Top Ten Start-up Lessons Learned

By, Mike Moyer

People say you learn more from your failures than your success. After many years doing start-ups, start-up-like jobs and advising start-ups I still don’t have a private jet so I must have a wealth of important lessons to share. Here are the Top Ten, or at least the Top Ten I could think of while sitting here in the back row of coach.

  1. Always collect a nickel from everyone who promises to buy from you. Do this and you won’t need any other revenue stream. People make promises all the time, especially to bright-eyed entrepreneurs. Nobody wants to say no and it’s easy to say yes something in the concept-stage. When it’s time to actually pay, customers seem to vanish. Always remember, there is a difference between someone who says they are going to buy and a buyer. Do you best to figure it out early.
  2. Don’t go in “50/50” with a partner. I’ve seen this mistake too many times. When two partners go in together 50/50 it seems to always end in disaster. A business needs a leader. Have the guts to pick someone, it shouldn’t be that hard. Use a Grunt Fund to track who gets what.
  3. Never let anyone get in between you and the money. This applies to two fronts- financing and revenue. I’ve learned both these lessons the hard way. I once did a financing deal with a group of investors who wanted to call the shots on any new investors. When they were unable to raise the additional capital needed my hands were tied. On the revenue side it’s more common. I once had a business where my software system was going to be sold by a distribution company. The company’s sale team wasn’t nearly as interested in moving the product as I was. Sometimes distribution deals like this sound appealing and they can work out, but always retain the right to do your own legwork.
  4. Don’t think your product will sell itself. This rarely happens. Entrepreneurs need to always be in sales mode. Unfortunately most of them spend more time developing their product than finding customers. If you simply can’t resist the temptation to work on your product make a rule for yourself to spend at least as much time selling it. Preferably a lot more.
  5. Be sure to make a product that will sell itself. If people like your product they will do two things that will help your business. First, they will stick around and buy it again, second they will tell their friends.
  6. Marry the right person. Being an entrepreneur is a lifestyle choice. Be sure to marry someone who will support that lifestyle and follow you down the rabbit hole as far as it takes you. If you want to start a company start preparing your spouse now. I started laying the groundwork with my wife on our first date. So far she has stuck with me even through the most difficult times. Without the support of your spouse it just doesn’t work.
  7. Start start-ups early. One of the best times to start a company is when you have nothing to lose. Most college students fit this description quite well. Before I graduated from college I had started several companies including a direct-marketing business and a manufacturing company. It was easy. Now I have a family, a mortgage, a reputation and student loans. It’s much harder now.
  8. Raise the right amount of money. I’ve been in start-ups where we didn’t raise enough and ran out. And I’ve been in start-ups where we raised so much we made bad decisions like hiring too many lawyers and buying fancy office furniture.  Be smart about how much you need, work hard on your budget and get the money you need to make it work. Being too lean hurts just as much as being too fat.
  9. Be careful not to overvalue “skin in the game”. VCs and investors always like to see that the entrepreneur has invested their own money or is taking a painfully low salary to show that they are committed and have something to lose if the venture doesn’t succeed. While this sounds logical, I believe that the best, boldest decisions are made when you have nothing to lose. If you have a lot on the line your decisions might be too safe and conservative. Investors need to set entrepreneurs up to think big and bold.
  10. Take lessons from other entrepreneurs with a grain of salt. Just because something didn’t work for them does not mean it won’t work for you.

Learning from start-ups and learning from failures are synonymous.  Every successful entrepreneur I’ve ever met has seen plenty of failure but it rarely prevents them from trying again. The best way to learn to be an entrepreneur is to be an entrepreneur. Start early, start often!

Mike Moyer is the author of Slicing Pie, a book about dividing up equity in an early stage start-up company. For more information visit www.SlicingPie.com.

 

 

The Preferred Shares Problem

A typical investor term sheet almost always includes a term that requires the invested capital to be paid back in full before any other cash is dispersed. This is often referred to a preferred stock purchase. In fact, it is not uncommon for the investor’s preferred stock to entitle them to a multiple of the original investment. This has been pretty much boilerplate in the angel and venture capital communities. Most people take it for granted. And I understand why they would want this protection. But it’s not really fair.

