Some Basics
- Cash contribution is more-at-risk than time or other non-cash contribution.
\(Your\ Share\ \left(\%\right)=\frac{Adjusted\ FMV\ of\ your\ Contribution}{Total\ Adjusted\ FMV}\)
- A Slice is a fictional unit used to represent the adjusted fair market value (FMV) of an at-risk contribution.
- Measuring risk in a startup is as impossible as measuring future value.
- A reward is financial in the form of profits/dividends or proceeds of a sale.
- A contribution is considered at-risk when participants invest, in a startup, contributions such as time, money, ideas, relationships or anything else and don't get paid.
- Slicing Pie is used before breakeven and equity is based on what people put at-risk.
- After breakeven everyone is getting paid, so equity is no longer about what is at-risk, but, often, part of a bonus or retention strategy.
\(Your\ Share\ \left(\%\right)\ =\ \frac{What\ you\ put\ at\ risk}{Everything\ that's\ at\ risk}\)
- What is at-risk is a function of the fair market value of a contribution and a risk multiplier that normalizes cash and non-cash contributions and imposes consequences on the at-fault party in the event of a person's separation from the company.
- To apply the model, you will have to keep track of what each person puts at risk.
- Use the model until sufficient cash is available to pay participants for their contributions.
- When everybody is getting paid for their contributions (after breakeven), they will no longer be putting their contributions at risk. At this point, the model will freeze and subsequently, will tell managers how to divide up the proceeds of a sale.
The basis for fixed split allocations are industry trends, guesses about future value, advice from well-meaning advisors or negotiation skills.
The hard part about fixed splits is unwinding them when you realize you've made a mistake.
- The allocation framework tells you how to give slices to individuals as they make contributions to the company.
- The recovery framework tells you what to do when someone leaves the company, ensuring that each participant understands the consequences of their decisions as they relate to ongoing participation in the firm. It also provides a means for buying out ex-employees if and when appropriate.
- When a person contributes to a startup they are betting the FMV of that contribution on the future outcome of the startup.
- FMV of a year of a person's time is their salary. If they forego that salary to work for a startup to do similar work, they're betting that amount of money.
- The opportunity cost of working for a startup is the amount of money you would've earned elsewhere doing a similar job.
- The way an individual reaps the benefits of a company's financial return is through their individual entitlement to a slice of the pie.
Allocation Framework
- Applies the Slicing Pie formula to determine a person's share of the at-risk contributions.
- The following contributions are recognized in the Slicing Pie framework -
- Cash Contributions - Unreimbursed Expenses and Cash
- Non-Cash Contributions - Time, Ideas, Relationships, Equipment and Resources such as Office Space
\(Individual's\ Share\ \left(\%\right)\ =\ \frac{Individual's\ Slices}{Total\ Slices\ of\ all\ Participants}\)
Calculations
- To convert an individual's contribution into slices, multiply the FMV of the contribution (less cash payments) by the cash or non-cash multiplier.
- Multipliers act as a built-in retention tool for companies and a severance program for employees.
- Non-cash Multiplier = 2
- Cash Multiplier = 4
Cash Contributions
- Cash contribution consumers an individual's actual cash, usually as unreimbursed expense or cash expenditure from the company account. It can also be tangible property with cash value like equipment or supplies.
\(Slices\ =\ FMV\cdot Cash\ Multiplier\)
The FMV of cash is the amount of cash spent. If the cash isn't spent, it's not at risk and just sitting in a bank. Slices get allocated when the cash gets spent.
The Well
- A pool of funds from which managers can make payments.
- They can use the money for whatever they need to, subject to restriction of the investor, if any.
- Money in the Well doesn't convert into slices at the time of deposit. Instead, slices are created when the company spends the money.
- When the money is drawn from the Well and put into a company account to pay bills, it converts to slices for each Well participant in proportion to their current ownership of the Well money.
- Best suited for active participants in the company.
Unreimbursed Expenses
- Most common cash contribution from employees.
- This is money spent on anything for the firm that doesn't get reimbursed from the company account (Well).
