Baking and Slicing the Pie of Shares, Yummy and Fair
Encode.org was bootstrapped as an enterprise with its members as its investors. Instead of trying to predict the perfect equity split up front and fighting over the percentages of shares later, we decided to try the dynamic equity principles of “Slicing Pie” by Mike Moyer on ourselves and directly bake them into our legal agreements.
Now, eighteen months after inception we triggered the end of the Dynamic Equity period, ‘baked the pie’ and dished out the slices to our members. The experiment was a success in that all members confirmed that transparently tracking contributions in time and capital and basing the equity split on that data led to an equity split and cap table that feels fair and clear. Let me unpack this a little more.
What is Dynamic Equity and What is it Good For?
Dynamic Equity is an alternative way of arriving at the capitalization table and percentages of shares among the investors of a company. A huge problem for startup founders is that at some point they will have to determine who of the multiple founders owns which percentage of the company. Usually they sit down up front and agree on a percentage, maybe 50/50 in the case of two owners — or 70/30, if it is clear that one of them invested much more in terms of time and personal cash (both of which is risky to different degrees). With three founders you might have a simple 33/33/33 split, or 40/30/30, and so on … you get the picture.
The reason why this often becomes problematic, is because things change — especially in the busy world of startup ventures. One founder drops out because his spouse got sick, one works his ass off day and night, while the other takes it much slower. Suddenly some extra cash investment is needed which only one of the founders is able to make from his own pocket to keep the business afloat, etc., etc. The variables are ever-shifting until the business becomes profitable, but when it eventually does, the profit shares are fixed due to a decision made blindly and predictively at the very beginning of the journey.
Welcome to the Alligator Pit of Re-negotiation
As soon as there is profits to be distributed long ignored questions of fairness around the fixed equity split creep back up. Now there is no way around anymore to having that uncomfortable conversation among the founders in the light of the new data collected along the journey. Suddenly the 50/50 arrangement feels deeply unfair and there will be no peace until everybody gets what they deserve, no more, no less. But in order to arrive there, the founders will have to descend into what Mike Moyer calls the “alligator pit” of renegotiation, where founders fight over their shares.
Many, many personal relationships and businesses have been destroyed over these kinds of fights. Friends parted ways, companies tanked.
But there is a better way than “Fix & Fight” which is the result of the same old predict-and-control mindset that dominates the business world today. Dynamic Equity works with sense-and-respond paradigm instead, drawing upon a detailed method of accounting for the variable contributions that founders and investors are making, grounded in real data, not prediction.
Accounting for Sweat Equity
If I put in unpaid work in the startup phase, this work is being valued at a market-price rate and accounted for by a multiple of two. For example, if I am a software developer and could make 6.000 $ for the kind of work I am putting into the startup, this contribution will amount in 12.000 inputs or Units of the total pie being baked. Why factor two? I am not getting paid directly for my work, so I am taking a certain kind of risk for the prospect of earning a share in the future profits of the company, which may or may not come. The valuation with factor two acknowledges and honours that risk taking. This leaves room for flexibility, too. If I work only 50% of the time during a certain month, only 50% of my compensation in Units is entered in the Dynamic Equity ledger.
Increased Risk Valuation of Cash Contributions
What if I put own cash into the company from my own pockets? In most startups cash is a very scarce resource, especially if you want to prevent outside investors from owning a huge chunk of the overall shares. Because it is so scarce and so valuable for the startup and because it is riskier to put in real money than just put work time or “sweat equity”, cash-contributions will get multiplied with the factor four. So let’s say, the start-up needs a certain expensive piece of equipment worth 10.000 $. Under Dynamic Equity rules those 10.000 $ convert to 40.000 units which is recorded on the internal ledger visible to everyone.
Baking and Slicing the Pie
Over time, cash-contributions and time contributions are being recorded from month to month. As soon as the business has consolidated in a zone of reliable and predictable turnover and starts to yield profits (or defined by other markers agreed upon), the founders trigger the end of the Dynamic Equity period and “bake the pie”. The overall number of units that the company accumulated in total gets divided through the number of individual units that each founder (investor) has accumulated, resulting in the individual percentage of shares, aka “slice of the pie”.
Choosing this path of tracking individual contributions adds a little extra-work on the front-end which requires some amount of discipline. But it has the unbeatable features of being maximally objective, transparent and fair for all parties involved.
