Splitting shares in a new company

My cousin recently introduced me to an entrepreneur. He is an inventor, who has developed a <$10K piece of machinery, that can save a specific kind of business $1M a year in operating expenses. I have been asked to help turn the inventor’s company into a real business, working perhaps 1 day/week. And I have a potential full time sales guy to add to the team.

The question, of course, is how to split the shares?

The virtue of common shares

First of all, I would insist that we all have common shares. Why?

The advantage of common shares is that it means we all have the same interest. We all want our common shares to be worth something. If we sell the company, all shareholders will make money (or not) together. If we pay dividends, all shareholders will get them (or not). It’s very hard with a pure common share structure for one person to completely screw the others. You all succeed (or fail) together.

This is important to me. It’s also important to protect the inventor, who has invented other things in the past, and been screwed by other people. I would be the sophisticated business guy in this transaction. I want to make sure he is protected. If we all have common shares, then when I fight for his rights I am fighting for my rights, and vice versa. (Compare and contrast with convertible debt.) The only difficult question happens now, with who gets how many shares. After today, things would get easy.

Existing company or new company?

As the CEO, I would become a director of the company. This leads to a second, fairly easy, decision: existing or new company?

The advantage of the existing company is that it has an operating history. People can do business with a ‘3 year old company’ rather than a ‘newly formed company’, or, for instance, we have a 3 year credit history. This matters. It also has a large disadvantage. I as a director could become legally responsible if it turns out the inventor has made mistakes in operating his business, even ones he didn’t know were mistakes. What if he promised shares to someone he worked with 2 years ago and never delivered? That is all of a sudden my problem.

The advantage of a new company is that I personally would have no liability for the mistakes he has made previously. He would sell his current business’s assets to the new company, and can then shut the old company down. If someone comes after him from the past, this is his problem, not ours in the new company. This approach costs a bit in company registration, and saves me a lot of risk, time and costs – in having to check out everything the inventor has done in the past.

So we need to trade off the value of being a ‘3 year old company’ vs. the risk to me of joining the board of a company that may have hidden problems (and/or cost of making sure problems don’t exist). We’ll make the decision one way or the other and move on.

Vesting, of course

One problem with common shares is that you are splitting ownership of a company among you before the future work is done to build value in the company. If one person drops out after 1 month of work, and the other two build the company, yet the first person owns a third of the company, that isn’t very fair.

You take care of this with vesting, as I have written about before. Let’s say 4 year vesting of the shares (i.e., the company has the right to buy back some of my common shares at the price I paid for them, if I leave the company in under 4 years), with a 6 month cliff (I get zero if I leave in <6 months).

Founder shares are forever

Let’s assume everyone stays their full four years and vests. It’s now worth noting that founder shares don’t typically change over time. Once you start to raise money into the company, the shares are worth something. If you get an extra 10% of the founder shares, you will typically pay a few thousand dollars more, and be done. When the company is worth $2M, you would need to pay $200,000 to get 10% more shares. That’s a lot of money for most entrepreneurs. Even if you didn’t pay cash for those shares, that would be considered $200,000 in income and you would owe taxes on that amount.

Those are hard obstacles to get over. So it’s important to understand that even if one person proves at the end of 4 years to be much more valuable than the others, it’s difficult to change the founder shares. I found this out the hard way in one company. So this is an important discussion. Get it right now, and be sure you are comfortable, because you may be stuck with it forever.

Voting power vs. ownership

I am potentially going into business with someone much less experienced than I am. I trust myself to make decisions for the good of the company. What if I can’t trust the other person? What if they get bad advice in the future from someone who says ‘screw your old CEO, you’re the important one, get rid of him and take me instead’? (This is a paraphrased version of what happened to me in a previous company, where I held too few shares.)

There are three solutions to this:

1. Split the voting rights apart from the shares in some way. We can make two classes of shares, giving me the majority of the voting shares, or we can enter into a voting trust, where the inventor owns his shares, but I vote for him. I don’t like these two solutions, though they are possible, because they are situations that can be abused.

2. Split the economic benefits off of the shares. We can do a side agreement with the inventor, where he gets additional personal economic value from the company from every sale, in addition to what his shares would entitle him to, and give him fewer shares. This might work in our case.

3. Keep voting rights in mind while splitting up the shares. For instance, if there are three of us in the company: the inventor, me and the sales guy, split the shares in a way that no one person controls more than half of the company. Then we can keep each other honest. And I then only risk the inventor plus the sales guy both taking the same bad advice together, which is less common.

Who gets how many shares?

The actual final split of shares is a negotiation. There are many possible splits. People often start with the democratic ‘divide the number of shares by the number of people’. This is a bit false: different people contribute more and less. I especially advise against it for only two founders. You need one person responsible: it totally changes the dynamics of disagreements, in a good way (if you have good partners). You can’t fight to a deadlock, because that means one person decides. So in avoiding the deadlock, you compromise.

There are a number of websites that give calculators that can be used to decide how to split shares, including Foundrs and SlicingPie (caveat: Slicing Pie’s mechanism of issuing shares for value contributed falls apart as soon as you raise outside money).

And really, these calculators only help justify something which already feels right and fair to you.

Making it personal, and final thoughts

In our case, who should get the value? The person who created the <$10,000 machine? The person who manages to convince customers to pay $200K for the machine? The person who pulls all the pieces and people together, and makes sure everyone is looked after? Good questions. Questions that we will have to reduce to numbers … and then see if those numbers are agreeable to all parties.

It’s a negotiation, after all. If everyone feels fairly treated, then you will reach an agreement. If you don’t make it worthwhile for people, then they won’t join.

It’s not easy. And it’s important to settle the share split early, do it well, make peace with it, and then move on.