- Anson pays £250 for a train ticket to take a company trip to Amsterdam and doesn't get reimbursed from the company account. Anson would receive 1,000 slices.
- Norvin pays £2500 to hire an attorney to write a customer contract and doesn't get reimbursed from the company account. Norvin gets 10,000 slices.
- Merrily uses her credit card to buy a client a £40 dinner and only gets reimbursed from the company account. Merrily gets 120 slices [£(40-10)*4].
- If it's not customary to cover an expense for employees in your country or local market you don't have to provide Pie.
- When employees use their own money to pay for things on behalf of the company and do not get paid back, this is an unreimbursed expense.
- Money in the Well could be used to reimburse employees, in which case the owners of the Well would receive slices, not the employees.
- Employees and Contractors should keep track of expenses and save receipts so they can accurately report their expenses.
Loans and Credit Cards
- Sometimes, an individua uses personal credit to secure a loan on behalf of the company or puts expenses on their credit card.
- If the individual is making payments on the loan, the money is treated as cash when money is spent.
- If the loan is a lump sum for general purposes, it becomes part of the Well and slices are given when the money is drawn out.
- If the loan is used to buy something specific, the money is spent and converts immediately to slices.
- If the loan is taken out in the individual's name, but is being paid back by the company instead of the individual, the individual doesn't receive any slices.
- Loans and credit card expenses are treated as cash (4x) if the individual who provided the loan is making the payments. If the company's making the payments - with or without additional interest - no slices are granted.
- When cash-money is spent on behalf of the company, and the individual who provided the cash is not paid back, the FMV of the cash is equal to the cash spent.
\(FMV\ =\ Amount\ of\ Cash\ Spent\)
Supplies & Equipment
- If purchased for the company and the person who purchased them was not reimbursed from the company account, the FMV would be the price they paid.
\(Slices\ =\ \left(PRICE\ PAID\cdot Cash\ Multiplier\right)\)
- Transferring ownership of a pre-owned asset into a company isn't the same as spending cash. It's a non-cash contribution. It represents a different level of risk and slices are at the non-cash rate.
- If the supplies or equipment are less than 1 year old, then FMV is the purchase price and resale price otherwise.
\(<1yr\ =Slices\ =\ PRICE\ Paid\cdot NonCash\ Multiplier\)
\(>1yr\ =Slices\ =\ Resale\ PRICE\cdot NonCash\ Multiplier\)
- When slices are received, the supplies and equipment become the company's property.
- If the person who contributed the equipment leaves the company, they can't take the stuff with them.
- However, as per the recovery framework, they may be entitled to some kind of payment.
- In many cases, personal laptops or cellphones used in building the company, wouldn't be treated as contributed equipment and people who own them wouldn't receive slices. The company, therefore, wouldn't own these items and departing employees can take them when they leave.
Non-Cash Contributions
- A non-cash contribution is pretty much anything an individual contributes without an outlay of cash.
- Time is an example since there are no direct expenses associated with the time spent working on a startup.
- Similarly, there are no direct costs associated with introducing the company to q qualified prospect.
\(Slices\ =\ FMV\ of\ Contribution\ \cdot2\)
Time
- The FMV of their time spent towards work at the startup is the salary they would be paid at another company for similar work.
- If £20k of a fair market salary of £50k is paid, the person is risking £30k.
- The more cash you pay, the less risk the person takes and the fewer slices are allocated for the time she contributes.
- If you pay 100% of their fair market salary they would contribute zero slices.
- Convert the annual salary into an hourly rate,
\(Annual\ Hourly\ Rate\ \left(AHR\right)\ =\ \frac{Annual\ Salary}{2000}\)
the 2000 is assuming a 40hr week across 50 weeks and 2 week vacation.
A Open Vacation Policy is recommended where people can take as much time off as they need as long as their work is getting done. This not only treats people like adults who can manage their own time, but it also avoids the problem of managing slices for paid time off.
Built-in Incentives
- Extra work is automatically rewarded when using the hourly rate.
- If someone works 50hrs/wk they will contribute slices for 50hrs/wk instead of 40hrs.
