How to distribute shares in an Internet start-up: Introduction

Today I begin a series of three posts called “How to distribute shares in an Internet start-up?” This is a difficult question. To answer it, we will have to take the bull by the horns and decide how much percentage goes to each group.

A possible answer is as follows.

It is practically impossible to create a large company without a good team. You need the best you can get: tireless, intelligent people with talent and ambitions to change the world, and the energy and madness to try and do this. They don’t grow on trees. They all expect recognition and a just reward for their efforts and contributions. How do we divide the pie? The first answers that come to mind are the easiest, which are also subjective and useless: “the distribution should be fair”, “reasonable”, “equitable”, etc., which mean nothing. Remember: if you don’t do your homework in advance, you will soon find problems such as “that’s unfair!” “you’re being unreasonable!”, “your proposal isn’t equitable!” What comes afterwards is just as bad: physical and emotional exhaustion, bad vibes, etc. to say the least.

Get to know all the players

The first decision is how many players will receive a piece of the pie. Many entrepreneurs believe that the problem lies in deciding how much corresponds to each founder. Nothing could be further from the truth. A company can have a long life and live through different phases. Each phase requires different types of people and help. Decide how many shares you will reserve for each phase and type of player:

  1. Founders: if there is only one founder, the problem of distribution is resolved (the bad news is that he/she must also be prepared for very HARSH solitary times). If there are more founders, the same percentage is usually distributed to everyone. “This way we avoid arguments“. I personally believe that this is a good option but not the only one. Sometimes each founder provides different experience, knowledge and dedication. On those occasions, the “everyone is equal” option brings problems.
  2. Key employees: they help the founders to make their dream come true. They are exceptional in their work (there is always a lack of resources in a start-up, so inefficient employees find it difficult to conceal themselves) and have low risk aversion. Many end up being friends forever after sharing mutual respect, hours (and hours) of work, uncertainties and risks. The reward should be on the same level.
  3. Stock plan: once everything starts working, the risk for new employees is lower and so are the rewards. Nevertheless, lower risk does not mean that it does not exist.
  4. Advisory board: this includes board members and advisors; people with know-how and know-who (not postcard fame or hot air) and people with experience and contacts who can derail a train but stay down to earth. They should be full of action and ready to get going by making phone calls, investing, finding partners and visiting potential clients if necessary (and it is). If not, out they go.
  5. Investors: they include both business angels and initial informal investors such as venture capital firms and institutional investors, which hardly ever invest less than seven figures.

Some believe that none or only some of those players are required for the project in mind. That’s perfect. All I’m saying is that, if you believe that you need them, decide how many shares you are going to reserve for them.

Size of the pie when eating it

There is a trick to this: suppose you are an entrepreneur with 100% of the shares of your company. Your service has become very popular and it receives many visits and obtains some revenues. You decide that it is time to seek investment in order to boost the project (more employees, servers, advertising, agreements, sales force, etc.). You find an investor who values your company at 2 million euros and wants to invest a further 2 million euros. Your company is worth 2 million euros pre-money and 4 million euros post-money (2 +2). However, the investor wants shares in exchange for its investment. Since it provides 2 million euros to create a company worth 4 million euros, it owns 50%. Your 100% has diluted to 50% in order to bring in the new investment partner. Nothing has changed: you still have the same amount of money (100% of 2 = 50% of 4). Now you have to make that money work in order to increase the size of the pie (company).

The dilution as a result of the entry of investors affects not only the entrepreneur but also the other stakeholders: managers, advisors, employees, etc., including investors from a previous round. The problem is that all of them want to agree on a percentage of shares before working but they will do so considering the number of rounds of financing (and dilution) that they believe will occur at the company and its value at the time of “leaving” (IPO or sale). The entrepreneur must also consider this and estimate (bet) how much should be offered to each group. The difference in estimates for each group can lead to a heated discussion. All of them will talk about “fairness”, “reasonableness” and “equity”. If the entrepreneur gives each group what it wants, he/she may end up without any shares or with a ridiculous percentage that does not justify his/her efforts. Conversely, if he/she distributes a small amount, he/she stands to lose valuable collaborators in a market full of competitors fighting like cats and dogs in the search for talent. This is a difficult but key decision. Mistakes should not be made.

Tomorrow: How to distribute shares in an Internet start-up: The market

By David Blanco
Saved in: Entrepreneurs, Internet, Venture Capital | 1 comment » | 13 October 2006

One comment in “How to distribute shares in an Internet start-up: Introduction”

[...] Investors do not generally disclose if they have shares, where and how many. Companies often use the entry of a new investor to publish a press release and get media presence. It is a good time to see who the investors are, where they invest and by how much, but there is an unwritten rule: never mention the pre-money value or the resulting stakes. Secrecy and shadows are important in these circles. [...]

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