Slicing Pie: Fund Your Company Without Funds
Page 7
If the idea is well documented and baked the value is set equal to the amount of time it took to bake the idea times the originator’s GHRR plus the costs of any research or legal protection.
So, if I spend 500 hours developing a business plan around my idea, 200 hours writing and researching a patent and $10,000 hiring a lawyer to file my patent then the idea would be worth 700 x my GHRR plus $10,000 ($80,000).
GHRR
$100/hour
Business plan hours
500 hours
Patent research hours
200 hours
Time @ GHRR
$70,000
Legal fees
$10,000
Theoretical Value of the IP
$80,000
Royalties
In addition to calculating the theoretical value of the intellectual property, it may be appropriate to also provide a royalty payment to the inventor. Royalties reflect the fact that without the idea the business would not be possible and that the idea itself is generating buzz or recognition for the company. Additionally, royalties only reward ideas that actually help the company generate revenues.
I recently spoke to a guy, we’ll call him “Ted”, who wanted to start a Grunt Fund with another guy who we’ll call “Xerxes”, who had been working on a technology product for six months. Ted thought that Xerxes would have been better off building a more basic product to test the concept instead of the robust prototype that was actually built. Ted was concerned that the theoretical value of the idea and related work was going to be too high. If Ted and Xerxes had been working together since day one, Ted could have helped Xerxes design a more basic product for testing. In this case Ted could offer a royalty to Xerxes that would only provide pie when the product actually generates revenue. This way if the product turns out to be a dud, Ted won’t feel that Xerxes has too much pie. Likewise, if the idea turns out to be a winner, Xerxes will be properly rewarded.
Solo entrepreneurs who spend years developing their ideas often over value their time. Royalties can help address time invested before the team actually forms.
Royalty payments are generally paid based on a percent of revenue or cash receipts. Paying a royalty based on profits is not recommended because profits can be manipulated at the inventor’s expense.
The percent you actually pay will vary based on the industry standards and your negotiating skills. Be sure to negotiate a fair rate because you may someday be paying out in cash.
Royalties are kind of like commissions (see below). You can either choose to pay all or part of the royalty in cash or give them a slice of pie equal to two times the unpaid royalty.
You can ask for a buyback provision for the pie, but it is okay to issue stock to the inventor when the time comes because investors will see the inventor’s interests aligned with the business and won’t consider it “dead equity”. It can be a good idea to stay close to the inventor unless they are one of those mad-scientist types that spend their free time trying to acquire human brains to control robots and household appliances.
Lastly, in some cases it is appropriate to cap or “expire” the royalty payments. This is important because a perpetual royalty may turn off potential investors. (Investors don’t like deals they can’t get out of.)
Traditional licensing deals often include an advanced payment against royalties. This prevents companies from securing rights to intellectual property they don’t plan on monetizing. I don’t recommend pie advances because it doesn’t jive well with the spirit of the Grunt Fund.
Relationships
The last input that requires discussion is relationships. Sometimes Grunts provide access to certain people that the company needs, but might not know. The right relationships can turn into sales or partnerships, a professional service provider, a reliable vendor or an investor. A well-connected Grunt can do wonders for a company and that value should be taken into account.
However, be careful not to be too bullish about the prospect of a Grunt’s relationships actually materializing as relationships with the company. I’ve been in more than one situation where a startup has over-paid for an employee based on the quality of their relationships. Once they were on board, the relationships failed to turn into anything substantial. In many cases even if the relationship does materialize it is difficult to quantify the value in any meaningful way.
Relationships are kind of like intellectual property, the relationship has low value unless you put the time and effort into making it work. However, a notable exception is a relationship that turns into a sale.
Nothing is more important in the early days of a startup’s life than an actual customer that pays its bills.
A business needs customers and, as obvious as it sounds, many startup companies don’t have customers. They’re too busy building products, designing slick web sites, writing ads, creating business plans, negotiating legal contracts and talking to each other.
The best way to translate relationships into value is simply by applying the GHRR to the hours spent cultivating the relationship after the Grunt joins the herd. If the relationship has the potential to turn into a sale, you should set up a commission structure or bonus for the Grunt that would reward them for successfully landing the sale. The Grunt should receive a theoretical value of twice the unpaid commission they might otherwise earn if they were getting cash.
For instance, if you agree to pay a 5% commission the theoretical value would be 10%. If you paid out 2.5% in cash the theoretical value of the unpaid commission would be 5%.
