In the second part of our series, Rod Drury explains why it's crucial to get shareholding decisions right from the word go.
KEY POINTS:
People who have built and sold businesses will tell you that the biggest factor in the money they receive on exit is usually determined by shareholding decisions made in the beginning.
Initial shareholder allocations are very difficult to change once a business is up and running. Founding shareholders always believe that the steepest part of the value creation curve occurred when they were inside the business.
Often, a year or two in, a founding shareholder will decide they want to exit the business, which can be very traumatic. They may take important skills with them, and more often than not, the business doesn't have the cash flow to pay out their shareholding.
Then you have the dreaded valuation issue - friendships are often destroyed during this process.
My advice when starting a business is to capture as much value as you possibly can before bringing on shareholders. Say you take a mate to the pub to discuss your idea; is the default share split 50/50?
What if you invite them down and start the conversation by tabling your business plan, then invite them to come on board to be the vital sales person. What is the split then, 70/30?
What if you had the name, brand, domain and a foundation customer, before you invite your smooth-talking buddy to the table. 90/10?
That first discussion is where significant value is gained or given away. And it might equate to big money a few years on into the business.
Next - make sure your shareholders' agreement deals with what happens if there is an early exiting partner. I believe there should be a penalty for giving up and leaving early. This can be handled by including a valuation formula.
A simple formula might be total revenue of the preceding 12 months, which will naturally be low for a start-up. You might also agree on payment terms. This takes the valuation fight off the table and puts certainty into the exit process.
Often in the early stages there will be disparity between the ability of shareholders to found the business and capital will be included as sweat equity. It is important that the basis of adding sweat equity to the business is clearly defined.
What is the rate? What is the maximum per month? Is it just incurring time, or is it tagged to deliverables?
Sweat equity should be accounted for each month and loaded onto the balance sheet, so all shareholders can see its effect. Otherwise it tends to all get loaded in before an external funding round when the books are being cleaned up, an exercise which can scare off investors.
When starting a business ask others who have been there before. They will enjoy the opportunity to have you learn from their mistakes.
* Rod Drury is CEO and founder of leading NZX-listed accounting software provider Xero (xero.com)
