Some entrepreneurs insist on maintaining 51% ownership of the stock of the company “in order to maintain control.” The best leaders have a minority interest in the companies they lead, listen to all constituencies and make optimal decisions that are in the best interest of all those constituencies. Leaders have no right to ever make a decision that is in the best interest of themselves alone.
The only reason that a person could want such a controlling position would be if s/he would rather not do things that are in the best interests of the whole. A good leader maintains control by building consensus, not by outvoting others.
If your fear of losing a controlling interest in the company lies in the fear of getting fired by the shareholders, think about this. If a majority of shareholders think you are making poor decisions, then perhaps you should be fired.
If you are paranoid that you will not be a good leader, then keep the stock yourself! But don’t expect many investors. And don’t expect loyal employees.
2. How many founders shares should you create
As a general rule, people prefer to purchase large numbers of shares (and people prefer to receive large numbers of stock options). Therefore, although totally arbitrary, I recommend founders start off with, say, 1,000,000 common shares.
3. How many options in the option pool
These are the shares you want to reserve for distribution to employees, consultants, board members, and so on, as stock options.
It is a good idea to establish the option pool size as a function of the founders’ round size, however, there is little agreement on what the relationship should be. I have read many entrepreneurship books that recommend that the option pool size be set at around 25% of the founders’ round size.
In most of my start-ups, I started with a plan to have an equity distribution look like the figure to the right when a liquidity event occurred.
Thus I create my initial option pool equal to around 40% of the size of the founders round size, i.e., 400,000 shares, with the plan to use this as the option budget for the first few years, and then add additional option pools in subsequent years, adding up eventually to 1,000,000 shares.
4. How much of the company to sell to investors
Investors are looking for financial returns, period. Based on the size of the investment, financial projections, and expected exit windows, they will calculate what percent of the company they must acquire today so they can obtain the desired returns upon the likely exit, factoring in all the risk factors.
For example, let’s say you want $1,000,000 in cash, and the investors agree to invest $1,000,000. Based on financial projections, an expected exit window in, say, 4 years, and valuations for similar companies that have been acquired, the investors can estimate that the most likely valuation for your company in 4 years will be, say, $10,000,000.
Assuming that the investors desire a 40% internal rate of return, they will need to see $3,840,000 upon an acquisition. That means they will need to acquire 38.4% of the company today for $1,000,000.
Other factors come into play, such as the company’s current valuation, and the ability for current round pricing to accommodate future round price increases, but the above formula shows the essence of the primary calculation which is based on desired returns, not control.
As a result of the above, the 33% pie piece I planned (at founding time) for the investors may become larger or smaller when the time comes for seeking investments, and I can control this to a limited degree with cash burn rates and by timing of the investment rounds.
5. Does controlling voting stock help
Some founders create multiple classes of stock and give voting rights to only some classes. Then they maintain a majority of the voting shares while distributing a majority of non-voting shares to others. This dual-class share methodology demonstrates the ultimate in paranoia, and shouts “I plan to make decisions that I think are best, and I really don’t care what the rest of you think.” This is legal of course (on Wall Street).
And based on the price of Facebook since its IPO, no shortage of investors exists who are willing to take the risk with their cash even though they have no corresponding say in governance. If you want to know more about this phenomenon, read this great blog by Matt Orsagh.
6. Making decisions
Once your company has been founded and you have decided to take on a job, for example, as CEO, you should consider yourself an employee of the company. Yes, you are an important employee, but you are just an employee. Your task is to make the best decisions on behalf of the company. Some of these decisions may not be optimal for you as an individual, and that is okay! In fact the more decisions you make that are clearly not in your personal best interest, the more respect you are likely to muster from fellow employees.
If you are looking for a script for the first act, try giving up a controlling interest in “your” company!
You are not your company. Avoid forcing yourself on the company by maintaining “control.” It inhibits the company’s growth and just feeds your own ego. Rather, lead your team and your company toward success and celebrate together.
ABOUT THE AUTHOR:
Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.
If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money?