by Mike Moyer
Cash contributions are weighted heavily in a formation-stage company for several reasons. First, it is much harder for a Grunt to replace the cash when he or she is in the process of starting a company. Unless they have money to spare (and most Grunts don’t), the Grunt must either keep a day job or find consulting work to pay the bills in the short term. Starting a business and trying to earn a living at the same time takes a lot more energy than doing one or the other.
Next, all businesses need cash to survive.
No cash = No business
Grunts like pie and if they can buy a big slice for putting in a little cash, everybody wins.
Lastly, weighting cash heavily allows founders to buy and maintain a big chunk of their own business during the early days.
Many founders want to retain ownership of their company and tend to be stingy about slicing pie. The best way to retain equity is to simply pay in cash. If you don’t have the cash you can use equity, but you can’t expect to keep most of the pie yourself.
Put this in perspective. If you simply pay people for the contribution they provide you can keep all the pie for yourself. However, if you want to start something from nothing, you are going to have to share it.
To recap, the theoretical value of a cash or cash-equivalent contribution a Grunt makes is the amount of the contribution times four.
The Well
The cash rule causes some people angst. They figure at 4x someone can plunk a big chunk of cash in the company and own the lion’s share of the equity. This is true and may be fine if the cash is used to pay people their fair market rate. However, if the cash isn’t used to pay people the unpaid people may feel demotivated. It’s important that the allocation of equity fairly reflects the risk that individuals take when they make contributions to the company.
Cash sitting in a bank account is not really at risk because unused cash can be returned to the owner. In a traditional investment the company takes the cash in exchange for a fixed amount of equity. The incentive is to spend the money because the equity is already granted. In a Grunt Fund we want to encourage people to only use what they actually need. The concept of the Well can help.
Cash can be taken into the company as a loan to create a “Well” of money that can be drawn from as needed. Only when the money is spent will it be converted to pie. This aligns the incentives of the investor (who wants to reduce risk) and the Grunt (who wants to be smart about how they spend. With a Well, Grunts can take sips of cash when needed.
Sometimes Grunts only need sips of cash
A Note about Cash Investments from Grunts Who Also Get Wages
A Grunt that receives current cash compensation should not be allowed to simply reinvest the cash in an effort to get pie at a higher rate.
For example let’s say my market rate is $50 per hour which would translate into a GHRR of $100. Instead of pie, the company pays me my market rate (if they have the money), so I do not get pie for the time I put into the company. If, however, I put the money they paid me back into the company I would get the 4 x rate. So, instead of getting $100 in pie (which is what I would have received for my time) I would get $200 at the cash rate. That’s not fair.
Generally speaking, a Grunt that receives wages is one that does not have the money to invest. However, if they really want to invest, the 4 x rate should only apply to cash investment in excess of what they were paid. Any money they invest that is less than what they have been paid should go in at the 2 x rate.
A Note about Crowd-Funded Cash
As of this writing, the impact of the JOBS Act is still up in the air. Theoretically, it will lower the restrictions on the sale of equity to non-accredited investors.
The problem with allocating small slices of pie to complete strangers is that you wind up with a bunch of absentee owners that could turn into a major administrative headache.
It is for this reason that cash from crowd-funding sites is less valuable to you. So, while cash from people on the team or close to the business might get a 4x value in pie, you might want to give the crowd-funded cash 2x or 1x. You will still be giving pie to random people, but at least you won’t be giving them as much. This is fair because of the additional complexity that comes with managing shareholders.
A Note for Grunt Leaders
It’s the job of the leader to make sure everyone is playing fairly and getting what they deserve. Overt trickery (like reinvesting wages in order to get the higher rate in pie) should not be allowed.
A Grunt who habitually tries to “work the system” clearly does not understand the intended spirit of teamwork and may need to be removed from the herd (more later on this).
To combat against other tricks, the leader should not accept cash investments that are significantly more than the company actually needs at any given time, this will help manage the pie better and prevent abuse.
Loans and Credit
Sometimes a Grunt will personally guarantee a loan or use their own credit cards for the company. If the Grunt pays the bill, the money he or she uses to pay it should be treated like cash—the amount of money times four.
However, if the company pays the bill the Grunt will receive no pie as long as the bill is paid on time.
The company should always cover interest charges and, if the company does no pay the bill on time, the company should cover late charges.
However, if the company can’t pay it off at all, the Grunt who provided the credit must pay it off by him or herself. In these cases, the payments are treated as cash contributions.
So, the theoretical value of loans and credit provided with a personal guarantee is nothing if the company makes the payments. If the Grunt makes the payments the amount of the payments is treated as a cash investment so it’s the amount of the payment times four.