When an investor requires repayment of principle before anyone else in the company can make money they are actually taking advantage of the founders or earlier investors. Additionally, they are over-valuing the cash relative to other inputs such as time, ideas, relationships, supplies and other valuable resources needed to turn an idea into a company.

It is important to know that cash is important and deserves special treatment. After all, cash is king and without it few companies have a chance at survival. However, it should be valued alongside other inputs, not above them.

For instance, many people dedicate time to a start-up and forgo salary. They are assuming the risk that they may never get paid. However, time is easier to come by than cash. It is harder to save $100 than it is to earn $100 so losing $100 in cash is more painful than losing $100 in time. So, relative to time, cash has more value. Both are important and if you assign the right risk premiums you can measure their relative value to one another.

Let’s say that I spend time on a start-up company that I would have otherwise been paid $1,000 for from clients. I’m willing to accept the risk that I won’t get paid and I feel like the risk is also “worth” $1,000. So the hypothetical value of my contribution is $2,000. At the same time another guy invests $1,000 cash to the start-up. It was a lot harder for him to save the cash than it was for me to put in the time. So he might feel that the risk is “worth” $3,000. So, the hypothetical value of his contribution is $4,000. At this point in time the total value invested in the company between my time and the investor’s money is $6,000. I put in 1/3 of the value and he put in 2/3 of the value.

If the company were to sell at this moment I would be entitled to 1/3 of the proceeds and the investor would be entitled to 2/3. If the amount were $60,000 I would get $20,000 and he would get $40,000. Likewise, if the amount were $600 I would get $200 and he would get $400. Either amount properly reflects the value of the inputs including risk premiums.

Entrepreneurs and investors today are so preoccupied with cash that they forget to value the other inputs in a company. If people are desperate enough they will agree to anything. If an investor plays hardball and insists to being paid back in full before the value you provide is recognized proceed carefully, you are being taken advantage of. But, sometimes you have to take what you can get.

To learn more about measuring the relative value of inputs in a start-up company visit Slicing Pie at www.SlicingPie.com.

The Early Bird Gets the Pie

One initial concern that I get about Slicing Pie is the fear that founders won’t get enough of the pie even though they were there during the beginning. Most people assume that the earlier you join a start-up the more risk you are taking and the more reward you should receive. Therefore, early participants should receive a higher proportion of the pie than later participants. This may not always be true, sometimes early risk is quite low because nobody has invested anything but spare time which isn’t the same thing and leaving your job a working full time, but I digress…

This concern often stems from founders who think their idea is actually worth more than it is. If you have read the book you will know that a Grunt Fund places little or no value on ideas alone. Rather, it rewards action and inputs that turn ideas into businesses that create value.

That being said, Grunt Funds have a number of mechanisms to reward early participants in the company. Most importantly, early hours earn higher percentages of pie than later hours. For instance, on day one if you are working with a partner at the same GHRR of $100 and you each work five hours the total value will be $1,000 you have each earned 50% of the available pie. In six months, when the pie has grown to a TBV of $100,000 your five hours will only earn you less than ½ of 1% of the pie. Clearly, getting in early has benefits. The sooner you can start generating revenue the sooner you can start paying people instead of giving them pie and the more you will own.

This applies to other inputs as well. The Grunt Fund provides incentives to invest cash, equipment and supplies early on in the process. $1,000 cash investment on day one of the above scenario would entitle the founder to $4,000 in pie bringing the TBV up to $5,000 for the day. Your partner would own 10% and you would own 90%. The same investment against a TBV of $100,000 would receive less than 4% of the pie.

Remember, however, that the pie grows and over time all hours are treated the same. Your first hour bought more because the pie was smaller. When the pie is bigger incremental hours are still valued the same, but they receive smaller pieces of the pie.

Another mechanism a founder can use to solidify a fixed interest in the company is to “partition” off a slice of the pie and only divide up the remainder. The early founders may take a 10% piece for themselves and slice the remaining 90% using a Grunt Fund. This is fair as long as you include all current participants in the partition.

If a founder wants to own a significant slice of their own pie they need to put in the most or find a way to pay people. If they start with no money they can’t expect to take the lions share just because they started the company. They should get pie according to a GHRR that properly reflects their experience, abilities and responsibilities. This is the only fair way to reward other participants.

