I retired from personal blogging in July 2008.
But you can find me over at http://blog.xero.com.
In the second of my NZ Herald articles I talk though some of things I’ve learned around shareholding, the importance of a shareholder agreement and some things to think about in the agreement.
Why it’s crucial to get shareholding decisions right from the word go.
Hopefully these points are as applicable for non-tech businesses.
Text of the article …
People who have built and sold businesses will tell you that the biggest factor in the money they receive on exit is usually determined by shareholding decisions made in the beginning.
Initial shareholder allocations are very difficult to change once a business is up and running. Founding shareholders always believe that the steepest part of the value creation curve occurred when they were inside the business.
Often, a year or two in, a founding shareholder will decide they want to exit the business, which can be very traumatic. They may take important skills with them, and more often than not, the business doesn’t have the cash flow to pay out their shareholding.
Then you have the dreaded valuation issue - friendships are often destroyed during this process.
My advice when starting a business is to capture as much value as you possibly can before bringing on shareholders. Say you take a mate to the pub to discuss your idea; is the default share split 50/50?
What if you invite them down and start the conversation by tabling your business plan, then invite them to come on board to be the vital sales person. What is the split then, 70/30?
What if you had the name, brand, domain and a foundation customer, before you invite your smooth-talking buddy to the table. 90/10?
That first discussion is where significant value is gained or given away. And it might equate to big money a few years on into the business.
Next - make sure your shareholders’ agreement deals with what happens if there is an early exiting partner. I believe there should be a penalty for giving up and leaving early. This can be handled by including a valuation formula.
A simple formula might be total revenue of the preceding 12 months, which will naturally be low for a start-up. You might also agree on payment terms. This takes the valuation fight off the table and puts certainty into the exit process.
Often in the early stages there will be disparity between the ability of shareholders to fund the business and capital will be included as sweat equity. It is important that the basis of adding sweat equity to the business is clearly defined.
What is the rate? What is the maximum per month? Is it just incurring time, or is it tagged to deliverables?
Sweat equity should be accounted for each month and loaded onto the balance sheet, so all shareholders can see its effect. Otherwise it tends to all get loaded in before an external funding round when the books are being cleaned up, an exercise which can scare off investors.
When starting a business ask others who have been there before. They will enjoy the opportunity to have you learn from their mistakes.
blog
oh how sensible! I’ve been around a number of these sorts of issues - working in a startup where the original founders are falling out - it isn’t pleasent.
The worst time though IMHO is when the company reaches that magic size where everyone can’t talk - ie when senior management is enough layers away from the workers, some of them founders, that they don’t talk day to day - I think it’s at that point where your manager isn’t on the senior management committee that’s making the decisions
Or to think of it a different way when each and everyone of the engineers doesn’t get enough face time with the VP of Eng (or the CEO/Pres/whatever) that they feel they understand what’s going on.
That’s the point where you go from that we’re-all-in-this-together startup world to something rife with politics and hurt feelings
Senior management have to do stuff that effects everyones stock options - and it’s seldom a good thing (dilution etc) and often around about this same time - but it’s part of making it to an IPO and the windfall everyones hoping for - largely I think it’s a matter of keeping everyone in the loop and explaining what’s happening and why
Rod, I am right now structuring the shareholding and agreements for our new company and what I am proposing is to set up a 100 share company with the promoter owning a 55 share parcel and propose to structure it with 9 other 5 share parcel allotments.
I have allocated a valuation to the total company of 1 million dollars making each 5 share parcel worth 50k. Each 5 share parcel has a buy back clause valid for 36 months giving the promoter first right of refusal at the orignal purchase price +12% compounding.
If the buyback is declined and the shareholder wants out for what ever reason within the first 36 months they forefeit their Interest and are drip feed their investment back over the next 24 months in equal payments so in the case of the 5 share parcel 50k is $2089.00 per month.
After 18 months in trade and it has become apparent there is surplus cash then 50% of the surplus is distributed back to the shareholders in proportion to the shareholding and the balnce invested in 3-6 month term deposits.
After 3 years we revalue the company using real world data and at that point if a shareholder wants to exit then all shareholders are given first right of refusal.
The biggest difficuilty I see is if the share parcels are not fully subscribed before we begin to trade or develop the back and front end.
