We won't go over this explicitly in class. However, many of you ask questions outside of class related to the challenge of allocating equity to founders. I bet this note answers most of these questions. This note may also be helpful in thinking about the valuation exercise.

Equity Allocation in New Ventures

One of the most common challenges faced by founding teams is how to allocate equity in their enterprise. This is essentially equivalent to the challenge of how to value the different inputs required to create the product, service, or company. There are no predefined formulas, but basic economic logic applies here. This figure illustrates how value might be accounted for over the first three phases of a typical new venture.

Usually it is easiest to think about valuing inputs at each of several discrete phases. For example, at the beginning of the "Founder Phase" an entrepreneur has a business concept developed to some level of detail. The value of what the entrepreneur brings to the table at the beginning of the Founder Phase is labeled "IP contributed" on the figure and is shown in yellow. (Here I use the label IP to refer to all the intellectual property created to date, usually comprising business plans, technologies, and other information.) Over the duration of the phase, the venture will typically require two other inputs. One is cash, usually contributed by the founders. This cash is shown in green as "founder's cash." (This is usually a modest amount, typically $2,000 - $20,000.) The second input is the "sweat" that the founders commit to contribute over the phase. "Sweat" refers to the labor and ingenuity provided by the founders for which the venture does not pay them wages.

If the founders are successful in nurturing the business concept during the Founder Phase, they will have created some value and will usually seek additional investment. (The creation of value is reflected in the increased height of the blue bar. It is also possible, of course, that they will fail to create value, in which case the blue bar may decline in height.) The First Phase investment will usually be in cash (green) and in further sweat from the founders and some new team members (brown). Team members are almost never paid full market wages during the First Phase, thus they are still contributing "sweat." The cash in the First Phase often comes from so-called angel investors, typically in amounts of $20,000 - 200,000.

If after the First Phase the venture still offers promise, the company may seek additional capital. For a few ventures this capital will be institutional investment from a Venture Capital fund, usually called the "Series A" investment. However, I refer to this phase generically as the "A Phase" whether or not investment is from a venture capital firm. At this point, members of the team and employees are usually paid something close to market wages. However, in most cases, the venture benefits from compensating members of the team in part with equity. I still refer to this as "sweat," even though it might be more appropriately labelled incentive compensation. In most cases the sweat equity allocated in the A Phase is in the from of stock options, but for simplicity you can think of these options as an allocation of common stock to the team. Most investors expect to see about 10 percent of the total shares outstanding reserved for future incentive compensation. In almost all cases, institutional investors expect this 10 percent to dilute the existing shareholders and consider it part of the "pre-money" value of the business.

Valuing the Inputs to the Founder Phase

There are typically three inputs during the Founder Phase: (1) the IP created to date, (2) the sweat of the founders, and (3) cash. Of these three, only the cash is easy to value. A dollar of cash invested is worth a dollar. But, how do you value the sweat and the IP?

Valuing Sweat Equity

When you place a value on the sweat of the founders, you are essentially creating an equivalence between the cash contributed and the sweat contributed. In other words, an investor (usually one of the founders) who contributes $20,000 gets the same amount of equity for that contribution as someone who contributes $20,000 worth of sweat. In valuing sweat, I have usually taken the approach of estimating the opportunity cost of the time contributed by an individual and then applying a non-cash adjustment factor. For example, assume that during the Founder Phase, Billy will quit his job (or not take a job) foregoing $5,000 per month in income for the four months expected duration of the Founder Phase. Billy is contributing time with an opportunity cost of $20,000. From one perspective, he should get $20,000 worth of equity for his contributions, the same as a cash investor contributing $20,000.