To learn more about the book Slicing Pie and how it can help reward employees for building value in a start-up visit www.SlicingPie.com.

Solving the Equity Trap

The issue of equity in a start-up company is always a sensitive one and it is rarely, if ever, handled properly. The most common way, and probably most destructive, is to split the equity evenly among the founders. So, for instance, two founders would get 50% each and three founders would get 33.3% each.

The problem with the equal split is that most people don’t put exactly the same amount of effort or add exactly the same amount of value to the organization. So, when some people work hard and others work less tensions rise and resentment soils otherwise good relationships. As the needs of the company grow and change more people may need to be added. Sooner or later the team will have to reevaluate the distribution of the equity when they realize that the equal splits just didn’t make sense. These conversations are fraught with danger. Missteps can destroy a good company and scare off potential investors.

The Greedy Bone

This “equal-equity” trap is caused by hopeful thinking instead of practical thinking. Founders think about the millions of dollars that they will certainly make and the Greedy Bone kicks in. Founders figure this is their last chance to get the best deal possible and they want to maximize their portion without appearing to be greedy or selfish to the other members of the team. So, splitting it equally is the easiest solution.

A Better Way

The better way is not to worry so much about the future value, but instead consider the current value of the various inputs into the company. For instance, if a founder leaves her job to start the company she is forgoing a salary and assuming the risk that she will never get paid. So, the current value is the opportunity cost of not getting a salary plus a premium for the risk.

Or, if a founder invests his cash into the company he assumes the risk of never getting it back. So, the value of the input (time or money in this case) is the opportunity cost plus a risk premium. Relative to time, cash is more valuable because it’s harder to save $1,000 than it is to earn $1,000 so it deserves a higher risk premium.

Let’s set the risk premium for the salary at 200%. In other words, if you risk your salary now the company might pay you twice your salary when we get the cash. This is a pretty good deal that most people would be happy to take. If the company, on the other hand, can actually afford to pay you your salary there is no risk and therefore no equity.

Consider the cash. For an early-stage company risk is very high so let’s set the risk premium at 400%. So, when the company liquidates you will get four times your money back. Not a bad return.

Of course, these are pretend values. The company makes no guarantees and the likelihood of paying out exactly 200% on the salary, for instance, is low. They may get less, but hopefully they will make more. However, by calculating this pretend value we better understand the value of each other’s inputs relative to each other. No matter what our splits are, we should be happy if we get back a proportion that is equal to the relative value that we put in. In other words, if I provide 80% of the inputs I would expect to get 80% of the reward.  Inputs include time, money, supplies, ideas and a variety of other things that turn an idea into reality. All of these things have a current value.

I created a mechanism for tracking the various inputs made by founders and early participants. It’s called a Grunt Fund and it allows individuals to earn equity on a rolling basis during the early stages of a start-ups life. This allows for the changes in a new company and the people who work on it. The advantage is that founders will avoid the risk of making equity-allocation mistakes while providing incentives for each other to contribute. If some people work harder or provide more value in other ways they will be rewarded in a way that is perfectly fair to their teammates. Additionally it allows the company to add or subtract team members as needed.

Dividing the pie equally among founders in an attempt to get the largest possible slice of some future value almost always leads to trouble. But if each founder gets out an amount that reflects the relative value of what they put in everyone should be satisfied (except the greedy ones who want more than their fair share).

To learn more about the Grunt Fund and how to use it visit SlicingPie.com

 

 

Slicing Pie

By, Mike Moyer

Few subjects cause more angst in the lives of entrepreneurs than the question of how to divide up the equity in an early stage company. Everybody is conflicted. Each person wants to maximize their share while being fair to the other players. The more people you add, the more complicated it can get.

There are two primary traps when it comes to dividing up equity. The first is dividing it up before the real work of the venture has actually begun. The second is dividing it up after real work has been done and value has been created.

In the first scenario the trap works like this. Jack and Jill start a company and split the equity 50/50. Jack breaks his crown and quits. Now what? Does Jill continue to do all the work for 50% of the company while Jack sits around doing nothing?