Any advice would be greatly appreciated.
re 2. Personally I would not use 100 shares, allocate 100,000 (or more) and make the parcels 5,000 not 5 shares. This means the shares are less in value each, but also gives you ability to use shares in other ways. Having a few high value shares is great if you never really want to do anything with them (the Buffett approach), but having more shares is no more work or cost, but gives you flexibility in the future that you may want, without having a special resolution to split shares. For example, giving an employee 1 share (as a bonus/retention etc) at $10K/1% might be too coarse grained in a couple of years
Comment to Gregg: Be sure to limit the number of exiting minority ahareholders that your client is willing to fund at any one time. Consider if 5 of the minority shareholders left, the drain would be over $10,000 per month. And, as only 5% shareholders, a non-compete might not be enforceable, so the $10,000 per month might end up funding a competitor.
Richard and Peter , Thanks for your help and input here…Both excellent points!!
I learnt the hard way about the importance of a shareholders agreement.
I founded a business and brought on two partners with skills I required. We started the business as well as began the shareholders agreement process. This kept getting delayed for various reasons. After 12 months the company had become very profitable and the other partners decided that a shareholders agreement was not in their best interest. As a minority shareholder I was in a terrible position. I ended up selling out to my partners (12 months late) and not realising the true value of my shareholding.
My advice is not to start work on your business until your shareholding agreement is totally finished and signed. This process can take some time but at least parties will be motivated to get it completed in order to get started.
Re rights of first refusal/pre-emptive rights and the like, just a note of caution that they are complex and require a good deal of thought over potential scenarios. In particular, I have seen many instances where the usual pre-emptive right (exiting shareholder must offer shares back to continuing shareholder(s) first) turns out to be worthless because the continuing (usually minority) shareholder(s) can’t afford the price (and can’t find a white knight to back them). So, the continuing shareholder(s) (often the founding technologists) are left behind with a new shareholder that they may not want or like (and, if they have not been careful in the agreement, which may even be a competitor) as the exiting shareholder (often a funder) walks off with a control premium. Conversely, a majority shareholder who has negotiated a great price for the sale of all the shares (but which the purchaser will not pay for the majority stake alone) may want to be able to compel the minority to sell. Tag alongs and drag alongs are the way to address these issues but they themselves can also be manipulated if one is not careful.
Rueben’s advice to get the agreement signed up first is of course a counsel of perfection but is absolutely right especially if you are the minority shareholder.
hi guys, good reading this. As a director in a reasonably new, yet-to-take-over-the-world company, i have a few observations…
shareholdings are normally decided up front, ie, before the business is worth much/anything. I have 2 other partners, and to date, our contribution has been unequal… but… we are still 33% partners.
So, my proposal, which I welcome being shot down, is to allocate a tiny amount of the company in initial shareholding, eg, 1% to each. Then, as quarterly targets are met/missed, each shareholder independently evaluates contribution, and the remaining share pool is thus gradually distributed, based on work to date.
any thoughts?
Should you try and ring-fence a portion of the shares for the creator of the concept? There are so many people along the way to inception and delivery, how does the inventor get anything?
I recall having a conversation with someone when I was gutted that someone had made significantly profited from my idea.Sure they had done lots of work, but it was my idea.
He gently and wisely pointed out to me ‘It’s not your idea if you aren’t the person who does anything with it’.
Ideas are a dime a dozen - people who are prepared to do the hard work to bring them to life aren’t. Those who execute ideas get rewarded.
Greg Day said…
yet-to-take-over-the-world company
Greg, I am pretty much sure (I am serious here & no kidding) that your take-over-the-world goal seems feasible (with very high probability), from a technology perspective. If you implement those AI technologies as you are intending to, then your recruiting app. would be a world beater, to be honest, it would be much much better than the current major online recruitment vendors of today, as far as I have know.
Anyway, good to chat with you off-line, and you’re welcome to fire me any questions anytime you want for a second opinion on something you have in mind.
Cheers.
Hi all
I’m a real novice at this but if you could help it would be great. If each shareholder in a 3 person company has 33/33/34 percent shares - and if one partner leaves before an shareholder agreement has been signed and the company is still very much in the red, does that shareholder leave with their percentage share of the total liability to date?
Not sure how it would stand legally, but ethically I’d say yes.