No need for nerve-wrecking rounds of renegotiation in the alligator pit or the heartbreak of parting ways. The valuation factors, 2 x for non-cash contributions (e.g time) and 4 x for cash contributions can be altered, but they have worked best so far in practice to set the right incentives.
Dynamic Equity — encode.org Style
At encode.org we are all in favor of the Slicing Pie model by Mike Moyer. In fact, we love it so much that we baked its principles right into the operating agreements that constitute our company container, a Nevada-based LLC in our case. We encoded these principles by defining different classes of membership interests in the form of “units”: P-Units, A-Units, D-Units and C-Units.
Together they provide founders with new financial vehicles and instruments to play with bringing a high degree of flexibility to navigate a broad range of situations.
Each member of a For-Purpose Enterprise is granted so-called a monthly amount of P-Units. This replaces the notion of having a salary as there are no employees at encode.org, only members/partners/investors, these units grant rights to certain Profit Interests, hence “P”-Units. One such P-Unit equals one dollar. If the company has enough cash to go around, those P-Units can be paid into your personal bank-account. If you choose this option, you receive no extra shares for your units in the end, since receiving payment for the hours you put in is not a very risky thing to do.
If however, cash is scarce or you would like to take risk now in order to be entitled to a greater profit-share in the future, those P-Units would convert to so-called A-Units at factor two during the Dynamic Equity period. “A-Units” stands for Allocation Interest. These units constitute your percentage of the overall pie and are dynamically recalculated in the context of the overall input of all members under Dynamic Equity.
Let’s say you choose to take out 2.000$ from your monthly 6.000 $ P-Unit grant (salary equivalent). Those 2.000 units will be deducted from the accountable units that constitute your piece of the pie later. The remaining 4.000 $ will be recorded in your unit ledger and multiplied with the non-cash multiplier 2 x. Hence, you accumulate 8.000 A-units in your ledger. Also, all reimbursable business costs paid out of private pockets such as travel costs are considered eligible to be accounted for at a 4 x cash-multiplier and converted into A-Units to accrue to your piece of the pie.
“Thanks for the A-Units” was an often heard phrase during our company meetups. Usually, one of the members would gladly pick up the bill at the restaurant, thanking the others for an opportunity to accumulate A-Units for business related expenses paid out of their own pocket. This is great, because both the less affluent members were happy, as well as the people willing to invest in the company who received an opportunity to do so.
These units come into play at the end of the Dynamic Equity accounting period. Once that point is reached, all the A-Units get converted to C-Units and mirror the organically developed Capital Interest or slice sizes accrued by the members.
Creating the capitalization table is no longer an exercise in predictive imagination, but rather a data-driven process of dynamic accounting.
The end of the Dynamic Equity period demarks the point at which a snapshot of the then current relative slice sizes is taken in fixed percentages, represented via individual C-Unit holdings.
D-Units refer to Deferred Interest, meaning cash that cannot be paid out by the company just yet (due to cash shortage), but is tracked in the ledger to be paid out as soon as the financial situation permits. Effectively, it’s cash which individuals lend to the company. D-Units are are interest-bearing (using standard interest rates), since lending money is a risky thing to do. The interests get added to your existing D-Units every year in the accounting ledger. When Dynamic Equity is over and the pie has been baked, A-Units are no longer available as internal currency (because they converted to C’s). This is when D-Units come in handy to navigate cash-shortages, while at the same time accounting for individual cash contributions fairly.
We started with 30.000 $ in the form of a well loan to kick off the operations. In our case, eighteen months after its inception, encode.org concluded its Dynamic Equity experiment on May 31st, 2017 as its equity split date. Until then we issued 2.380.149 A-Units among 12 members, some of them early contributors who have laid down their roles to focus on other commitments. Still, they receive a valuation of their pioneering inputs in the form of a slice of the pie.
I can wholeheartedly recommend Slicing Pie if you consider starting up a business. If you want to go one step further and even encode it into the operational agreement and legal structure of your company, you might want to consider bootstrapping a For-Purpose Enterprise with the help of the legal templates developed by encode.org. Simply drop us a message.
You can also use the Slicing Pie methods to retrofit the Dynamic Equity accounting and reconstruct a fair equity split based on the data that you have. In this case a transition to becoming a For-Purpose Enterprise with an adequate cap table is still possible. We’re here to support you on this journey.
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