So, at a 5% rate if the sales person had a connection that resulted in a $20,000 sale the 5% commission would be $1,000. You could give them $2,000 in pie, or if you paid them $500 of the commission in cash, you would give them $1,000 in pie because only $500 of the $1,000 would be at risk.
Similarly, if a Grunt’s relationship provides a significant Series A investment, a finder’s fee might be appropriate. A typical finder’s fee is 5% on the first million and 2.5% on funds over a million. The finder’s fee would convert to equity at the same terms the investor receives (not GruntFund terms).
Other Resources/Partnerships
If a Grunt or business partner can provide temporary access to important resources they should receive pie in exchange for at least part of the opportunity costs of letting the company use the asset. For instance, a Grunt may have a forklift for another company that your company could rent from time to time. In these cases you should negotiate a reasonable rate in pie. If the asset would otherwise be rented to another client the rate could be set to the rental rate times two to account for the risk. If the asset would not otherwise be rented then a fair rate can be negotiated.
The same would apply to certain human resources. For example, my company, (Lake Shark Ventures, LLC) employees a number of people who work on company projects. When I make investments into startup companies I often invest the resources of my company at a very reasonable rate in pie. They aren’t freelancers, nor are they employees of the company, nor are they unreimbursed expenses. They are Lake Shark employees that work on projects for startup companies. I pay them out of my own pocket. Lake Shark takes pie.
This scenario can be quite common and can form the basis for important partnerships and alliances that your company needs. Most of the time there is no set rule; you would simply negotiate a GHRR that makes sense for the company and for the partner.
Vacations
During the early days of a startup company things are so fluid that a formal vacation policy doesn’t make much sense. Grunts should not get pie when they are on vacation. (Unless they are working on vacation in which case they would receive pie for the time they work).
Grunt Funds account for actions and behaviors that contribute to the building of a company. Sitting on a beach sipping piña coladas doesn’t help a new company much so pie is not provided.
Later on, when the company is more mature, you can create a more formalized vacation policy. My favorite i
s one with no cap on vacation days provided the employee is doing their job and meeting goals and expectations. This allows employees to manage their own time and sends the message that managers respect their ability to behave like adults with a sense of responsibility. It’s also easier to manage because you don’t have to pay people for unused vacation days or split hairs about what constitutes a vacation day, sick day, or personal day.
This has nothing to do with the Grunt Fund, but like a Grunt Fund it is based on mutual trust and respect. Now…back to the model.
Summary Calculations
The following table summarizes the theoretical value of the various ingredients:
Ingredient
Calculation
Time-Grunt
Grunt Hourly Resource Rate (GHRR)= negotiated base annual salary x 2 ÷ 2000 ( or 250 for a Grunt Daily Resource Rate-GDRR)
Time-Grunt who also gets cash compensation
GHRR = (negotiated base annual salary – current compensation) x 2 ÷ 2000
Time-Consultant
Hourly rate x 2 (reserve the right to buy back)
Money-Cash
Amount of money x 4 (2x if crowd-funded)
Money-Personal credit, paid off by Company
Nadda
Money-Personal credit, paid off by Grunt
Amount of money paid towards bill (including interest) x 4
Money-Loan to the company
No pie, just principle and interest from the company. Treat as cash if not repaid by company.
Money-Unreimbursed expenses
Amount of expenses x 4
Ingredient
Calculation
Supplies and equipment-business facilitating
Nothing
Supplies and equipment-business enabling
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
Facilities
Equal to rent or lease amount if appropriate for business
Equal to cost of more appropriate facility
Ideas & intellectual property
Development hours times GHRR plus costs
Unpaid royalty x 2
Relationships
Unpaid commission x 2 or finder’s fee for investment
Other resources
Negotiated rate
If you don’t like these calculations you can make up your own. Just keep it fair and consistent.
Pie A La Mode
Cheat Sheet
To download a cheat sheet with summary calculations visit SlicingPie.com and click Pie à la Mode or scan the code.
Put it all together and bake for 12-18 months. Delicious! Pies that take too long to bake get kind of boring…
Chapter Four:
Using a Grunt Fund
Now that you have determined the value of the various ingredients in the pie you have a simple way of calculating everyone’s share. You simply add up the theoretical value of the ingredients contributed by a single Grunt and divide by the total theoretical value of the ingredients contributed by all the Grunts. This will give you the percent contribution of a single Grunt that you can convert to equity whenever you want.
Contribution of Individual Grunt
÷
Total Contributions from All Grunts
=
Individual Grunt’s Percent of the Pie
The total theoretical value of all the contributions is called the Theoretical Base Value (TBV). To determine ownership percentages divide the theoretical value of each Grunt’s input by the TBV.
