Paying for the Pie
There are a number of ways to finance your company. The best way is to start generating revenue as soon as possible. Generating cash early will enable you to not only prove your concept to investors, but also potentially get a better valuation and, therefore, keep more equity. In my experience, startups don’t concentrate on revenue generation early enough. They often spend too much time and money on product development or give early versions of their product or service away for free. If you can’t get someone to pay for your product or service it’s not a good sign!
Of course, some products or services take time to even create a basic offering for which you can start charging. This will require cash and non-cash contributions to allow the team to keep working. Slicing Pie gives you the model to properly account for these inputs and divide equity accordingly. Slicing Pie is based on the fair market values of the various contributions, but there are other, non-pie fair market ways of dealing with investments that will enable you and your team to conserve slices and keep more equity.
There are four basic types of funding:
- Revenue- earned
- Grants- free
- Debt- expected to be paid back, income is from interest
- Equity- never actually paid back, income is from dividends or sale
Yes, there are also things like preferred stock (which does get paid back) but these things aren’t practical for bootstrapped startups with limited resources. Putting together special classes of stock, options or other complex investment tools is expensive, time-consuming and unnecessary. If you’re spending time and money setting up complicated stock and option programs you’re probably over-thinking it. Wait for Series A.
Whenever possible, choose the “cheapest” form of funding. Revenue, as mentioned before, has no impact on your Pie and getting it is well-aligned with your company’s purpose. Government grants don’t impact the Pie either, but applying for them may be time-consuming and waiting for them may be impractical.
Debt financing is favored by many because it is easier to understand and predict. In most cases payments must be current before dividend distributions can be made to shareholders and, in the case of a sale, debt obligations must be met before distributions of proceeds can be made to shareholders. This is referred to as “debt preference” because lenders must be satisfied before anyone else. In exchange for this added level of security, lenders are willing to accept a lower return on the investment. In fact, oppressive terms or abnormally high interest rates could be construed as predatory and may be illegal. Another benefit to debt financing is that is cheaper and faster to put together a deal.
Equity financing means you are selling a fixed chunk of equity for a fixed price. This is called a “priced round” and can be suicide for your company unless it is done in the context of a Series A investment or 409A valuation. Read this article for more backstory on why slicing is better than pricing. Unlike debt, equity in the form of common stock is never actually paid back and there is no interest rate or preferential treatment. Equity represents ownership in a company and entitles the owner to dividends or it can be sold.
Before the Priced Round
If your company is worth $0, you can’t use stock price as the basis of your equity split. You can’t divide by zero nor can zero be divided, so it’s worthless as a denominator or a numerator. A non-zero value is useful because you could use stock to pay people based on how much it’s worth. Lacking a reliable valuation, the only fair option is to use Slicing Pie during the bootstrapping stage when the company is worth nothing.
The most common funding source for new companies is the founding team who cover expenses directly or by depositing cash into company bank accounts. It doesn’t matter if the team member is draining their personal bank account, racking up credit card debt, or keeping another job for income. What matters is that he or she paid for things and will not be reimbursed. When this happens, the amount of the expense converts directly to slices in the Pie.
In the Pie Slicer, team members can log cash expenditures directly for immediate allocation of slices
It’s a better practice for a company to pay expenses directly from corporate accounts. For this to happen, the company must have money in the bank. In the early days, this money is usually provided by founders, team members, advisors, or other people close to the company who deposit money to cover short-term expenses.
For instance, a founder might deposit $5,000 from a personal account into a corporate account from which expenses can be paid. In Slicing Pie, no slices are allocated when money is deposited because it’s not really at risk. However, when the money is consumed it converts to slices. This prevents individuals from “swamping” the Pie simply by making large deposits. It also forces managers to be smart with expenses knowing that every dime converts to slices with the cash multiplier.
Slicing Pie uses a concept, called the “Well” to manage deposits. Cash contributed by individual team members for future business-related expenses should be put into a corporate savings account (aka “the Well”). When cash is needed, it should be transferred from the Well to the corporate checking account at which point it converts to slices.
Deposits and withdrawals can be logged using the Well feature in the Pie Slicer. Balances are naturally low because the cash is intended to cover expenses in the near term.
Working with only enough money to cover short-term expenses may not be a practical choice for the team. Raising money from friends and family may be one way to obtain larger amounts that will allow the company to make larger investments and make longer-term commitments. Raising larger amounts from people who may be unaccustomed to making high-risk investments introduces new problems. For instance:
- Individual investors may not be comfortable without a clear understanding of payback.