However, I have often applied a "non-cash adjustment" factor to this sweat calculation. By that I mean that I have discounted the non-cash contributions by a factor before comparing them to the cash contributions. Here's why:

Cash is king. A dollar of cold, hard cash is worth more than a dollar of unpredictable, to-be-delivered effort.
Cash is invested on an after-tax basis; sweat is effectively a pre-tax contribution (assuming you are smart about how you handle the granting of equity).
Sweat is often contributed at the margin by someone who has a day job. The opportunity cost of this time is not usually cash, but rather time with family, pursuing hobbies, or watching TV. Lots of research has shown that people value their non-work time at quite a bit less than their wages at work.
Opportunity cost is sometimes inflated, particularly by consultants. People who are used to charging for their time by the hour are inclined to value their time at their marginal billing rate, sometimes $1000 or more per hour. There are of course situations in which this is appropriate. For example, if you need a busy lawyer on your team and that person can bill every available hour at $500, then that's really the opportunity cost of the time. This is rare. More typically a consultant (e.g., programmer, graphic designer) will commit to working "after hours," and that time is rarely really worth the marginal billing rate of the consultant. A rule of thumb I have used with consultants is that their inputs are valued at one half of their standard billing rates. (For the record, university professors are one of the few classes of individuals who often do have very high opportunity costs for their time because in most cases their employers limit their "outside activities" to about 50 days per year.)

Depending on how these factors play out in your situation, you will need to apply a non-cash adjustment factor to convert a dollar of opportunity cost of sweat invested to a dollar of cash invested. Having said all this, at the end of the day, the equivalence between cash and sweat is determined by an agreement between the individuals providing these different inputs.

Example 1: A new MBA graduate committing to work for a few months for sweat equity might forgo salary of $40,000. That would be equivalent to about $28,000 of after-tax income. This sweat should be valued the same as $28,000 in cash invested by another founder. (This salary would be for someone in a "normal" job. The masters of the universe who command seven figure salaries/bonuses as traders, etc. are not going to buy into this logic, and you probably don't want them on your team anyway.)

Example 2: A freelance graphic designer who normally bills her time at $125 per hour agrees to provide 100 hours of sweat to the venture. This input would be valued at $12,500 at the marginal billing rate, but the designer is unlikely to actually forgo paying work to do this. The team agrees to value her time at one half of her billing rate, so this commitment of 100 hours would be valued at $6250 and she would receive as much equity as someone investing that much cash.

You can avoid actually putting a price on sweat if (a) you don't need any cash, (b) all members of the team contribute equally, and/or (c) all members of the team contribute cash in the same ratios as they contribute sweat. Under those conditions you just allocate equity according the time people contribute. Such conditions rarely hold. Thus, at some point you are going to have to figure out what an hour of Billy's sweat is worth relative to $1000 of Betty's cash.

Valuing Intellectual Property Contributed

The short answer to how you do this is that it is a subjective judgment and/or the result of a negotiation between the original founder and the other members of the founding group. Some of the factors that influence the value of the IP contributed are:

How refined is the IP? Is it just an idea or is it a working prototype with satisfied users?
How original is the IP? Is this a brilliant idea or one that many people have attempted to exploit?
How strong is the intellectual property protection likely to be? Is there an issued patent? Can others be excluded from exploiting the opportunity?
Is the originator of the IP going to be an integral part of the founding team or does he/she intend to be a passive participant?
How much effort (and other resources) has been contributed to date?

I don't think the originator of the raw opportunity would typically expect less than about 5 percent of the Founder-Phase Equity. I can also imagine an inventor of a new molecule with amazing properties and iron-clad patent protection to command 90 percent of the Founder-Phase Equity.

Estimating Tasks, Effort, and Allocation Among Founders

When dividing up equity for a venture, you benefit from making explicit what the different roles of the founders are and what contributions each will make. As an example, consider how Billy and Betty allocated equity for a venture that did not require significant external cash. Billy had invented a new device (let's call it "The Widget"). Betty wanted to join in commercializing it. They agreed on the set of tasks that had to be completed. They then independently assessed who would do what and what each task was worth in "points." (The total number of points ended up being, somewhat arbitrarily, 122.) In this case, they explicitly listed the work that had been completed to date, including the contribution of the "idea." Remarkably, they agreed to a considerable extent on the relative allocation of points. Here is their actual spreadsheet. ("Billy" and "Betty" are pseudonyms, of course.)