- This applies only to the at-risk portion of the salary. The paid portion of the salary doesn't reward extra work in the same way. In addition, to rewarding extra time, this provides a disincentive to take cash from the company, which is what you want if you're trying to conserve cash.
Overtime
- In most cases, the amount of time people spend on the startup varies dramatically. It's for this reason the hourly rate is used.
- Participants simply track the hours they spend working to determine the fair market rate of their contribution of time.
\(FMV\ of\ Time\ =\ Hrs\cdot Hourly\ Rate\ \left(plus\ Overtime,\ if\ applicable\right)\)
- Slices/hr will show you how many slices you contribute with every hour you contribute -
\(Slices\ per\ hour\ =Hourly\ Rate\cdot NonCash\ Multiplier\)
- An awesome side benefit to tracking time and other contributions is that it provides great information for professional investors during the due diligence process.
- Time reports will not only tell you what someone is focusing on , but how productive they are. If you have a chronic time-waster, you may have grounds for termination with cause.
Value
- Time spent on a startup doesn't automatically make it more valuable.
- Experienced people usually have a higher hourly rate, which encapsulates their skills, education and expertise.
- You pay more for good employees because they can produce more for less money.
- You also pay more for good employees because they are supposed to come up with more great ideas than other employees.
Raises and Incentives
- If you have an employee that has lot's of good ideas, they will be more valuable to your company and may deserve raise, just like they would if they were working for a company that was paying them a cash salary.
- Similarly, it's okay to negotiate a salary bonus if bonuses are typical for the type of position you are hiring for.
A good bonus program should be tied to company performance. A bonus program may not make sense for a company that isn't making money.
Contractor Time
- The hourly rate of a contract/freelance employee is likely to be much higher than their fair market salary.
- The fair market rate for these people is their hourly rate.
- It's fair to negotiate a buyout for the company so that the managers can avoid an absentee owner.
- It is recommended for the payment schedule to increase the buyout price to 200% of the base price.
- If you can pay them, you do pay them else add their slices to the pie.
- You'd maintain the right to buy back slices if you suddenly came into money, according to the following schedule -
- Month 1 - 100% Buyout
- Month 2 - 109% Buyout
- Month 3- 118% Buyout
- Month 4- 127% Buyout
- Month 5- 136% Buyout
- Month 6- 145% Buyout
- Month 7- 155% Buyout
- Month 8- 164% Buyout
- Month 9- 173% Buyout
- Month 10- 182% Buyout
- Month 11- 191% Buyout
- Month 12 - 200% Buyout
- At the end of the year, you can buy them out for twice what they would've billed a regular client for their work.
- After that, the buyout option goes away for any billings more than a year old.
- You may still be able to come to an agreement, but don't force them to sell.
\(FMV\ of\ Time\ =\ Hrs\cdot Rate\)
The fair market srate calculated above is for calculating slices, not the buyout price.
- A normal employee charges an annual rate and gets the benefit of being able to keep his slices (subject to termination rules).
- A contract employee charges a contract rate and, in exchange for a higher rate, is subject to a buyback.
- If the contractor's going to be working with you over an extended period of time, it'd be better to negotiate a fair market salary and include them as an employee, rather than a contractor. Use contractors for limited engagements.
Ideas
- In the context of fairness, slices are only given when the FMV is put at risk, and the way to determine the FMV of an idea is to determine what kind of compensation an inventor would otherwise receive.
- In the non-startup world, an inventor of an idea often receives a royalty on revenues.
- Royalties generally apply to "the" idea that is the idea upon which a company is founded. Ideas generated "on the job" usually don't get royalties, since it is part of your job to come up with new ideas.
- The slicing pie model uses the FMV of unpaid royalties to calculate slices.
\(FMV\ of\ Ideas\ =\ Royalty\ Rate\cdot Revenue\ Generated\ from\ Ideas\)
- This assumes, of course, that the revenue generated can be directly attributed to the idea.
- Not every idea deserves a royalty. The idea has to enable a business to generate revenue and create a competitive advantage.
- For this to be true, the idea has to be good and unique enough that it creates some sort of "ownable" intellectual property, usually in the form of a patent or copyright.
