I recently read one article about compensation in early stage ventures. One of my friends is planning to invest in a startup where he is one the four partners of which two of them will be running the show while the other two will be just investors. The proposed equity structure is 25 percent each for the pure-investors in return for 35 percent investment (each) while the two guys who would run the show are putting in 15 percent of the money for a 25% stake (each). This means they are getting 10% extra as sweat equity. Interestingly, both of these folks would work for full salary in the new company (no salary cut).
Is this a good arrangement? In my view the managing promoters don’t deserve any sweat equity upfront as they are working for full salary. I would say that all four should have equity proportional to their percentage investment.
My friend wants to know what would be the best equity structure for this company with 2 working and 2 non-working promoters assuming that the working promoters take market compensation.
- Software As A Service: Is India ready for it yet? - September 25, 2008
- Sweat equity in new ventures - October 28, 2007
Hi Shyam,
My view would be that the company’s capital could be split equally based on the promoters capital i.e. with all founders putting in equal amounts and getting equal stakes. In addition there should be a stock option pool where a percentage of the company’s stock will be allocated for the team running the company. The two founders should be given Stock options at the present price (par) and vesting over multiple years with at least an 18 month hurdle i.e. no stocks vest if they leave before 18 months. This I feel will align your friends interests at the same time ensuring that in the initial stages of the company the shareholders effectively control it and so there is a certain pressure on management to deliver as per the plan outlined. If they are getting market level salaries they should not find it difficult to subscribe to their equity esp. at par. I also feel that the stock options should be part of the yearly compensation plan so next year the board should be prepared that there will be a new grant of options and so the value of options being granted should be in sync with the YEAR’s variable compensation that the shareholders want to give management.
Alok,
Is sweat equivalent to “gains made through increase in valuation” ??
Actually i could not first make out where did 71% and 29% come in the picture.
Only way i could come to that number was as follows…
Lets first create a company with the 2 executive promoters.
Assume the 2 allot 25 shares (each) to themselves for Rs.15 each. Company valuation Rs. 30 Number of shares : 50
Share value : 60ps
Then the 2 investor promoter come in to the picture and take 50% equity for Rs. 70.
That means we have to issue 50 more shares for rs.70.
This would make the company’s value equivalent Rs. 140.
Share price Rs. 1.4
But the actual cash the company would have would be Rs. 15+15+70 i.e. Rs.100
So Company’s capital in cash is 100/140 = 71%
First, the right way to look at sweat component is as follows: 71% of the company is being capitalized for cash and 29% for sweat – i.e. each executive promoter is getting close to 15% as sweat and not 10%.
Second, it depends on what the market salary is – there is a difference, IMHO, in someone taking a market salary of Rs 10 lacs versus 1 crore – its is typically not a good thing to have someone compromise on their current standard of living – you dont want them to feel the pain of being out of cash.
Thirdly, it depends on what is the equivalent money for 29% sweat – i.e. is the 71% being bought for 1 crore or for 10 crores? Percentage by itself has no meaning unless absolute amounts are known, and how far the capital being infused can take the company.
Shyam,
I could not understand the proposed equity structure.
The sum of percentages of investment is not adding up to 100%.
Is there some typing error or is it just me??
i am referring to this line “The proposed equity structure is 35 percent each for the pure-investors in return for 25 percent investment (each)” so that makes 50% investment…
and then “are putting in 15 percent of the money for a 25% stake (each)” so that makes another 30% money… Who would be bring in the rest 20% ????
Some typo I think 25% stake for 25% investment is what I guess you meant.
If the working guys take market salaries, where is the question of sweat equity? Sweat equity is one that is given to make up for the differential between market salary and current salary.
Since startups are cash strapped, promoters draw lower than market salaries. This also provides incentive for proper execution and shows commitment. While current investors will be ok with market salaries, future investment rounds will be difficult to come by in such a structure – unless this is a single shot funding enough to take it to exit.
Mohan