There are many things that can repel an investor. Most of them have to do with a faulty business model or lack of a competitive advantage. However, sometimes your business will have real potential but the investor will flee when they take a look under the covers and see how the business is organized or financed during the formation stage. A convoluted ownership structure, for instance, can destroy a company’s chances of raising real money.
Some of the biggest deterrents can be the company’s ownership structure. Disputes over equity and ownership between founders can lead to big troubles with team dynamics or a situation where there are a variety of small, absentee owners that may not have good relationships with the management team. Unfortunately, this is not uncommon; but, fortunately, it is avoidable.
In the early days of a company’s existence it is quite common to promise equity to individuals in exchange for their work on the company. The founder or founders slice of hunks of the pie and pass it out to employees, consultants, lawyers, small-money investors and a variety of others. As the company grows the founders realize they passed out too much and attempt to get it back from others in hopes of having a larger share for themselves. This creates animosity, resentment and a tangle of amendments to operating and shareholder agreements that no investor wants to touch. Investors like clean, simple deals with a happy management team that controls all, or most, of the equity.
I recently spoke to a man who started a company with a partner. The made the classic equal-split equity mistake where they each started with 50% of the equity. When the man’s partner didn’t pull his weight the man got frustrated and resentment between them emerged. To solve the problem they amended their operating agreement to provide a profit sharing program that would reward each of them profits based on their hours worked in the company. There were no profits so this didn’t really solve the problem. Next they agreed that they would further amend their ownership so the man got 80% and the partner got 20%. Again, this created another amendment to their operating agreement. The problems continued, however and the relationship got strained even further. Both men hired lawyers. Their lawyers advised them to stop talking to one another during the negotiations. How can you run a company if your managers can’t talk to each other?
Scenarios like these play out time and time again when founders get into disputes about equity and ownership. The main disputes occur when determining the percentage each person gets and what happens when people leave the team.
One structure, called a Grunt Fund, attempts to address these issues in a fair, systematic process whereby values are assigned to the various inputs provided by founders and other participants. Inputs can be time, money, supplies, overhead and other tangible and intangible assets. When equity is actually issued, the percentage ownership is based on the percentage of the inputs. So, if a person puts in 20% of the inputs they will receive 20% of the equity.
The Grunt Fund also includes a set of rules that apply when someone leaves the company. The circumstances under which they leave will influence what they get or don’t get. For instance, someone who is fired for good reason will be treated differently than someone who is let go through no fault of their own.
The key is to outline the rules early in the process, treat everybody fairly, and handle departures with the right level of respect. This will reduce the need for convoluted legal agreements and amendments that might scare away an otherwise willing investor.
For more information about Grunt Funds and how to fairly allocate equity in your start-up company visit www.SlicingPie.com.