In the second scenario the trap works like this. Jack and Jill start a company and decide to worry about the equity later. Jill, being an avid tumbler, is great a fetching pails of water while Jack has more trouble. Several months later little Bobby Shafto wants to buy the company. Jack and Jill fight about who did more work and wind up blowing the deal.

Both these examples describe worst-case scenarios, but both traps are common in start-ups often leaving the start-up team at odds. The good news is there is a system of slicing the equity pie that is both simple and fair. Rather than slicing the pie in the beginning or waiting to the end, you slice the pie on a rolling basis throughout the start-up phase based on the theoretical value of the various inputs.

The Rolling System

Start up equity is worth nothing so values are always theoretical. You will use the theoretical value to calculate the ongoing ownership of the company. In other words, equity share is calculated on a rolling basis.

Jack and Jill both agree to be “paid” in equity at the theoretical rate $5 per hour. They start their company. In the first month, both work 100 hours or 200 hours between the two of them. Therefore, the theoretical value of the company is $5 x 200 or $1000. Because they both contributed $500 they each earn 50% of the company.

The next month Jack works 50 hours before he breaks his crown. Jill works 100. Between the two of them they added another $750 in theoretical value to the company so it’s now worth $1750. However, Jack has earned 43% of the equity and Jill has earned 57%. Both see that the model is fair. Jill is doing more work and the model provides sufficient incentive for her to keep working. Likewise, because Jack is no longer earning equity he is motivated to get back in the game if he wants to stay with the business.

Three months go by. Jack has not returned to work. Jill has worked 300 additional hours she now has 77% of the company and Jack has 23%. When little Bobby Shafto comes along it is clear how the proceeds should be distributed.

Using this rolling system of equity allocation the team can calculate a fair equity split at any given time.

Hours worked isn’t the only input a company needs. You may also need cash, equipment, intellectual property and supplies. A theoretical value can be assigned to virtually any input the company needs. For instance:

-          Jack buys 500 buckets at $5 each. Since it is real cash out-of-pocket the theoretical value of the investment is higher than the actual value. Jack and Jill could agree that the investment is worth $1500 in theoretical value.

-          Jill provides the use of her hill for fetching water. She could have rented the hill to some marching ants for $500 a month. Jack and Jill agree that the investment is worth $500 a month in equity.

-          Jack and Jill each buy about $50 in supplies each month. They agree that the investment isn’t very big, but it’s still worth allocating equity at the actual cash value.

Jack and Jill can agree on the theoretical values as the inputs are provided. Generally speaking, significant real cash investments or outlays should be granted equity at a premium because cash is harder to come by.

Paying Employees

In some cases start-up employees will get paid. Jill is a landowner and has other income so she does not draw a wage from the new venture. Jack, on the other hand, needs at least $2 per hour to make ends meet. Therefore, Jack earns equity at a lower rate. When an employee takes equity rather than cash they are taking on risk. When an employee draws a wage the risk is reduced or eliminated. Therefore, there is not a 1:1 relationship between real cash and theoretical cash. If Jack takes $2 per hour his risk is reduced. Jack and Jill agree that the cash wage will reduce Jack’s equity earning rate to $1 per hour.

Therefore, when Jack works ten hours he earns $20 cash and $10 in equity. When Jill works ten hours she earns no cash and $50 in equity.

Quitting and Firing

Perhaps Jack decides to quit after breaking his crown. Jack is leaving Jill holding the bucket. Therefore, Jack should not expect to retain his equity after his departure unless both Jack and Jill agreed, in advance, what would be retained. For instance, it would be fair that Jack forgo equity earned by working and retain equity from investments of cash or cash equivalents.

On the other hand, if Jill fired Jack it is not fair for her to revoke his earned equity. This would prevent the larger shareholder to simply fire the others in order to attain a larger share themselves.

Using a rolling method of equity allocation is simple and fair. Ultimately, you and your partners or teammates have to agree, in advance, how you will calculate the value of different inputs. Putting real cash is high risk so it should receive a premium stake. Taking real cash out reduces risk so it should reduce equity stake at higher rate.

The rolling method will eventually run its course, especially as your company matures and takes on significant outside investment. When this happens you will have to switch to another method, use stock options or some other system that makes sense. Professional Angels and Venture Capitalists will certainly have their own ideas. However, they may not make sense in the nascent stages of a start-up’s life.