- In some cases, the time and money spent developing the idea before the company started could be translated into slices using the relevant calculations. In these cases, the development of the idea would be part of the development of the company and the royalty wouldn't apply.
Relationships
- Relationships are valuable when and if they generate revenue, investment or other financial benefit.
- A well-connected person who simply makes introductions may not deserve slices. But a person who can help convert them into value certainly does.
- Relationships turn into value when they lead to revenues, investments, or other formal relationships with the company.
Customers
- When relationships turn into sales, the individual responsible for the sale is generally entitled to a sales commission on the revenue generated.
- Rates vary by industry, but a commission of 5%-10% is typical.
- Pay the rate appropriate for your industry and make sure you pay the same commission to all salespeople.
\(FMV\ =\ Revenue\cdot Commision\ Rate\ \left(\%\right)\)
- A commissioned sales person usually receives a sales commission in addition to a base salary, which is often smaller than the others in the firm at a similar level.
- In some cases, you can provide one commission rate on the initial sale and a lower commission rate on subsequent sales.
- Whoever's responsible for generating the revenue deserves the commission. If someone hands your salesperson a business card from someone they met at a party and your salesperson does all the work, your salesperson deserves the pie.
- Only offer slices to individuals who drive sales. A casual introduction probably isn't good enough.
- It's important to determine, in advance, when you're going to recognize the sale. It is recommended to enter sales on a monthly basis and only counting cash collected during the month.
Investors
- Similar to generating revenue, when someone's relationship creates a new investment, that person would be entitled to a finder's fee.
- They should do more than just make an introduction; they should stay active throughout the process as needed.
\(FMV\ =\ \left(First\ Million\cdot5\%\right)+\left(The\ Rest\cdot2.5\%\right)\)
Employees
- Sometimes a relationship will turn into a new hire. Choose an amount you're comfortable with and offer it to anyone who refers an employee.
- Typically, you'd wait at least 6 months before providing slices, so you'll have time to make sure the employee sticks around. £250-£500 is a good start.
- Referral fees can be a great way to reward current employees for participating in the recruitment process.
Facilities
- If someone contributes office or warehouse space, they would receive slices instead of rent.
- The FMV is equal to the amount of money the space would command on the open market if there was a willing tenant.
It's important to note that the startup should only pay (in slices) for the space that is needed for the startup. If the landlord gives them 20 offices and they only need four, they should only have to pay for four.
\(FMV\ =\ Market\ Rate\ Rent\ of\ Space\ Used\)
To calculate slices contributed from non-cash contributions, determine the fair market value of the contribution and multiply by the non-cash multiplier.
Recovery Framework
- Absentee owners are individuals who own part of a company, but are no longer actively involved, referred to as "dead" equity.
- Professional investors tend to avoid investing in companies with too many absentee owners, so the company needs a mechanism to recover shares or slices from people who leave the company.
- The framework applies to just about anyone who separates from the company. There are a couple of exceptions for contractors and advisors, but for the most part, in Slicing Pie everyone gets the same treatment.
Nature of Separation
- The recovery of the slices is dependent upon both the nature of the separation and the nature of the relationship with the individual.
- There are four primary reasons -
- Fired for Good Reason
- Fired for No Good Reason
- Resigned for Good Reason
- Resigned for No Good Reason
"Fired for Good Reason" might be called "Terminated for Cause", for instance. In the UK the terms "Good Leaver" and "Bad Leaver" are common.
Fired for Good Reason
- Being fired for good reason means that the employee's behavior led to a management decision to fire the person.
- Performance-related issues are the most common. But, if there's a performance issue, the individual must be given chance to correct their behavior. At least two warnings are recommended with a clear outline of the issue and what needs to be done to correct it.
- Other good reasons to fire someone would be stealing, sexual harassment, threatening coworkers, drug abuse, and other extreme behavior.
- When an employee is fired for good reason, their decisions negatively impact the company. Consequently, they'll lose any slices allocated from contributions except supplies, equipment and cash contributions which would be recalculated without the multipliers.
