Many projects are started between friends without a consideration of what each is putting into the business. The act of “starting”, of creating, is exciting
Sometime later, when the founders can see that the business has legs, they decide to incorporate it and put in place a shareholders agreement. That is the point at which ownership of the new company first becomes an issue.
Ownership and control is, by default, based on share ownership, which is in turn “considered” in terms of financial value. If you are dealing only in financial units, such as money, determining who will own what percentage of the business simply is a question of how much money each party is willing to invest as equity. The person who buys more, gets a greater say.
Any other input first has to be converted into a financial unit, and that is where problems start arising, particularly in relation to work contributed, or “sweat equity”.
In order to value someone’s contribution in time and effort, you need a comparison that is measured in financial units. Common ones used are wages foregone (a measure of what has been put in) and contribution to the value of the business now (a measure of what has been created). Neither are perfect.
The first stumbling block is that common equity gives both value and control. If you are looking to compensate or reward someone in place of paying a salary, then ideally you want to give shares in stock that has no voting rights attached.
The second hurdle is that the value of the company should grow over time, but perhaps not directly as a result of the initial work the founder. If initially, if Founder A creates the website and the Founder B creates the products, then at the point of incorporation, both might have contributed equally and an equal share of ownership might seem appropriate. But if Founder A then contributes little else, leaving B to manage and grow the company, is a 50:50 split fair a year on? Founder A might have been better to employ B to build the website using the capital he would otherwise use to buy the equity, and own 100% of the company.
If equity shares do reflect work contributed, then ideally shares need to vest over time. That is to say that founders take a growing stake in the company over time, or as projects complete. That won’t be perfect either, because one person’s contribution is unlikely to be the sole driver of growth.
Lastly, equity only has a value if there is someone to buy it (the shares and not just the assets in the business) or if the company is profitable enough to issue dividends. The value is also dependent on the buyer – it is worth what someone is willing to pay.
Full control of the company is often worth more than partial control – especially if the shareholding is a minority one with few rights. Therefore any founder with a minority of shares that have been “bought” with sweat equity may find himself or herself waiting for a long time before the company is sold, at a price that may not reflect his or her contribution and patience. A majority shareholder could block any outright sale that would value the company more greatly. The true value of the sweat equity when it is liquidated might not be as expected when it was agreed as compensation for not buying in with cash.
This could be mitigated, in theory, by options to have the company buy back the equity from the shareholder at a given price if a particular event happens. This might allow the sweat equity to be cashed out sooner. But it is unlikely to reflect the true value of the equity because the other shareholders will want to make sure that holding on is always more attractive.
Sometimes there is no alternative other than to let one of the founders invest with sweat equity. He or she might be critical to the project, but have no cash. But you should be careful, and you should look into alternatives such as loans.