21 January 2007

Slicing up the Pie

One of the toughest moments for a new founder/CEO is when she realizes that success requires she begin to slice up the pie. Sometimes this happens first when its time to attract or compensate early employees - not all of whom are willing to take severe pay cuts without something in return. Or sometimes her first encounter is when it's time to raise some outside capital. But how big should the slices be? And how many of them should be cut? And what does this term dilution that people keep throwing around really mean?

The "pie" analogy is often used to describe the cutting and serving of slices of the business often in return for something of value. Whether this is a pizza, lemon meringue, or other category is not necessarily the relevant question. Venture capitalists will talk about "increasing the size of the pie" - usually about the time they are angling to cut themselves an oversize slice. And founders are often times seen giving out big servings to their original founding team without thinking through how many her pie will feed.

So there are several important considerations for how, when, why and how much, and to whom to serve from this founder's pie. Below are three common mistakes that the unwary founder may be (mis)guided to endure.

Common Slicing Mistakes

  • Excessive Portion Sizes for Early Employees - Early stage companies are often run like families. Sometimes they in fact are families (see Why CEO's Fail). Close knit groups of employees come together to do the impossible. To create something extraordinary from nothing but a vision. They dream dreams of (market) power and riches beyond most of the founding team's conceptions. They work hard, often in close quarters, and form strong interpersonal bonds. Many times these bonds cause founders to mistake relationships for value. At what Venture Capitalists might consider a "weak moment" for the founder, large slices of the pie are doled out early to the founder's team.

  • Using equity instead of cash to pay operational costs - in the earliest stages of a new venture, it is common for cash to be dear. There is much to get accomplished and too little cash to "pay someone" to do it. So often founders are induced to use equity (another slice of the pie) to substitute for cash. Whether this be for a bargain property lease, purchasing of equipment, or hiring a consultant, equity may be all the founder has as a currency to purchase these resources. So necessity itself is the mother of this mistake. And, although there may be little alternative than to use equity, the cautious founder should realize that while these expenses may be real, the use of equity is akin to mortgaging the future of your venture "just" to get this resource today.

  • Unwilling to create slices that increase the size of the pie - the flip side of the prior error is the contrary position. There are times in the life of a new venture when resources present themselves, in the form of unique talent, critical opportunities, and cash funding. Founders sometimes find themselves unwilling to part with even a relatively small slice of the pie, even though these resources may only be fleetingly available and could materially grow the size of the pie.

So how does a founder avoid these mistakes? Some forethought about the end result and understanding a bit about dilution will certainly be helpful.

There only is One Pie to Slice

The first thing to understand when slicing up your pie is that there is only one pie to slice. Better put and despite some notable con-men to the contrary, you can only give or sell 100% of your company. That means there are a limited number of slices. Once you cut a slice out of the pie, that slice is gone. Even if the pie gets bigger (the venture gains value) that slice will grow proportionally as well.

Early stage employees may be very important to the early stages of a venture. It is common for these early stage employees to be just that: good early stage employees. They may not be capable to take the company to the next stage. They may have to be replaced by new talent at a later stage. Realizing that giving up an extraordinarily large slice of the pie early, may leave you "slice-less" later when your venture needs to attract talent that may not be willing to work for just a salary. Employees may come and go, but there only is one pie.

When you pay for current expenses using slices of equity, you also should be thoughtful about what that means at a later stage. Remembering you only have one pie, while realizing your expenses will continue forever (they are recurring), will help you to understand that you won't be able to use slices of your pie for ongoing expenses forever. Therefore if you have to use slices to pay for ongoing expenses, be sure you know when you can reverse this trend. And, while the size (value) of your pie (entity) may be small today, most people value equity based upon future value. [Our own public stock markets are really valued based upon the potential value the ownership right (shares) that you purchase. Financial types often speak about discounted cash flows - or the value of this share of the company based upon expected future results.] So if you use stock to pay for current expenses, be sensitive to this valuation process and don't sell yourself short.

Increasing the Size of the Pie

Being realistic when opportunities arise that will grow the size of your pie is equally as important as careful scrutiny of giving out early slices for employees or expenses. Your value (the size of your slice) is truly dependent upon BOTH the proportion of the piece you have for yourself AND the size of the pie. A 1/4 slice of an extra large pizza is bigger than a 1/4 slice of a personal-size pizza. Understanding what will grow your pie is critical. When angels or venture capitalists offer you cash in return for a slice of your pie, you must look at the impact that financing has on the size of your pie.

Here's a quick lesson in pre and post money valuation.

Venture capitalists speak to you about the value of your venture. They may offer you $1 million for a 33 1/3% share in your venture. To you that means your venture is worth $3 million. Once you get their money your whole pie will be $3 million sized - that's the size after they added their $1 million. By simple math - the "pre-money" size of your pie was $3 million less the $1 million they added - or $2 million.

So based upon this financing offer - you used to have a $2 million pie that you had unsliced - all was yours. The VC is offering to increase the size of the pie another million larger - now $3 million. In return, they are going to take a slice that is 1/3 of the pie (1/3 of $3 million). You get to keep 2/3 of the pie or $2 million of the size.

So in this case the pre-money valuation was $2 million. The post-money valuation was $3 million. Assuming you both agreed on the $2 million pre-money valuation of your entity, the new financing was not dilutive - did not reduce the actual size of your slice. While you now only have 2/3 of the pie left, that slice increased in size sufficiently to leave you with the same amount (to eat?). While the amount of (surface area) of the slice of the pie that you still hold has neither increased nor decreased, the financing has put you in a position to continue to grow the value (size, surface area, value) of your pie into the future. You now may be in a position to stop using pie slices to pay for current expenses. You now may be in a position to attract the kind of talent you require for this stage in your venture without giving up too many large slices of what you have remaining. Overall, taking on the cash should help you continue to grow your pie beyond where you could take it yourself.

Of course you always could be happy with the size of your current pie. You always could decide that there is no need to grow the pie. Those are your decisions. But understanding and accepting that outside resources may be required to ultimately grow your pie to the size you desire, and that to do so may require you reduce the percentage of the pie that you own, will be critical to how you deal with the distribution of slices and the raising of outside capital.