The answer to the question posed by the title is probably, in all honesty, “Not much!” But before we write off left-wing political and economic theory entirely, there is one principle that is perhaps worth a bit of further exploration.
“To each according to his contribution” is one of the core dogmas of Marxism. What does it mean? Basically it is saying that people should be rewarded based on the amount they contribute to the social product; or, to put in other ways – “you get out according to what you put in” or even “no pain, no gain”. That sounds like the type of approach that could have an application in the entrepreneurial world, especially in early stage startups, doesn’t it?
Well, it certainly is in use already today and it even has its own very impressive-sounding name – Dynamic Equity Splitting. We’re going to abbreviate it to DES for the rest of this article, if you don’t mind. DES is basically the opposite of Fixed Equity Splitting (FES), a model where the equity is divided in the beginning of the enterprise based, it could be argued, merely on a best guess as to what each founder’s role and contribution will be in the future. History is littered with cases of FES causing problems between stakeholders, largely connected with dissatisfaction on the part of those who felt that the allocation of equity was unfair based on the actual post-splitting contributions.
Problems of fixed equity allocation
It doesn’t take a genius to figure out what can, and often does, go wrong in equity splits. Some very insightful research, performed by Harvard Business School Professor Noam Wasserman, has shown that over seven out of every ten new startups split equity within just a month of being formed. At this very early stage, almost all aspects of the business are in a constant state of change – except, ironically, for perhaps the most important element of all: who is going to be entitled to what. At the dawn of any new venture, there always seems to be a burning desire to at least be able to pin something down – and the equity split seems to be an ideal candidate to be agreed upon at the start. But the danger is that it is far too easy to make the assumption that the high levels of commitment shown by each stakeholder will continue in perpetuity, and also that the various roles and contributions of each will remain static over time – that almost never happens in reality and, if the latter really does occur, then it is probably because the enterprise is not growing or developing as it should be. Another factor is that it is difficult to weigh up and measure the contribution of each without letting individual bias get in the way – most entrepreneurs like to think that they are the key driving force behind the entity and underweight the contributions made by others. This means that “allocation by opinion” is unlikely to go well!
There is no doubt that choosing an inappropriate fixed equity split can prove to be very expensive for those that find themselves on the wrong end of it, either through lost returns in terms of dividends or capital gains or perhaps through having to pay a premium to buy out an under-performing partner. Amongst all the craziness of the early life of your business, it is so critical that an unpremeditated or thoughtless approach isn’t taken. It is incredible how many partnerships default to a simple handshake and a straight 50/50 split – it can, of course, prove to work out fine but it also may not!
Fair ways of allocating equity
Not everybody is aware that there is an alternative to the commonly used fixed model and the fact that DES may be the best solution to avoid future problems. The beauty of DES is that it’s a model where the ownership changes over time based on cumulative contribution by each participant, seemingly in a fair way (or, at the very least, a way in which every participant agrees to beforehand.)
It is suggested that fixing the equity split does not need to occur prior to the first round of external financing, when newcomers will, of course, want to know how big piece of the pie they will be getting – but as long as it is all private money and your own sweat, then there is no real need to rush things as long as everyone in the game plays by the agreed rules.
One version of DES is known as a “vesting approach” which is very familiar to those who have enjoyed stock-based compensation in some form, usually as part of an employee stock option program, but vesting can also pop up in some well-crafted founder shareholders’ agreements. In this approach, parcels of equity are gradually allocated over a set period of time to the participants either on a pre-determined percentage basis or on some flexible terms to be agreed. For (a very rough) example, on the anniversary of the founding, the two stake holders receive 10% equity each for each of the following five years until the full 100% is allocated. This approach has the benefit of ensuring that each participant remains involved over the five years, although there may need to be explicit terms to cover what each participant needs to accomplish or contribute over that period to ensure that each is still pulling their weight.
Other way of allocating shares according to contribution in a startup is to create a roadmap of tasks to be done (to get your project moving ahead towards your milestones and goals) and assign a certain value for each task, and then compare tasks done by one founder to the tasks done by all founders and determine the correct percentages that way. In this model only the effective contribution will be counted. For example if you completed four tasks, each worth 5% in current equity, you would get 20% of the shares afterwards. Naturally after all the tasks have been completed and 100% allocated, there will be new tasks to be created and valued appropriately reflecting the situation and valuation of that moment.
The “grunt fund”
Another approach has been called the “grunt fund” method – this concept has been pioneered by Professor Mike Moyer of Northwestern University in his book “Slicing Pie”. In this approach, every contribution to a startup, whether it is a tangible contribution like cold, hard cash or a more intangible input like time or intellectual property, is given a pre-determined monetary value. Each participant logs his or her contributions into a “grunt fund” and their proportion of the total of each grunt fund represents their equity at any point in time. What is especially interesting about this approach is that more value is assigned to items where the value is readily quantifiable. How much is an idea worth? Well, the reality is that an idea in itself is worth nothing, in commercial terms, unless there are other assets and resources employed to take advantage of it and to make it happen, like making a movie out of a comic book character. This way is something that the creative members of the entity might struggle with, but it is an important component of the whole exercise.
Implementation of dynamic equity approach
Are there any potential pitfalls to the DES approach? Yes – one of them is that it can take a lot of time and effort to keep track of all the various inputs in a dynamic model – the number of people who actually enjoy filling in timesheets must be quite minuscule! There has to be a high level of trust involved as well, in terms of the completeness and accuracy of data being submitted. Perhaps the most difficult component is agreeing on the value of each item to be contributed – it may be necessary to get some external and objective advice from an independent third party to get to a mutually satisfactory conclusion.
Finally, you also need to consider what will happen in the event that a participant exits the relationship, for whatever reason, especially before significant revenues have been generated. Does the equity built up represent a fair proportion considering that the person concerned may be exiting before their role or all tasks are complete? All of these factors indicate the need for both legal advice upfront and for agreements to be documented in extensive detail – otherwise you could find yourself in exactly the same situation that you were trying to avoid with FES!
With that all said, DES are certainly something worth exploring and well worth the investment of your time among a multitude of other tasks. After all, timesheet filling and non-stop calculating of your slice of the pie is not the core of your startup actions, however, learning from Wasserman’s study results stating that 65% of all startups fail due to team problems compared to only 35% failing due to product or market problems, keeping everyone involved in your project satisfied is absolutely crucial if you wish to attain success.
If you decide to choose the dynamic model and it does turn out to be a winner for you, then don’t forget to raise a glass – in honor of Mr. Marx!
About the author: As a serial entrepreneur, Jan Ameri, internet and information addict, loves to connect ideas, things and people cross-platform, cross-media and cross-science for concept creating, business development and marketing purposes. Currently he is working on developing a system for supporting fair entrepreneurship in a Helsinki based project still in a stealth mode.