To learn more about Slicing Pie and how it can help you fairly allocate equity in a start-up company visit www.SlicingPie.com

 

 

 

My Feelings on Fairness

Treating people fairly in a start-up company means giving them a reward that is proportionate to the contributions made relative to others participating in the business. In other words, if you make 75% of the necessary contributions to a company you should enjoy 75% of the benefits when that company someday starts generating excess cash either from operations or the sale of all or part of the equity. However, because people generally lack a method for valuing and monitoring the various inputs made by an individual (more on this later), fairness tends to be highly subjective and difficult to achieve.

When a group of people work together towards a common goal they are a team, but when it comes time to negotiate their slice of the equity it’s every man for himself. It pits start-up brother against start-up brother (or sister, of course). Individuals naturally act in their self-interest and when the split isn’t clear greed creeps in. Even when individuals have good intentions mistakes will be made. For instance, when two founders go “50/50” on a business one inevitably makes a disproportionate contribution and they will both know it.

There are two directions of unfairness. The first is someone having less than they deserve and the second is someone having more than they deserve. Both can cause irreparable damage to an otherwise healthy relationship, especially as the stakes get higher. In a good start-up, the stakes start out low, but get high (hopefully). When the stakes are high the negative feelings caused by unfairness manifest themselves in arguments, resentment and sometimes legal battles which can take their toll, if not destroy, a young company.

More Than They Deserve

When someone gets more than they deserve they are taking advantage of the other members of the team. Perhaps they are a better negotiator, perhaps they are a better salesperson, perhaps they lied when they made their case or perhaps they intimidate others. Whatever the reason, they have treated others unfairly and damage will be done.

Professional investors routinely take more than they deserve offering term sheets that are oppressive and serve the interests of the investor much more than the interests of the start-up team. Young entrepreneurs often fall prey to these tactics. It is so common, in fact, that people take it for granted that venture capital or other outside investment will come at great expense. It is important for entrepreneurs to appreciate the extent to which they are being exploited and know their own tolerance for the behavior.

In some cases an individual will actually be allowed or even encouraged to take more than they deserve. This can be a form of manipulation that could be costly down the road when that person will owe favors to others that may not be in their best interest.

Less Than They Deserve

When someone gets less than they deserve they will immediately feel resentment toward those who got more. Feelings of distrust and/or inadequacy will hurt productivity and motivation will dip. Those most likely to get taken advantage of are those who don’t have the willingness to walk away from the negotiation and will feel stuck in a bad situation. Even those who ultimately reap the rewards of a liquidation event will still feel resentment toward others.

If the individually willfully accepts less than they deserve problems will arise when they see what they could have achieved if they had been more diligent during negotiation. Amateur investors, like friends & family, may allow an entrepreneur to get more favorable terms than they actually deserve because they want to “help them out.” Here, too, problems can arise as the stakes get higher.

Repairing the Damage

When unfairness exists, it is often difficult (if not impossible) to remedy the situation without stirring up additional problem. For instance, the remedy may tip the scales in the opposite direction as the one with more gives up more than they should. Partners will find themselves back at the negotiating table before too long.

Changing ownership structures often requires legal and accounting work to amend agreements, calculate tax implications and other expensive tasks that would have been unnecessary. Too many rounds of changes can leave a shareholder agreement looking like the back seat of the family car creating a major deterrent for potential investors.

Avoiding the Problem

The best way to manage the problems caused by unfairness is to avoid them altogether. A Grunt Fund is a tool for tracking the tangible and intangible contributions to a start-up company. Time, equipment, supplies, relationships and intellectual property are just a few of the inputs that help a company succeed. Each one can be valued relative to other inputs. When the time comes, the Grunt Fund allows entrepreneurs to then allocate equity in a manner that is fair to everyone involved.

In a start-up company fairness is fun. When everyone feels like they are getting what they deserve they feel respected and valued as a member of the team. Under these circumstances a team can do their best work.

To learn more about Grunt Funds and how they can help you allocate the right amount of equity to those who deserve it visit www.SLicingPie.com

Investor Repellent

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 http://www.SlicingPie.com.