TheWidget-EquityWorksheet.xls

Details

Mechanics of Granting Equity to Individuals

There are two basic ways to grant equity to individual members of a venture team. You can grant them restricted stock or you can grant them stock options. Options are much simpler to administer, but as a founder you should avoid them if possible. Here's why. First, an option is simply a right for a fixed period of time to purchase shares of a company for a predetermined price. If the share price increases, then an option holder can realize value by exercising the option. Options are rarely exercised unless the resulting shares can be sold for cash, as is the case for a publicly traded company or when a company is purchased by another entity. When you exercise an option and then sell the shares you acquire, any gains are treated as ordinary income. This will cost you at least twice as much in taxes than if you were taxed at the long-term capital gains rate. Second, options expire, usually just before they have any value. Third, options are hard to value. Most employees are clueless about valuing their options, pretty much ignoring the exercise price (the "strike" price) in their feeble mental accounting. Of course, as an evil manager, you could use these facts to your advantage and offer options to your employees in an effort to avoid sharing the wealth.

Restricted stock is a much better way to go for core members of the founding team. Restricted stock carries with it some, ahem, "restrictions," meaning typically that it has a vesting schedule that determines when, if ever, you actually have the full rights of ownership of the stock. Because of the restrictions, the IRS allows the stock to be valued at substantially below the fair market value of the common stock of the company. This is important for tax treatment, in that you must typically pay taxes on outright grants of restricted stock. (At this point, I should warn you emphatically that you need to consult a lawyer and an accountant about the details of restricted stock grants. Otherwise, you could get whacked with a very ugly tax bill and have no cash to pay it...)

Of course, the ideal scenario is to be granted "founders' stock" when the company is first formed and when that stock has essentially no value. Then, you have essentially no tax liability and any future gains eventually realized will be taxed at the long-term capital gains rate (which is just 15 percent in the US as of October 2011).

What if people don't do what they committed to do?

In my experience, often some members of a founding team do not deliver on their commitments. If you've allocated equity to them in expectation of delivery of a commitment, then you have essentially paid in advance for work that may or may not be done. There are several ways to deal with this problem, none of them perfect.

First, the stock you grant can "vest" (acquire its full value) according to some combination of time and performance milestones. If you can reasonably agree on the major contributions of each member of the founding team, then their stock can vest only when and if those contributions are delivered. The problem here is that it is very hard to determine in advance what all the tasks will be. I've been involved with companies in which stock vested proportionally to effort applied to the venture, but I'm not sure those agreements would be viewed favorably by the IRS. (Again, consult your attorney.)

Second, you can exercise caution and only grant equity for contributions expected over a quite limited time period, say half a year. If the team member doesn't do his or her part, then you won't make future grants, or will modify the grants in the future. The problem with this approach is that you will have to grant future equity when it presumably has significant value, which is going to have negative tax implications. (Unfortunately, for tax reasons you really want to grant most of the founder's equity right when the entity is first formed.)

Various forms of preference

The analysis/graph shown above implicitly treats all equity alike. In reality, Series A investment is almost always "preferred stock." Vanilla preferred stock simply provides for a liquidation preference over common stock. That is, in a down scenario, the preferred shareholders get paid first. Until their principal is returned, the common shareholders get nothing. Preferred stock can generally be converted to common stock before a liquidation event in an "up" scenario. Sometimes preferred stock includes payment of an extra dividend or converts on a greater than 1:1 ratio to common stock in an up scenario, a provision sometimes called "double dipping." See Andrew Metrick's excellent book on venture capital finance for details.

Compensating advisors/directors

Are you looking principally for real advice or for a credential/endorsement? If seeking principally an implicit endorsement, see "Contribution of Intangibles" below. If you are seeking real advice, then you should be prepared to pay in equity for the cost of that advice. Advisors tend to value their time at somewhere between $3k and $15k per day. Remarkably, some otherwise saavy advisors don't bother to analyze equity deals relative to the opportunity cost of their time. These folks have too much spare time on their hands.

Contribution of intangibles

Sometimes you wish to grant equity to advisors or others who are largely contributing their reputations and connections to the venture, rather than contributing significant chunks of time. In my opinion, a reasonable way to think about this is simply how much cash value their contributed intangibles are worth. Obviously, having Oprah Winfrey endorse your product is worth more than having your mother endorse it (except in the very rare case when your mother is Oprah or an equivalent.) You should think about what the intangibles are worth and negotiate an appropriate exchange of equity at the valuation at the time the equity is granted.