Being Fair To Entrepreneurs
I have heard countless times from investors and potential investors something like, "I am taking all of the financial risk, but this entrepreneur still insists on retaining a majority of the company. These terms just aren't fair!" Notably, the protest usually comes from investors who have not been involved in many deals. Their frustration is understandable, but misplaced. It is rooted in a fundamental misunderstanding of the allocations of risk in a startup deal. The best deals are had when both the founders and the investors feel that the terms are fair, and recognize the risks that each have assumed. In fact, in most deals the entrepreneur is taking a much greater financial risk than the investor.
Absolute Financial Risk
One reason for the perception of greater risk-taking by the investor is the failure to recognize that "dollars in" are not the only measure of financial support. For purposes of this discussion, it is useful to have an example: Frank Founder created InventionCo to exploit his new technology invention. InventionCo was formed, and entered into agreements for space and services. It bought supplies and things. Frank paid for this out of his retirement savings. Frank also used wire and metal from his garage, ideas from his head, and a great deal of personal time (none of which has been compensated). InventionCo has a proof-of-concept, but not a fully-developed prototype, which Frank believes to be the next step. Building the prototype will require Frank to leave his current job and go full-time into development. It will require purchasing goods and services that Frank cannot supply. Frank is looking for an initial angel investment of $250k, and is offering 20% of the equity in InventionCo in exchange for the investment.
Frequently, the investor will value the IP that Frank has contributed using some kind of rule-of-thumb valuation method (it is expensive to get a full valuation from an expert). The basic model is to guess what products the invention will replace for the next 20 years and how much profit those will make absent the invention (reduced to present value), then estimate the profit from the invention for the next 20 years (reduced to present value). Subtract, and you get the amount of value the patent added - as good a measure of value as anything. Maybe the investor will adjust this for risk, which will reduce its value. That gets booked to Frank's credit. Against this, the investor will compare his $250k. The investor may well decide that Frank's contribution of IP is simply not worth $1m. If so, this looks like a lousy deal.
But the investor is forgetting Frank's other contributions, few of which will be represented on the books of the company. First, Frank created InventionCo. In doing so, he took financial risk above and beyond the administrative cost of starting the entity. For instance, the existence of the entity increases (if only slightly) Frank's risk of being subject to a financial inquiry. It may impact his ability to obtain a loan, or at least complicate the process. It adds a step to his taxes every year. It creates legal risks for him. None of these are huge, and none of them are properly booked to Frank's account with InventionCo because none of them are contributions to the company. But they do increase Frank's risk. And these are the small ones - some of the big ones wait for Frank down the road, like the risk he takes when he leaves his current job.
To be sure, a portion of the amount being raised is intended to be salary replacement for Frank, and in that sense compensates him for taking the new job. But leaving a stable job to make InventionCo his sole source of sustenance represents a huge financial risk for Frank. If InventionCo fails, the inventor will be out a discrete $250k investment. But Frank will be out lost income while he searches for a new position, and the fact of his having left may impact his ability to obtain a new position comparable to the one he left behind: employers may well be (justifiably) wary of hiring someone with entrepreneurial ambitions and a history of what could appear to be fickle loyalties. Consider, too, that Frank likely would have obtained raises (or at least valuable experience that he could parlay into future salary raises) if he had stayed put. The total cost of this to Frank in the event that InventionCo fails may far exceed $250k.
Finally, Frank is also forgoing other entrepreneurial opportunities to put his energy into InventionCo. The investor will object at this point, "but I could have put my $250k into other investments, too! The opportunity cost is a wash." But practically speaking, this is rarely true: investors in most markets have more money to invest then they have opportunities that meet their risk and growth profile. The fact is, most investors are not choosing between putting $250k into InventionCo versus some other comparable startup, they are choosing between InventionCo and a less desirable investment class (such as the stock market, which does not closely match their risk/reward profile).
Relative Risk
In any event, there is another way to look at the risk allocation that must be understood in order to construct fair deals. This method would look at the relative effect of a loss of investment on the parties, rather than trying to compare absolute investment values.
Say that the book value of Frank's total contribution to InventionCo is $500k. For the sake of argument, let's say that this includes everything Frank has put in. On a straight dollar-for-dollar comparison, it seems as if the investor should get 33% of InventionCo. But look at the impact of the various risks. If InventionCo fails, Frank will be devastated. His retirement savings will be wiped out, and he will have no further prospects for income without some reinvention. The investor, on the other hand, will take the loss and move on. In short, relative to the rest of their assets InventionCo represents a substantially greater risk to Frank than it does to the investor. When considering to what deal Frank should be willing to agree, the investor must keep in mind that Frank needs more upside potential to convince him to continue with InventionCo than a simple, absolute dollar-for-dollar measure of contribution would indicate.
Suggestions
The purpose of this discussion is not to suggest that the investor is being unfair to desire more than 20% of InventionCo in exchange for his investment. Every investor has his or her own appetite for risk and demand for growth, and the investment has to fit that profile or it is a bad investment. Moreover, if the investor has another place to put the $250k where it will grow faster or at less risk than 20% of InventionCo, he or she should run to the best opportunity. Similarly, one some level Frank must decide whether he is better off owning 80% of a business that cannot get started or (say) 66% of a going, and growing, concern. The point is not to dictate how the players value the transaction, but instead to recommend that both investors and entrepreneurs carefully consider the actual risks each is taking, and their relative impact on each, before assuming that a proposed transaction is "unfair".
As a concrete suggestion to entrepreneurs: make sure you are never lying to yourself and underselling your contribution to your business. One of the issues that leads to the problem Frank might face is that likely he failed to book contributions like the value of his time in the garage inventing, the value of the parts he contributed, the value of the cash he contributed to buy things he would not have bought if not for InventionCo, etc. in addition to the value of the invention itself. Among other things, mistakes like this will impact your valuation. They will also impact your ROI calculation, and not favorably. But both you and your investors will appreciate you taking an honest and forthright approach that adequately accounts for every contribution. And doing so will help both you and your investors understand what allocations of investment risk are most "fair".