- Inconvenience of an inexperienced third-party monitoring your operations as an equity holder.
- Potential legal issues the company may face by offering equity to unaccredited investors.
- Inability to set a meaningful valuation for equity.
To mitigate these issues, it may be preferable to use debt, rather than equity or slices.
It is difficult for bootstrapped startups to secure loans from banks because most will require some sort of asset as security. Financing inventory or equipment may be an option, but probably not working capital. Some companies may be able to get working capital loans from the Small Business Association (SBA), but it still may require some sort of security.
A team member can take out a personal loan against his or her home or on a personal credit card, but he or she will be obligated to pay it back even if the company fails. If an individual secures the loan and deposits it in the Well and it will convert to slices when consumed.
However, if the company makes the full payments no slices are allocated. Yes, there is risk associated with the loan, but it’s not put at-risk. The difference is important. The risk associated with the loan is only incurred if the individual has tolerance for the risk. The actual consumed cash is worth what it’s worth no matter where it came from and it’s only at risk when it’s consumed. If the person is asking for regular payments the nature of the money is debt. He or she has borrowed it from the bank and loaned it to the company. It would be fair to charge an interest rate, but if a founder is profiting from the company it may breed animosity from the team.
Slicing Pie Loan
Cash is loaned to the company from people at “arms-reach” from operations like friends and family. The loan carries market-rate interest and repayment terms. The company makes payments to the lender as agreed. However, if the company skips a payment, the amount of the skipped payment converts to slices with the cash multiplier.
Log skipped payments as cash under the “other” contribution type in the Pie Slicer. Upon a formal valuation the remaining balance can be paid back or converted to equity at the same terms as other convertible contracts.
Angel investors are accustomed to providing cash to companies as working capital under the terms of a convertible debt or equity instrument and have no impact on the Pie. Popular formats are SAFE or KISS agreements, but the actual form it takes and the terms in it will be negotiated with the angel or angel group. The nice thing about convertible debt or equity is that it relies on the future valuation set by professionals and does not require complicated legal documentation. This makes it a much more practical tool and represents the fair market for angel investments.
Angel investors will likely ask for a cap table at the time of investment. The summary report from the Pie Slicer will give you a breakdown the current ownership. Be sure to explain that the split will change before Series A or breakeven in response to changes in the team or the individual contributions of team members.
The Priced Round
Using a mix of unreimbursed expenses, the Well, Slicing Pie loans and convertible angel investments you can (hopefully) demonstrate that you have created a sustainable, scalable business that warrants the attention from professional investors. A professional investor invests other people’s money usually in the form of a Venture Capital Fund or some sort of crowdfunding platform.
Cash is provided to the company as working capital in an amount that should allow the company to invest in growth-oriented activities and sustain the spending until the next round of funding (Series B, C, D, etc.) In exchange for the investment, the professional investor takes a fixed equity stake in the company and imposes conditional terms on the founding team (such as reverse-vesting). The price of the equity determines the investors share of the company and is determined through negotiation with the founders and a review of rather extensive documentation including due diligence documents, business plans and a private placement memorandum. This process, combined with the VC’s fiduciary responsibility to his or her investors, allows the company to set a meaningful valuation for the company.
At this point, the company should have enough cash on hand to cover expenses and salaries so the Pie will no longer accumulate slices and the team’s equity will vest or otherwise become fixed and subject to the terms of the professional investment. This is known as “baking” the Pie.
Breakeven – 409(a)
If the company reaches breakeven on its own the Pie will naturally stop accumulating slices and, therefore, the Pie will bake. To convert outstanding KISS, SAFE or convertible investments the company can obtain a 409a valuation from a certified, professional accountant. This will allow the conversion of investments and set a strike price for the creation of an incentive stock option program.
While there are many ways to fund a company it’s always important to use the most efficient and practical tools available given your circumstances. Unproven, bootstrapped companies must rely on funding from founders and use Slicing Pie. As the company gains traction other funding sources become available and founders can choose those that provide working capital while conserving slices. It’s important to avoid setting a premature valuation.
|Model||Slicing Pie||Bake Pie||Fixed Split|
|Tool||Expenses||The Well||Slicing Pie Loan||Convertible Debt/Equity||Series A||409A|
|From||Founders||Founders, Participants||Friends and Family||Angels||VC, Crowdfunding||After breakeven|
|For||Immediate Costs||Short-Term Costs||Short/Medium-Term Costs||Medium-Term Costs||Growth||Lifestyle|