Are you an entrepreneur with a great – but unproven – idea and you are looking to bring on investors? One of the single biggest challenges that you are going to face in this process is how to split the equity in your start-up.
How much is an idea worth? You may have spent hours labouring over the development of a Minimum Viable Product (MVP) but does that make your contribution more valuable than the first round of capital which will get your product into the market or facilitate a pilot project with a key client? Is the technology worth anything without distribution and marketing skills?
Using models such as Discounted Cash Flow (DCF) valuations or Price: Earnings (PE) multiples won’t work, because the business hasn’t sold anything, let alone generated a sustainable profit. Hence, most entrepreneurs end up using a ‘guesstimate’ for allocating equity in their start-up.
In the absence of cashflow and profits, a number of questions invariably come up when entrepreneurs start to bring on new shareholders. The skilled technology player on the team may have the ability to build something but a new investor bringing in cash or a strong sales resource who wins those early clients could be even more valuable in the bigger scheme of things.
This is where debates around who gets what shares at what price can become contentious. Your technology maestro is looking at the sales resource asking whether they will really be able to justify giving up 20% because they talk a good game. The finance person is looking at the other team members and making the point that they wouldn’t be able to cover running costs to get the product to market without a cash contribution. Surely this justifies a higher equity contribution than the traditional 5% ‘founding share’?
These are common discussions in high-potential business ideas. In my line of work, I deal with numerous conflicts on a daily business between shareholders, who used to be friends and team-members but now want nothing to do with their ‘ex-partners’. It is very sad to see an otherwise good business idea fail, because the founders didn’t start on the right basis. The allocation of equity in these situations creates tension between stakeholders, consuming significant amount of time that could be better spent on getting the business off the ground and the product to market.
One of the easiest ways to resolve the circumstances described above is to look at the Dynamic Equity valuation model. Pioneered in the US by Mike Moyer a lecturer at Northwestern University, this methodology provides investors, shareholders and employees with a clear-cut set of rules for valuing the individual contributions and assigning equity accordingly. Dynamic equity takes into consideration contributions including financial investments, other assets, time and even key relationships and assigns values and equity accordingly. You can learn more by visiting his website at: http://bit.ly/2vSmTz5.
The methodology has yet to take off in South Africa but is one of the tools we are advising clients to use, particularly in Intellectual Property (IP) rich start-up enterprises that require a combination of cash, technology and route to market assets to generate value for the shareholders.
The key to managing this process is the involvement of somebody who understands the methodology and can help manage its implementation at key milestones in your business.
If you are an entrepreneur and you are currently having discussions on how to split your equity, we would be happy to assist. The methodology and means of resolving the inevitable questions around fairness have been answered in the US, so it is just a matter of time before South Africa adopts similar techniques.
Guy Addison is a Chartered Accountant and Corporate Finance expert for Addison Inc. He specializes in assisting high-potential businesses with valuations, share structures and associated transactions.
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