Big Loans
The above loan rules apply no matter how large the loan.
“Major” loans, like Small Business Administration (SBA) loans or mortgages on real estate (like for a rental property), get treated like any other loans. No pie is given for the loan if the payments are covered by the operations of the business.
Example One:
Joe and Frank buy a rental property for $100,000. Frank secures the mortgage with his assets, but he splits the $20,000 down payment and closing costs with Joe— $10,000 each. The mortgage payment is paid from the proceeds of the rental income.
Both Joe and Frank receive pie for their cash ($40,000 each), but Frank gets nothing for securing the loan. That’s it.
If the owners have to pony up more money because the house isn’t rented they will receive pie according to the cash rules.
The value of the house has nothing to do with the theoretical value of the business. Only the cash inputs count.
Example Two:
Kendra and Millie buy a scarf company from Robin for $100,000. Using their personal assets as collateral, they secure an $80,000 SBA loan.
Kendra fronts the $20,000 to complete the purchase, plus an additional $20,000 to cover operating expenses and some new marketing efforts for the company. Millie puts in no cash.
The cash from Kendra goes into the theoretical value according to the cash rule (times four). So, Kendra’s input gets her $40,000 x 4 or $160,000. Note that this exceeds the actual value of the company. This is still fair, Kendra has taken on some serious risk. The actual value of the company ($100,000) has no bearing on the Grunt Fund.
This May Sound Strange
There are at least two things about dealing with loans that might seem strange at first:
Disregarding the actual value of something purchased with a loan
Disregarding the security behind the loan
The Grunt Fund disregards the value of the underlying asset because Grunt Funds deal with the inputs from the different Grunts to create a theoretical value, not an actual value. So, actual value doesn’t really matter much.
Let’s pretend, for a minute, that actual value does matter. In that case w
e would account for the actual value of the asset, but, because there is an outstanding loan, the liability would offset the actual value so it’s a wash.
As for providing pie to whoever secures the loan, the Grunt Fund ignores this because there is no practical way to translate this into pie. It’s too subjective.
One could argue that the person who secures the loan should be rewarded because it’s their butt on the line if things fall apart. That is a valid point. However, with no objective way to value the risk we have to ignore it.
With Grunt Funds we only count what we can count. If we can’t count it, we don’t count it. Don’t lose too much sleep over this; it all works out in the end.
If a Grunt doesn’t like this they can opt not to secure the loan — even if it means an end to the business. Nobody has to take risks if it makes them uncomfortable.
Putting actual cash in the business is always the fastest way to earn pie. If you feel like you deserve more pie, put in more cash.
Loans from a Grunt to the Company
When a Grunt loans money to the company the Grunt is entitled to the same thing any other lender is entitled to which is repayment of principal and interest. The interest rate should be set to whatever the Grunt is willing to accept. No pie will be given if the company is paying as agreed.
If the company defaults on the loan, the balance of the loan can be treated like a cash contribution according to the cash rule.
Supplies and Equipment
Although supplies and equipment are important ways to offset cash expenses, their cash-value is often difficult to assess. If the supplies and resources facilitate the business, meaning they help make running the business easier (pens, paper, temporary office space, personal computers, etc) their value may be incidental to the theoretical value of the business and should not be taken into account at all. Despite the expense incurred by the individual participant, the act of accounting for such inputs may cause more damage to the relationship than it is worth at an early stage.
Think about it. If a Grunt shows up with a box of pencils should they really expect to receive pie in exchange?
A potential investor will likely place little or no value on access to personal computers or office supplies. Such expenses should be ignored during the early days of a fledgling business.
Eventually these expenses could be covered by the business. However, it is rarely advisable to reimburse past expenses from an early-stage investment fund. The expenses are sunk and offer no future value to the company. Investors loathe using their investment dollars to pay off debt and will pass on deals that have too much.
Old laptops and pencils are one thing, but if a Grunt is going to the office supply store on a weekly basis and spending hundreds of dollars on supplies that’s a different thing. In those cases the purchase of supplies should be treated as an expense for which reimbursement is not expected which is equivalent to cash. Note to Grunts: save your receipts!!!
In some cases, equipment and supplies enable the business. Without them the business would not exist, so having access to them is material to the value of the business and would be valued by potential early-stage investors. For instance, if you are starting a t-shirt printing company a screen-printing press would be a piece of business enabling equipment.
If the Grunt acquired the asset specifically for the business then it should be treated as an out-of-pocket expense for which no reimbursement is expected (cash).
If, before joining the herd, the Grunt owned the asset for less than a year it should be valued at the price the Grunt paid. For instance, the Grunt may have a few servers leftover from a previous business that are less than a year old and still in good shape.
