater share of the equity.
• Full time trumps part time. A founder who is working on the startup full time is taking a much greater risk and committing more time and energy to the startup than one who is still drawing a regular paycheck from somewhere else. (Besides, part time founders also raise thorny issues of a part time founder’s employer disputing the startup’s ownership of intellectual property.)
• Vesting is utterly vital. The shares the startup issues to a founder should be subject to vesting, i.e. the founder should only obtain full ownership of the shares after certain milestones are met or after a certain amount of time has passed. This prevents a founder from joining the startup, and then leaving after a short period with a significant equity ownership.
• Cash is king. A founder that provides cash to the business should get equity commensurate with that cash commitment and be treated as an investor in the startup because he is no longer just providing skills and materials. The cash commitment may be treated as a convertible debt transaction or an acquisition of preferred stock (although this can complicate the cap table at a very early stage).

The 4Ds

One last difficult question that founders will need to address in their operating agreement or shareholders agreement is what happens if a founder dies, becomes disabled, gets divorced, or there is a fundamental and unresolvable disagreement among the founders. The key issue is what happens to the equity if any of these situations occur.

These are awkward and difficult topics to discuss. They can very quickly dampen the mood in the room and stifle conversation. Yet an effective founding team needs to plan for the worst, so that if it happens they have some method of dealing with it.

The typical solution for death, disability or divorce is a repurchase right which gives the startup the right to repurchase the shares if a founder dies, becomes disabled, or is divorced and the divorce court transfers the shares in the startup. The startup will typically finance this with the proceeds of key person insurance.

Disagreement, well, that is a whole different question. In general, I find it easier to figure out an acceptable solution before a real fundamental disagreement happens, rather than try and negotiate something after an irreconcilable difference occurs. Typically, the best way to deal with this is to have some recourse to buying out the dissenting founder, although this can be difficult to finance in practice.