- Additionally, the company has the right (but, not the obligation) to buy back the equity in an amount of cash equal to the outstanding slices.
- Lastly, the employee should agree not to compete directly with the company or cause the other employees to leave.
- Removing the multipliers has created a consequence for the employee. Knowing that this is the consequence forces employees to think twice before slacking off and hurting the company, or choosing to engage in other negative behaviors.
Fired for No Good Reason
- If the employee is fired through no fault of their own, they get to keep all their slices. The company can offer to buy slices back in an amount of cash equal to the outstanding slices, but the employee should not be obligated to sell.
- The company has to deal with the inconvenience of having "dead" equity or buying it back at a very high premium. Keeping the multipliers has created a consequence for the company, forcing the management to think twice before letting someone go for no reason. This protects the employee from the decisions made by the management that negatively impact their future.
There are a number of reasons a person would be fired for no good reason, including a change in strategy, reduction in force, elimination of redundant position, or "just because". Most jobs (at least in the US) are considered "at will", meaning the company can fire anyone, for any reason, at any time.
- The company can't prevent the individual from going to work for a competitor either. This doesn't mean the person can steal ideas and customers, but it does mean they can go join the competition. However, the company would be within their rights to ask for a non-solicitation agreement which prevents the employee from hiring the company's employees within a specified period of time (usually one year).
Resigned for Good Reason
- There are well documented legal reasons as to why a person would be entitled to resign for "good reason" that are often found in employment contracts.
- The employee wouldn't have to leave, but they can if their job is clearly no longer what they signed up for. If they stay, however, they can't use these as good reasons later on. The good reasons are include:
- Adverse change in title or responsibilities. If the Vice President of Marketing was demoted to the Head Burger Flipper, the person would have a good reason to leave.
- Adverse change in compensation that doesn't affect other participants at the same level. If the management team cuts the individual's salary or raises their own by a significant amount, but doesn't take similar action against others at the same level.
- Relocation of the company more than 50 miles from its original location. The person may not be able to manage the commute. Extending the commute puts an unfair burden on the employee.
- Death or disability. This happens, unfortunately.
- Adoption of the Slicing Pie model after a fixed-split agreement is in place. If you're retrofitting Slicing Pie a person may want out of the deal. In fact, any unexpected change of a person's equity would be good reason.
- Changes to Pie Settings. This, in effect, changes the compensation program.
Leaving a company for good reason is essentially the same as being fired for no good reason. The employee gets to keep all their slices. The company can offer to buy back the slices for an amount of cash equal to the outstanding slices, but the employee shouldn't be obligated to sell. They shouldn't be asked to agree to a non-compete.
Resigned for No Good Reason
- The last reason for separation is when someone quits for their own reasons unrelated to the firm. Perhaps they no longer believe in the company's vision, perhaps they found a better job somewhere else, or perhaps they won the lottery and want to retire. It may be a good reason for them, but not for the company.
- They will lose any slices allocated from contributions except supplies, equipment and cash contributions which would be recalculated without the multipliers. The company may buy back the slices if they have the money and a non-compete/non-solicitation agreement would be appropriate.
This is the same consequence as being fired for good reason. If employees make choices that adversely impact the company, they have to suffer the consequences.
Loyal Employees
- Sometimes, a loyal employee works hard, but has to resign to make ends meet. It's true they may be leaving the company in the lurch, but taking back their equity may not seem like the right thing to do.
- In these case, it is recommended the person reduce their hours, but stay involved on a part-time basis. This'll allow them to keep their slices and allow the company to continue to benefit from their expertise.
- You could also adopt a rule which states that any slices over a certain number of months or a pre-set percentage stay in place in the event of resignation with no good reason. This'll give good employees who have to leave an option to do so without losing everything. It's important to have some consequences, but people's personal lives may not always stay compatible with working with a startup.
- Do not do this for people who are fired for good reason. It's best to sever ties completely with someone who may have left on anything but amicable terms.
Buyout Price
- The price will be the number of outstanding slices times the currency rate.
- When you buy someone out who was terminated for good reason or resigned for no good reason you're essentially paying them back for cash and tangible contributions. Their "investment" of time, money and other contributions didn't pay off, which is fine because leaving was their fault or choice anyway.