If the supplies or equipment are older than a year the value should be set to the same amount as it would have cost the company to acquire the asset from a third party. If it’s a car, for instance, you could use the value listed in the Kelly Blue Book or take it to Car Max to see what they might give you.
The value of most items can be assessed with a quick glance at other items selling on Ebay. Ebay sets the standard for what people are willing to pay for just about anything.
It’s okay to err on the side of generosity because the Grunt providing the asset is assuming the risk that they may not get it back.
To summarize, calculate the contribution of supplies and equipment as follows:
Zero if the contribution simply facilitates the business
If the contribution enables the business:
Treat as a cash equivalent if it was acquired specifically for the business
Use the purchase value if it is less than a year old
Use the resale value if it is more than a year old
Grunts who contribute business-enabling supplies and equipment for which they do not receive payment can be compensated fairly with pie.
Facilities
Office space, warehouse space, retail space and other facilities that enable the business have value, especially when the Grunt could otherwise rent or lease it to a paying customer.
If the facility is appropriate for the business it is fair to value the facility equal to the amount the Grunt could otherwise lease or rent the space (not as cash). An appropriate facility is one that the business might rent or lease in order to run the business if they had the cash.
Sometimes the facility will work, even though it’s not ideal. For instance, if you need small office space and a Grunt in your herd offers use of an entire floor in one of his or her buildings you probably have access to more than you need. In such cases your fledging company shouldn’t be expected to provide pie to cover the entire value. The fair value is proportionate to what the business needs in order to grow and prosper.
Also, space in someone’s house probably shouldn’t be exchanged for pie unless the person would otherwise rent the space to a different business. People don’t usually rent their garages to startup companies.
I once started a company and was able to negotiate some office space from a friend of mine who owned a marketing agency. My team and I took over a few cubes in the corner of the office. It worked out nicely. We only paid for the space we used and had free Internet access and use of the phones for a nominal price. This is ideal. Ask around, situations like this are sometimes easy to come by.
Ideas and Intellectual Property
There are two ways to reward Grunts for business-enabling ideas and related Intellectual property: The first is to calculate the theoretical value of the idea and the second is to provide an ongoing royalty payment (cash or pie) to the inventor. You can use both, if appropriate.
It’s important to remember that ideas without action are relatively valueless, no matter how good the idea is. In the startup world, a dozen ideas are worth about a dime, less the cost of the lunch over which the ideas were generated. Generally, ideas should not be taken into account in a Grunt Fund unless they fit the following criteria:
The idea must have existed before the inception of the business
The idea must be original
The idea must be non-obvious
The idea must be “baked” as opposed to “half-baked”.
Selling Halloween costumes in October is obvious and unoriginal. Therefore, it should receive no pie.
That doesn’t mean you can’t make plenty of money with an idea that is as unoriginal and obvious as selling Halloween costumes. Sometimes better execution is all it takes. You could make millions if you have the right people.
In the case of unoriginal and obvious ideas it’s the execution that really counts. Most businesses today are founded on unoriginal and obvious ideas. This is good, these ideas could have a huge market and you won’t have to reinvent the wheel.
A book about implementing a dynamic equity split, however, is both original (there are no others like it) and not obvious. It may be obvious in hindsight, but most entrepreneurs are unaware of the concept until it is brought to their attention (otherwise everybody would be us
ing dynamic splits). This doesn’t mean that nobody has ever used a dynamic equity split before, but the details presented in this book are not widely known (yet).
A “baked” idea often comes in the form of a polished concept, a thoughtful business model or legal protection. They require insight, experience and creativity. Baked ideas usually represent the investment of considerable time and money and are often business enablers. This book, for example, is baked.
Ideas that fit the above criteria have value that should be taken into account. Ideas developed during the regular course of business, however, would not be taken into account no matter how good the idea is. It’s the nature of business to generate new, good ideas and it is part of the job of a Grunt to come up with the most awe-inspiring new idea that ever existed.
Calculating the value of ideas and intellectual property can be a challenge because inventors tend to really overestimate the value of their ideas. People tend to say things like, “Michael Dell stole my idea for building computers in my dorm room! That crook made billions! He owes me.” It’s ridiculous.
Don’t get me wrong, ideas are critical to a business’ success. But turning the idea into a reality is usually where the value is built, not in coming up with the idea in the first place. This doesn’t mean you can’t give someone who came up with a great idea some pie as a bonus. But be careful not to put too much emphasis on the idea itself. Ideas, even good ideas, are plentiful. It’s the initiative, passion, action and grit that turn ideas into good businesses.