Co-founders: sweat equity and cash investment

Discussions
#1

Hi guys,

I have bootstrapped a few companies before, but never with another co-founder, which is introducing a whole new dimension, with dividing equity and all.

Me and my partner have done quite some research on what is considered “normal” in dividing equity. So far we’ve been nearing a consensus of dividing 2/3 and 1/3.

2/3 will go to the co-founder that has more experience, is more technical and will be able to invest more time. The co-founder with 1/3 of equity will continue with a full time job and will be able to contribute less in the building (coding / designing) part of the business, but will add more value in terms of sales and contacts.

Makes sense so far?

Now this is all based on so called ‘sweat’. But to bootstrap the business we will also need a small cash investment. And to my surprise there is not that much info available on this topic.

Let’s assume the business initially need $10.000 to get things going and that we both have enough resources to invest. What would be a good way to do this investment, considering the sweat equity agreement?

A few options I could think of:

  • Invest the full amount based on the equity division (the 2/3 co-founder invests $6.667 and the 1/3 co-founder pays 3.333) and maintain the division
  • Invest 50/50, since we both want to have the same stake in the company. Just our sweat dictates that one owns more than the other.
  • Invest opposite to the equity division (2/3 co-founder invests only 1/3 of the cash) so both co-founders end up with 50% after all
  • Don’t invest but consider it a business loan
  • Get a third party (family member, friend or something) to invest (for minor share) or lend the money

Any advice on how to handle this clean, fair and simple?

Thanks!

#2

Preferably, you should each contribute cash in proportion to your equity stake. That is the simplest way forward, as it maintains the balance of cash and sweat.

Alternately, if that weren’t a possibility, you need to put a dollar value on the time and energy that each of you is contributing, and then assign additional shares on that basis.

Let’s say you both estimate that the up-front development of the company will require six months. You’re putting in full-time work, and your co-founder is putting in half-time work. You both consider that $100k is a reasonable starting, round-figure salary. That makes the initial contributed value $50k from you, and $25k from your co-founder. Let’s say each initial share is worth $100, that means you get 500 shares and your co-founder gets 250.

Now that you’ve valued your shares, it’s pretty trivial to give additional shares to whoever ponies up the dough:

  • If you put in the entire $10k, that’s an extra 100 shares for you (giving you about 71% of the company).
  • If your partner puts in the whole $10k, that gives them about 41% to your 59%.
  • If you find someone else to put in the money, they get the 100 shares, giving you about 59%, your co-founder about 29%, and your investor about 12%.

You can do similar calculations on ownership if you, say, put in $2k, your co-founder puts in $2k, and someone (or multiple someones) put in $6k.

The important thing(s) to bear in mind are:

  • Everyone needs to be comfortable with the valuation of the “sweat equity” involved. If the work ends up taking a lot longer than you estimated (which it always does), then that is effectively making the 100 shares bought with cash much cheaper than your sweat equity – if it takes 9 months to get going, then you effectively “paid” $150/share for your 500 sweat shares, vs the $100/share for the cash shares. The converse could also happen, in theory (ha!).
  • This valuation method only works for the initial investments before anything’s been done. The moment you’ve created any value whatsoever within the company (copyrighted code, designs, plans, etc) the company’s valuation is more correctly obtained by placing a value on all of those assets to obtain a valuation for the company, which is then divided equally amongst all existing shares to give you a number at which any further shares will be sold at. Yes, valuing ideas and plans is hard; that’s why VCs make such head-scratching deals.
#4

How about risk? Personally, I believe, it’s combination of what work you will do and how much risk you taking.
If you are technical co-founder and 100% of your time is vested, and another co-founder is vest 50% of his time, and doing 1/3 of work, then his equity has to be 1/3 % 2 = 1/6 something like that.

#5

Hi guys! Thanks very much for the answers and my apologies for not responding before. I didn’t receive any update email until uberCX’s last reply and didn’t revisit the site frequently.

See below my answers / comments on your posts.

@mpalmer:

Thanks for your clear calculations, that really helped to understand the subject. Basically your point is that it keeps things easier if you contribute cash proportionally to the equity stakes, because you avoid putting an initial value on the stake, right?

I mean, if the other partner invests more cash (and that changes the equity balance), you are required to put an actual value on the sweat. And if you keep it in proportion, it doesn’t matter if you work 6 months or 9 months on the project (given the other partner also puts in the same proportional time / sweat during those extra 3 months), since it won’t change values between partners. Correct?

As for your point of it only working before anything has been done, how would you say it changes things? How much value in terms of equity would you put on % of the product being finished before actually starting the business?

@gregormckelvie, uberCX

Our situation is as follows: none of us will work full time on the new business. We will both continue to work, to sustain a basic income. But in different ways and proportions.

The technical co-founder (me) is able to invest around 2,5 days per week actually developing / coding the product, besides working as a freelancer for other companies the rest of the week. Then off course the are some evenings / weekends that will be spent working on the business (other than coding).

The other co-founder will indeed continue his full time job (until the business would take off) and be able invest time on evenings, weekends and ocationally during lunch breaks.

This is indeed and unequal investment in both time and technical know-how. Also in risk taken. And I’m aware of that. But I think it does make some kind of sense.

The point is that, yes, I’m able to build an entire product by myself (off course it will be better with the feedback and input of a partner), but I won’t be able to also “sell” the product and manage everything around it. I think that will be very difficult, and might end up in a big waste of time building a cool product that never sees the light of day. So what I really want is a dedicated partner / co-founder that can take up that role.

Now I realize that the problem is that the selling and managing the business only starts after there is a product. Or at least after there has been done a considerable amount of development work. So then if you come back to the point that equity should represent risk (as also uberCX mentioned), then indeed the majority of the risk will be with the technical co-founder, which would vouch for a far higher percentage of equity.

But if we have established that the role of the other co-founder will only become more important after there is an actual product / prototype, then indeed it doesn’t make sense for him to quit his full time job now and watch me code :wink:

So the problem is given the fact that I really want / need a co-founder to take on the business side. But that his input will mostly becomes needed / valuable after I have put in a big time investment to build the product. How can you get to a comfortable agreement, that somehow ensures that the technical co-founder is not being taken advantage of, but also gives the business co-founder a sense of really being involved in the business?

Any ideas or suggestions on this?

Thanks a lot!

#6

Hi mvdg,
I was victim of “taken advantage of” (probably my mistake), 10 yrs back. I & my friend started working on building e-commerce shopping site. He promised me inventory, when website is launched. I spent 3 weeks (many nights, I worked full night) to develop nice website, working with payments, analytics … the whole package. A week after launch, he told me his contact for inventory is NO more available. And here I was, looking at marvel of my hard work, but no inventory :smile:
-=-=-
Coming back to your question, how you make sure, you partner is also invested in risk. There are different ways, I can think of,

  • Get some money invested in company’s account.
  • Or keep your roadmap such, even if he decides to pull out or it doesn’t work b/w you both, then you should be able to launch by yourself or find new co-founder
  • or (lack of better terminology), divide equity like this, you get your equity invested right after you built. He gets his equity invested over period of time, as he delivers.