When you start your own business, one of the first things you have to figure out is how to split equity between your co-founders and any investors that come on board. How do you divide the pie? This can be tricky and lead to a lot of frustration if not approached systematically, but it doesn’t have to be that way.
Slicing the Pie can help you understand what each person brought to the table and ensure an equitable distribution of equity. In this post, we’ll show you how to slice the pie when starting your own business and make sure everyone feels happy with their equity split and shares awarded to investors in your new startup.
What Is Slicing the Pie
The Slicing Pie equity model is a way to allocate a share of the pie based on the contribution made by each stakeholder.
In all equity splitting models, parties with different levels of contribution should be given different amounts of equity based on a fair market value. This is crucial, as contributions may differ between cofounders and founders need not have identical roles or take on equal responsibility for each element of startup success.
Co-founders who contribute similar amounts of capital to a startup may reasonably expect an equitable distribution of ownership without regard to labor performed; founders who bring on investors or other key contributors may also see value in equitable distributions. Whatever methodology you adopt, it must consider how contributions were made and their impact on overall business viability and goals.
Slicing the Pie separates contributions into two categories; cash and time.
Investments and the Well
The 'Well' is a method of tracking cash investments and turning them into slices of the pie for early startups, typically at the seed investment funding stage when the company has no post-money valuation. With no valuation available, investors accept a loan agreement that converts into equity when a valuation is agreed upon in the future.
As the Slicing Pie equity model only grants slices when a contribution is made, investment alone does not warrant a slice of the pie. Instead, the Well acts as a holding space for the investment (which will be secured in a separate savings account) and when the business needs to withdraw money from the well for business expenses, the amount withdrawn converts to slices using the cash multiplier (a rate of 4x) and the balance of the loan is reduced.
WE.VESTR's Slicing Pie tool allows you to digitize this method, setting up individual rules for investors, as fitting to the deal and situation, as well as seamlessly integrating with the cap table without the use of a notary.
Why Use This Model
The equity split is up to you and your team, but many entrepreneurs find a Pie-Slicing model easy. The Pie-Slicing model is also called a formula method because it uses a specific formula for determining equity.
Ultimately, this model rewards owners, partners, investors and team members in a way that is proportionate to the contribution and risk that they have made; simplifying the very basis of your shareholder management.
Determining a Fair Market Value
Fair market value is simply the market value of a product or service. Someone who is more experienced at the service they are providing for the start-up will demand a higher market value but someone providing a non-skilled service can only demand the average market rate for that service.
This can be applied to the unpaid hours contributed by founders and owners as well as used in salary negotiations for new staff, who may consider the promise of equity as an alternative to a competitive salary.
Of course, the fair market value of an employee will always be a negotiation between what you are willing to pay for their skills and experience and what they are willing to accept as remuneration for said skillset and experience.
The higher proportion of cash salary paid, the lower the contribution and risk taken, meaning fewer slices of the pie are allocated. Labour contributions should be calculated using the non-cash multiplier of 2x.
Pros and Cons of Slicing the Pie
- An environment of fairness and accountability; every participant knows where they stand from the beginning and is held responsible for what they promise to deliver in return for their share of equity.
- Active distribution of equity; the Slicing Pie framework is by no means static. At-risk contributions are frequently being made to organizations, and each time, more slices are added and the equation adjusts to reflect contributions and risks made by all parties.
- Dealing with co-founder departures/resignations; when founders leave or abandon the company, things get ugly. Thankfully, the Slicing Pie framework can help minimize this. Using this framework, if a founder leaves, equity can easily be regained and redistributed in order to survive the exit.
- The value of ideation can be minimized; Slicing Pie weighs each contribution, and it is common for ideas to be undervalued in favor of more tangible contributions such as time and money in such cases. The most valuable thing you can do with an idea or vision is to make it a reality. However, to successfully execute, you need strong ideas.
- Value isn't always determined by time; you can't gauge what an individual contributes solely by the amount of time they spent. Sometimes it takes a long time for one person to do what it takes someone else a shorter period of time.
The Slicing Pie is a powerful tool for startups and presents a fair and transparent basis for splitting equity, which might otherwise become problematic. WE.VESTR’s integration of the Slicing Pie makes the process even easier for businesses, combining ESOP, cap table and shareholder management into one single, digital platform. To find out more about how the model is used check out our article on the startup coop or Book a demo today to find out how we can help your start-up.