Allocating Startup Equity by the Hour

Allocating Startup Equity by the Hour

Contributed by Alon Cohen  EVP/CTO at Phone.com

How do you move from a few friends brainstorming on a new startup concept, to actually getting the group to sit down and start working to build a company?

How do you deal with situations in which one team member already has a job and cannot devote the hours to the project that other founders can devote? What if you start and one team member gets an offer he cannot refuse from say, Google? What if one member is a good salesperson or marketing person, and will only be utilized later on, while you do all the R&D work now? In other words, how do you divide the cake to begin with?

Resolving all that from the get-go is important, but is usually awkward for first-time entrepreneurs, and many times prevents good things from happening or good ideas from coming to fruition.  Venture capitalists say often that they mostly invest in a management team.  Accordingly, a group of founders that has these issues resolved will be more attractive to investors.

To start, one must look on at least on three periods: the periods before funding, during funding, and after funding—i.e., when an investor decides not to invest anymore, for some reason, and the founder is left stranded with the rent and salaries to pay.

Say you, the entrepreneur, have an angel investor, or that you started working with an incubator for a defined period of time. The incubator or the investor stops investing, while you are willing to continue to work on the project on your own time until funding or revenue comes along. Will the incubator get to keep all the equity they initially received? How would you be compensated for the work you did during the post-incubator or post-funding period?

Existing solutions do not favor the entrepreneur, and normally the only situation in which you can recover some equity when things change is if a team member quits while the company is funded and a “reverse vesting” mechanism that was agreed upon in the investment documents is activated. (Generally speaking, I like the reverse vesting mechanism).

I was thinking about the startup bootstrap problem in over the years, and again recently, particularly in my role as a mentor with the TechLaunch program in NJ and ffVC in NY. It seems that there is a need for a simple method that can help individuals to resolve some of those common problems that emerge when you start a company.

The concept I came up with is based on the basic axiom (sometimes forgotten by some investors after the funding is done) that “Time is Money,” and, in our case, time and talent are money.  The concept is as follows:

You define (agree on) the value of each hour of work invested by a team member as say, $50.

When the group starts the project, usually working with no salaries, each participant logs the time invested, as money, based on the agreed-upon conversion rate. If a member needs to put some money into the company for anything, it is logged as dollars.

For instance, if one person invested 100 Hours + $10,000 (that is 100*$50 + $10,000, or $15,000) and say the other partner invested only $15,000 (with no work), the two investments are deemed equal (theoretically, with no official share distribution yet). When another person joins, he or she starts accumulating their own share in the same way. If the investment goes to pay anyone a salary, then no hours will be logged for that paid individual.

Now, say that the bunch created an application, and it is selling nicely on the App Store. Any revenue left to distribute will be split based on the percentage “invested” by the partners. This process nicely solves the situation in which one person leaves for some reason and others continue, since the relative share of the one who left diminishes over time unless he or she continues to contribute.

As you move to the funding phase, the key is to get investors or an incubator to agree to accept that principal and keep that process going when, or in case, they stop investing. Say the founders decide to keep working with no pay after the funding ended, or until the next round is secured—the contributing founders keep counting hours, which will be regarded as if they invested more money as part of the last round.

Clearly, after an investment, the rate of gaining back equity by the founders might not be the same as the rate at the beginning stage, (since the company now has a post-money valuation) but that might serve the investors well, since, in spite the fact that they might lose some relative equity at some rate, they will still be in the game for an upside in the event the startup makes it. It is also acceptable that the rate of investment of each working individual will now be defined based on the salary they received during the time the company was funded. Without that founder’s compensation, most startups will disintegrate when the funding ends.

Angel investors and incubators might be smart to accept these terms, as the terms give the founders an incentive to keep working on the project, and can also prevent unwanted friction moving forward.

I was pondering if the people and founders investing hard-earned money should have some sort of preferred compensation in case of distribution of revenue. Eventually I concluded that time plus talent should be treated just the same as money. In much the same way, that the investor risks wealth (and, in most cases, not even his own), the founder risks his or her future, and misses on potential earnings. Hence, in my eyes, the two parties bear a similar risk.

While taking to David Teten, a partner at ffVC, he recalled that he successfully used a similar model at his prior startup, Navon Partners.  There, he preferred the vesting to be calculated on a daily basis, instead of an hourly basis. As he put it, “it’s sometimes annoying to track activity by the hour.”

There may also be tax ramifications to a founder who earns equity through providing services.  I urge you to consult with your accountant or attorney to be sure you avoid any tax landmines.

What do you think of this structure?  Have you used a structure like this yourself?  What challenges have you encountered?

Editor note: the views & opinions expressed herein are those of the contributor and do not necessarily reflect the opinions & views of ff Venture Capital.

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