- However, when you buy someone out who was terminated for no good reason or resigned for good reason, they compensated for the risk they took. They are getting what they would've been paid on the open market times the multipliers.
- It's not uncommon for the people who are bought out to be the only people who walk away with anything from the startup. This is because startups pay people who leave the company and then the company goes out of business, leaving the people who stayed with nothing.
On-The-Job Buyouts
- In some cases, the company can offer to buy back slices from participants even though they are staying with the company.
- If the company uses company money to buy back individual's slices, the slices will vanish from the money and the Pie will recalculate everyone else's shares, which means they will all have a higher percentage.
- When someone sells slices back to the company they're getting a chunk of money and forgoing a share of future profits.
- The company can make any offer it wants, it just can't force a buyback.
Employee Requests
- If an employee needs cash, they can request a buyout. This's different from a company offer because if the employee is making the request, they are essentially "backing out" of the deal and removing their at-risk contributions.
- If the company has the money, it can provide lump-sum payments which will reduce the employee's at-risk contributions - starting with cash contributions - up to their total at-risk contributions. You'll have to recalculate their slices after paying them.
- Sometimes employees need the money or can't tolerate the risk associated with startups. There's nothing wrong with this and providing these payments may enable the company to retain people who might otherwise resign.
- Be careful, however, that the employee isn't simply trying to get paid before quitting. Paying someone just to have them quit is not in the spirit of Slicing Pie. Consider waiting before making payments or paying in installments.
Claw Back
- When someone resigns for good reason, or is fired for no good reason, the company can offer to buy them back at an amount equal to the outstanding slices that were calculated with the multipliers.
- It's not fair for the company to buy back the slices and then turn around and sell the company for a far better return. If a transaction takes place within a year of a buyout that would have led to a higher return, the person should be paid the difference. This is known as a "claw back" and it prevents the managers from firing everyone, buying back their slices at one price, and then selling the company at a higher price.
- If the person was fired for good reason or resigned for no good reason, the claw back would not apply.
Caveats
Advisory Board Members
- Advisors are usually successful people who may have unusually high fair market salaries. So high, in fact, that it may not be practical to pay them such a high rate.
- It is recommended to cap their hourly compensation at 200 slices/hr and asking them to contribute at least ten hours before cutting them in. For this, they enjoy the benefit of being immune to termination.
- Unless there were extenuating circumstances, you wouldn't be able to fire an advisor who took the capped hourly slices option. Instead, you'd simply stop going to them for advice and they would simply stop earning slices.
- However, you'd not be able to erase their slices if you fired them. So, when it comes to advisory board members, there's rarely such a thing as termination for cause. Advisors would typically keep their shares with the multipliers.
- However, If they told you they no longer wanted to work with you, this is the equivalent of resignation for no good reason and you could recover their slices.
- If the advisor doesn't want the slices cap then you have the option of giving them a rate that more accurately reflects their market rate, but they wouldn't enjoy the benefit of protection against termination.
Investors
- Friends and family investors who put cash into the Well can't really be fired either as long as their primary role is investment. They'd keep their slices with the multipliers, no matter what happens. You could offer to buy them out with the 4x multiplier, but they shouldn't be forced to sell.
- If an investor wants their money back they can ask for it, which is the same thing as resignation for no reason. In these cases, you'd have to pay them back without the multiplier if and when you can afford it.
Contractors
- If you're using a contractor schedule, the termination rules wouldn't apply. Once the contractor's slices are accounted for, you can't fire them and get the slices back. You can, however, offer to buy back slices or pay them if they request payment.
Rent and Royalties
- If a terminated participant is entitled to a royalty for their intellectual property, they'll continue to contribute slices unless the company pays the royalty in cash.
- If the terminated participant owns the facilities, they'll continue to contribute slices unless the company starts paying rent.
A claw back provision should be included with any sale that allows the employee to benefit from the full price of the shares in the event the company is sold at a higher price within a year.
Freezing the Pie
The Slicing Pie model is best suited for early-stage companies who don't have much cash.