Individual Grunts should keep track of the hours they spend on the business and how they spent the hours. Keep enough detail so that it’s meaningful, but not so much that it is aggravating. Keeping the balance is up to you. I once worked for a man who tracked his time in 15-minute increments—probably an overkill for the average Grunt. Still, it is nice to know how Grunts spend their time in a startup business.
A simple time sheet could look a little like this:
Date
Hours
Notes
1/5
9.50
Worked on business plan, lunch with potential client, interviewed printing vendors
1/6
8.25
Discussed plan with Frank, prepared investor presentation, met with Joe about web site, reviewed and edited specs
1/7
4.50
Edited web site specs
1/8
1.75
Stared out the window
Grunts should also keep track of the other ingredients they provide and submit them regularly to the founder or lead Grunt. You can use whatever format you are comfortable with, but make sure you keep track of the different inputs.
When to Calculate Equity
For the most part, you will want to calculate it on a regular basis, say monthly, to see where everyone stands. More importantly, however, you will want to calculate it if you anticipate that someone, like a potential investor, will ask about it.
I started a business a few years ago where I wound up pitching the business dozens of times to potential investors. If I was using a Grunt Fund, I would have needed to have the equity allocation numbers handy just in case I needed them. Investors often want to know about ownership.
In some cases (such as small investors) you can tell them the current equity allocation, but explain to them that you are using this system and let them buy their own copy of the book. It will be good for them to know how you are calculating it and they will think you are a fair and wise person. It will also help me sell more copies so it’s a win for you and for me.
Order a Six-Pack of Slicing Pie
To get a special price on six copies of Slicing Pie for your team visit SlicingPie.com/sixers or scan the code.
However, when real investment dollars come in they may not be subject to the cash rule (4x) how much of the pie will depend on your ability to negotiate and set a good pre-money valuation. Significant outside investors, in other words, may not be Grunts.
Calibration
In a perfect world the value of equity would go up in excess of the theoretical value of the various inputs.
This is the point of a growth-oriented business. Often, when you pitch a potential investor you are trying to sell them on a base value that is hopefully more than you and the other Grunts have put into the business. Successfully negotiating a high valuation is very motivating for Grunts and it breathes more life into the business.
However, you can set a new TBV earlier in a startup’s life with a slightly different purpose: adding Grunts to the herd.
Sometimes, if you and other Grunts have worked hard on the company for a period of time, you may want to “harvest” a little of the value for yourselves before allowing others into the herd. This is fair, early Grunts take on more risk than later Grunts. I call this “Calibration”.
Pretend that you and two other Grunts have each put in $30,000 worth of theoretical value into a company. You have been working for six months and you need to bring on more people. The company has a little traction now so you would like to reap some of the benefits for your hard work. You allocate the equity at 33% each on a TBV of $90,000. If you think the company is now “worth” $300,000 you can move the base to $300,000 and move forward as if you had all contributed $100,000 each. On paper your investment of time and whatever else you put in has grown threefold.
Now, when other Grunts enter the herd they will be earning against a base of $300,000 instead of $90,000. So, if they contributed $100,000 in value and the rest of you did nothing, they would have earned 25% of the company ($100,000/$400,000) instead of over 50% of the company ($100,000/$90,000). This allows early Grunts to keep a higher percent for themselves. Keep in mind, however, that the new work the original Grunts contribute will be calculated against this new TBV so they will consume pie at a sl
ower rate.
The other thing to keep in mind is that if you calibrate too high you run the risk of exceeding the value you can sell to an investor, which would mean that when you do find an investor, newer Grunts will actually realize less value than they feel they contributed which is a good way to anger a good Grunt. I could tell myself and the other Grunts that the company is worth $1 billion, but if I can only convince an investor it’s worth $1 million I will have disappointed my Grunts.
It’s best to calibrate only when enough value has been built that an early herd deserves to benefit from the higher-risk work.
Also, as time goes by, a Grunt Fund will have to be replaced with a different method of allocation. As a company grows it may take on a more formal structure to handle equity sharing.
Pie Partitioning
As an alternative to calibration (which some people find confusing) you can simply create a “partition” in your pie which isolates a hunk for you and your fellow super-early-stage founders. The partitioned part will maintain its percentage no matter what. For instance, you could partition off 10% of the pie and use the Grunt Fund to divvy up the rest. The 10% will always be worth 10%. So, the other Grunts will earn a percent of what’s left over (the 90%).