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Dividing ownership in a startup...

For all the entrepreneurs that read this blog, this post contains suggestions on how to effectively divide ownership in a group project - prior to taking on the burden of launching and operating a legal corporation.
The tasks within this post may seem like a lot of work.  However the process described below is essential to building a motivated organization...regardless of the legal structure (and legal minds) you employ.
If you are working with equals that you know and trust, the group should be able to read this document, negotiate the items on the ownership earn-in spreadsheet, and then construct a signed letter of intent in under three hours; it doesn’t get much easier than that.
Fictional scenario:  a group of professionals are about to create and promote a new media website that will attract and entertain a slice of humanity; as visitors come to this website, the business goals will be to convert visitors into fans (subscribers and repeat visitors), and then to eventually sell something that has perceived value to a percentage of the fan base. 
Everyone involved desires to protect their investment (time, money, art, etc.) and to preserve their ownership rights until the day arrives when the group decides to turn the project into a real company.  The following is a list of people involved in the (fictional) project and a brief description of the assets that each person proposes to contribute to the project:

  • The Originator:  The Originator has original art (intellectual property) that he or she has been working on (part time) for the last six months.  The originator has already invested 500 hours, and she plans to invest 200 additional hours over the next six months.
  • The Video Person:  The Video Person has a track-record of, and the skills necessary to, produce compelling video footage.  The Video Person is willing to invest 200 hours over the next six months.
  • The Tech Person:  The Tech Person has proven software, website or mobile application development skills.  The Tech Person can invest 400 hours over the next six months.  However the Tech Person’s personal financial situation requires him to charge a reduced hourly fee that equates to 25% of his normal, billable, hourly rate of $100 per hour.
  • The Business Person:  The Business Person is proposing to handle daily operating chores, and to develop strategic partnerships that will rapidly grow the fan base and/or increase gross profit margins.  The Business Person can invest 500 hours over the next six months.
  • The Instant Traffic Person:  The Instant Traffic Person is stating that he or she has the capacity to bring almost instantaneous and significant attention (traffic) to the project once it launches.
  • The Money Person:  The Money Person is proposing to invest $15,000.

The Challenge:  The six people involved are bringing assorted value (assets) to the project; each person is willing to invest an allotment of time, traffic or investment capital; one person needs to earn a spot of money (an income) right away; nobody knows for sure how quickly this project will take off; but everyone involved wants to move forward as quickly and as inexpensively as possible. 
You need three things to get going quickly and inexpensively.

  • The second thing you need is a binding letter of intent that covers stop-dates, triggers, the ownership earn-in spreadsheet, and a method that dictates how all debatable matters are resolved.
  • The third thing you need is an attorney to take a quick look at what you are proposing to cover with this “thin” set of documents.

In my experience, dividing ownership equally is mistake. Without fail, things always happen that prevent or enable project participants from contributing more or less resources than they originally pledged.  You want a plastic (cable of expanding and contracting) ownership structure that enables participants to contribute as much or as little as their ever-changing (financial, time, family, health, etc.) situation dictates.  A plastic ownership structure, governed by an ownership earn-in formula, is the best way to align motivation, commitment, value delivery, timing and expectations.

Step One - All contributions have to be valuated / appraised...
Everything (time, art, inventions, equipment, website traffic, etc.) that is being contributed to the project has to be translated (valuated) into a uniform monetary unit such a U.S. Dollars; this will enable a math-ready apples-to-apples comparison of all contributions. 
Once you have completed the valuation process, copy and update the accompanying ownership earn-in spreadsheet to determine ownership of the project.
Here are some suggestions for appraising value:

Art, inventions and intellectual property have to be assigned a value.
Originators (artists, inventors) often over-valuate their creations.  My best advice is to sum up the actual hours invested (in the art, or the invention/idea) over the last year or so, and then multiply the hours by a reasonable hourly rate to arrive at a valuation.  If you have created something that is truly remarkable, increase the value of your creation accordingly.  Note: if you assign too much value to your creation, it will be proportionately difficult to negotiate an ownership agreement with your prospective partners.
Labor contributions have to be assigned an hourly rate.
When you are forming a team of equals, one of the easiest points to negotiate is hourly (wage) rate.  If you can agree that you are all equals in the marketplace (in your prospective fields), then assigning everyone the same hourly rate makes this part of the negotiation simple.  However, if a team member works in a field where demand for a certain skill is red hot (example: iPhone app developers), you will probably have to bump up his or her hourly rate to reflect current market rates / market demand; the same logic applies to assigning hourly rates to those that bring significant experience to the table. 
You may also have a team member that can contribute labor at a reduced hourly rate, but he or she must also be compensated to justify participating in the project.  The accompanying ownership earn-in spreadsheet accommodates this (reduced compensation / paid out) scenario.
Non-cash contributions have to be assigned a cash value.
If someone is pledging a significant non-cash contribution to the project, it’s not unreasonable to offer (additional) ownership in the project in consideration for the contribution.  Non-cash contributions are things like: six months of office space, the use of a vehicle, equipment, or even measurable Internet traffic.  Non-cash contributions should be valued at the cost of substituting the contribution with a market-priced, comparable alternative.
If someone is pledging something like “Internet traffic”, “strategic relationships”, or “mass-media mentions”, proceed with caution.  All of the above are valuable.  However they should be (somewhat) measurable (for example: by using Google Analytics or internal sales figures) and accounted for at the end of the project term.  Your goal should be to create an incentive whereby the person supplying these (promotional) contributions is highly motivated to demonstrate (ongoing) measurable results.
Investment cash contributions and the risk multiplier.
It’s obvious that cash contributions are easy to quantify - it’s cash!  However within the ownership earn-in spreadsheet, there is the option of multiplying the impact of a cash contribution (a loan or an investment) by a “risk multiplier”.  The risk multiplier is a simple mechanism that you can use to motivate a cash investor.
Investment money (any money) is hard to obtain.  There are three criteria that motivate investors: the first is a compelling business plan, the second is a great team, the third is the potential for significant upside.  If you have criteria one and two locked down, the risk multiplier helps to telegraph a significant ownership and upside message to the investor. 
Note: if an investor is loaning the project money, versus directly investing in the project, and the investor is charging an annual interest rate on the loan, I would negotiate a risk multiplier that is substantially less (or none at all) than the risk multiplier that I would offer someone that is directly investing (cash for ownership; no loan documents).

Step Two - Create a binding letter of intent...
Here’s a partial list of items you can use to construct your letter of intent.

  • Ownership, voting, tax, and profit sharing rights shall be accumulated on a monthly basis and calculated at the end of each month - using the ownership earn-in spreadsheet.  The more resources a team member invests on a monthly basis, the more ownership, voting, tax, and profit sharing rights - the team member acquires.
  • Unless noted otherwise, intellectual property pledged to the project, and intellectual property created during the term of the project, including URLs used for the project, will be owned according to the ownership acquisition methods outlined in this document.
  • All team members shall report their monthly contributions (time, accomplishments, resources) to the entire team at the end of each month.
  • All disputes and all debatable matters will be settled by a vote whereby a simple majority (more than 50%) rules; in the event of a tie, a coin toss will resolve any dispute.
  • Primary contact, day-to-day management, bookkeeping, and all communications shall be the responsibility of an elected Project Manager. 
  • At some point (a date or a trigger) initial ownership should be finalized.  For example: six months from day one, and/or triggers such as raising a certain amount of investment capital, or acquiring a specified quantity of subscribers. 
  • Briefly document the methods, incentives and values you are placing on non-cash contributions such as art, inventions, Internet traffic and strategic relationships.
  • Bills / liabilities are the responsibility of the project’s owners.

Step Three - Consider hiring an attorney...
Before you launch your project, consider hiring an attorney to review your letter of intent and your ownership earn-in spreadsheet.   I would direct the attorney accordingly:

  • The attorney is representing the project team and not any single member of the team. 
  • The attorney should transcribe your documents into the simplest set of legal documents that he or she can create - given what you have already negotiated with your team.
  • The team is not interested in getting bogged down negotiating the particulars of launching and operating a corporation and/or negotiating investment terms at this time.
  • All items pertaining to creating a corporation (in the future) will be stipulated by the persons controlling ownership in the project once the initial ownership is finalized.

This document (Google Docs version) and the ownership earn-in spreadsheet is for rapidly launching and for managing ownership in (smaller) projects.  If you are looking to do something more ambitious (complicated) that calls for raising larger amounts of money, consider using the legal documents provided by TechStars as an alternative starting point.


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