On Economics
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On Economics

On Cutting the Cake

Splitting Startup Stock and the Principle of Proportionality

Alice meets Bob

A startup founder (let us call her Alice) approached an investor (let us call him Bob).

Alice had built a small but stable business with annual revenues of Rs. 2M, from about 40 loyal customers. Her yearly costs, taxes, and other expenses were about Rs. 1M, and she paid herself the remaining Rs.1M as a salary.

Alice asked Bob for an investment of Rs. 2M, for a 20% share of the company (at a Rs. 10M valuation).

Alice claimed that the company had the potential to 2x revenues annually for the next five years, while costs would be proportional to revenues.

Bob did some quick calculations. The company currently made an annual profit of Rs. 1M. That would double at the end of the first year to Rs. 2M. Similarly, the profits at the end of the 2nd, 3rd, 4th and 5th year would be 4M, 8M, 16M and 32M respectively. Hence, (ignoring inflation), the total profits in the next five years would be Rs. 62M.

And assuming the lifetime of the business was five years, the valuation of the company would be a similar figure. Hence, an investment at an Rs. 10M would be a steal.

But of course, this is not the case. Bob’s calculation does not factor in risk. And startups are all about risk.

Distribution of Valuations

In her meeting with Bob, Alice gave, actually, two valuations.

  1. A best-case valuation, while describing the companies “potential”, where the company would be worth at least Rs. 62M
  2. A “conservative” case valuation while making an offer to Bob, where the company was worth Rs. 10M.

It is a good bargaining tactic first to describe an optimistic potential and then describe a more “conservative” offer.There is also a worst-case valuation that Alice (and most founders) failed to mention. Rs. 0, or even negative, where the company fails and goes bankrupt.

Hence, in reality, valuations follow a distribution.

A founder’s “conservative” valuation is rarely conservative. An investor is more likely to get an 80% best-case valuation when they are, perhaps, expecting a 50% best-case (median) valuation.

Distribution of Valuations

What should Bob do?

There are some obvious things that Bob should do; due-diligence to make sure that everything makes sense.

  • How reputable is Alice?
  • How happy are the customers?
  • How genuine are the numbers?

But there is another sobering reality: Everything is uncertain with startups. Everything we said about the future, from the best case to the worst-case valuation, is highly unpredictable and debatable.

So, what should Bob do, after doing the obvious things?

The Principle of Proportionality

Alice and Bob don’t know the future: whether it would be the Rs. 62M Best Case, the Rs. 10M not-so-“conservative” case, or the Rs. Zero-or-worse worst case. But we know there would be some case.

Whatever the case is, Alice and Bob should try and enforce the following principles of proportionality:

  • Any dividend or profit or gain should be proportional to investment share
  • Any loss should also be proportional to investment share

These principles are another way of saying, everyone should be treated fairly.

What does this mean in practice?

Alice and Bob — Revisited

Let us consider the worst-case first, where the company, in actuality, has no value. During the first year, Bob loses his Rs. 2M and Alice loses Rs. 1M (assuming she paid herself a fair salary).

Now, we see that “Any loss should also be proportional to investment share” is broken. Bob suffers 67% of the loss, after investing 20%. Alice, on the other hand, only suffers 33% of the loss, after owning 80% of the company.

Hence, in the worst-case, the share split is not fair. How can we fix this?

Now, Bob’s 20% share is based on a Rs. 10M valuation. In other words, Alice agrees that the company is worth Rs. 10M. But at the end of the first year, she has committed on Rs. 1M to the company. Hence she should own only 10% of the company. Not 80%!

Instalments to the rescue

We can fix this problem by giving Alice stock, not all at the beginning, but in instalments. In the beginning, she has zero shares, but by the end of the first year, she is awarded a total of 10%, possibly in monthly instalments.

This assumes that Alice takes all her compensation in the form of shares. Alternatively, she might opt for Rs. 500K in cash, and 5% of the company share.

Conditional cliffs

But this was the worst case. What if the company does well? What if, as projected in the best-case scenario, at the end of the first year, the company makes Rs. 2M in profit. Now, this will entitle Alice to a further Rs. 2M of shares, or another 20% (a “cliff”). Hence, in this best-case scenario, at the end of the first year, Bob will have 20% of the shares, and Alice 30%. Similarly, at the end of the 2nd year (Rs. 4M in profit + Rs. 1M in salary), Alice will have an 80% share in total.

Now, what happens if the 3rd year also completes accordingly to the best case projection? All shares have been divvied up, and Alice can’t have more stocks. This might sound unfair, but this is a function of Alice and Bob deciding on a 10M valuation. Alice could buy some of Bob’s shares, but given the performance of the company, Bob will undoubtedly want a higher valuation than Rs. 10M.

Alternatively, if Alice could have predicted this future, she could have pushed for a higher valuation at the beginning. For example, if Bob agreed to a Rs. 20M valuation, at the end of the first year, Bob would have owned 10% of the company, and Alice 15%. And at the end of 3 Years, Bob would have remained at 10%, while Alice owned 90%.

Conclusion

To conclude, whatever the case is, founders and investors should try and enforce the principle of proportionality. Fairness is the key to all successful partnerships.

Update: Follow-up

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