Slicing Pie Method: How to split equity fairly among co-founders in a startup?
A classical dilemma most startups face is splitting up equity at a fair price. We live in a world where early-stage company participants and entrepreneurs get taken advantage of so frequently that anyone can hardly notice. So, how to resolve this bad equity distribution? How to split equity fairly among co founders in startups?
Splitting up equity can be a hard and emotional subject for startups. Sometimes the model used could result in unnecessary financial losses and relationship sacrifices.
Are you dealing with this dilemma? If so, you may be looking for a dynamic equity-split model to help you decide the best alternative. Well, in this scenario, the Slicing Pie Model can help you! A simple and fixed equity model sometimes doesn’t work. Businesses have to look for the best alternative that can help them.
Let’s learn more about the slicing pie model and how to resolve many of the current equity issues.
The fixed-split problem
Before diving deep into the slicing pie model and how it works for the startups to split up the money, think of the traditional equity split.
Traditionally, nearly every second startup company uses the fixed or static equity split plan. In the fixed split method, the company’s equity is distributed among participants in chunks based on their potential customers. This process is the same as giving an annual salary to the participants on the first day of work with the belief that they will work hard for the company’s success. Does it sound silly? Well, it is!
Entrepreneurs start their business to gain maximum profit in the long-term, believing that they are doing the right thing. This happens because of the optimism and confidence to build up the new empire. However, these characteristics can’t be used to guarantee someone else’s determination and hard work. That’s where the traditional equity plan went wrong!
Generally, founders enter into the fixed-equity-split agreements based on the predictions of the equation:
Cofounder’s share % = The value of their contribution/The total value invested in the startup
Let’s take an example to understand this situation:
Damon has invested $100,000 in a company with a post-money valuation of $1 million; he would have 10 percent as per the equation:
10% = $100,000/$1,000,000
This process seems perfectly fair to the startups and co founders earlier. Cofounders will get the exact percentage based on their proportion to the money they invested in the firm. However, in some cases, we don’t know the values precisely because of their changing nature. That’s why people start guessing or predicting the variables.
Slicing Pie Model
In order to avoid these types of pitfalls while splitting equity among co-founders, the slicing pie model comes into the picture. It is an excellent resource that helps businesses on equity distributions for startups. More importantly, the slicing pie model is a universal, one-size fit model that develops a fair-equity split in an early-stage or bootstrapped startup company.
Slicing Pie Principle:
Slicing pie method is not a complicated concept and is based on the simple formula.The share percentage of the person should always reflect its share percentage in the incurred risks.
The traditional splitting formula :
Cofounder share % = The value of their contribution/The total value
After applying the slicing pie method, this splitting equity formula becomes:
Cofounders share % = The adjusted FMV of their contribution/The total adjusted FMV.
This formula’s risk contributions talk about the equipment, supplies, ideas, money, facilities, relationships, time, or anything else that doesn’t give the full payment or contribution to its fair market value.
Many people contribute to the startups every day, intending to generate the profit, go public, or even sell. Cofounders constantly made these types of contributions; as a result, the model becomes dynamic in nature. That’s where this model helps to adjust the equity fairer as per the participation of the cofounders.
Advantages of the Slicing Pie Model :
- It helps to motivate the participants to stick with the project and continue on their contributions towards the firm.
- The Slicing Pie model is dynamic in nature and attains flexibility over time.
- It allows founders to remove or add new co founders and other contributors in a fairway.
How does it work?
At any given point of time, the splitting pie method works perfectly for the startups. Startups are like a gambling spot where people bet on their business ideas. These contributions can be of two types: Cash contributions and non-cash contributions. Slicing pie normalizes the cash and non-cash contributions by making it in the fictional unit, called “Slice.”
Let’s dive through the example of how slicing pie come into action:
Slicing Pie in action
Let’s consider a situation to get some insights about the slicing pie method.
Let’s say Company XYZ Ltd. has started a new business and is seeking for various investors to start the company. The co founders can contribute to relationships, money, time, ideas, and many other resources. But here, we are assuming that every contribution will be converted into the slices. Here, two partners are contributing to the firm, Mike Rose and Donna Lit.
In the first quarter, they invest 100 S (A mixture of money, time, supplies, equipment, times, and much more). It’s quite logical that the equity would be distributed among the co-founders in equal proportion, i.e., 50 percent. Since the contributions have been transformed into slices, Donna’s total value will be equivalent to Mike Rose.
Let’s say, Donna Lit again has invested 100 S in the Second Quarter, but Mike Ross didn’t invest anything, maybe for some other reason. Here is what would happen to the splitting plan. In the second quarter, Donna Lit won’t get any incentive in the second model even if she has invested extra than Mike Ross. This is because the split would be decided to be 50/50. Do you think it is fair? Well, this is not at all!
Donna Lit and Mike Ross would need to jump into the alligator pit and should start to renegotiate their split. Here Slicing Pie Model would be the best perspective. In this dynamic model, the split would be done as per the additional contributions. This model will help both the investors feel happy knowing that they would get what they should have.
But what if, during the second quarter, the company’s main client decides to cancel the contract? This actually means that the contributions for the second round would be more riskier than the earlier contributions.
Let’s go back to the slicing pie method:
Cofounders share % = The adjusted FMV of their contribution/The total adjusted FMV.
Donna Lit so far gave 100 (1st Q) + 100(2nd Q) + Mike 100 (1 Q)
Here Donna’s 2nd quarter investment would be only 50% of the 1st quarter ones, as the risk would bring down her FMV of the contributions.
So Donna would have a total of (150 S of FMV contributions / 250 S total adjusted FMV) and Mike would have (100 S of FMV contributions / 250 S total adjusted FMV). Therefore, Donna lit will get 60% of the shares because of the risk factors, money, supply and other resources she had contributed in the firm, and Ross would get 40%.
Let’s again assume that the following quarter neither one contributes more, and the company sells for $1 million. In this scenario, Donna Lit and Mike Ross would get $600,000 and $400,000, respectively.
Let’s summarise the example to get a good insight about the working model of slicing pie, and how it helps to split the equity fairly among co founders in a startup.
The Slicing Pie method won’t only determine the perfect equity split among co founders as per their risk contributions. Still, it will also help to calculate the fair buyout price when someone decides to leave the company.
Most of the time, people usually try to negotiate about how much supplies, time, and money they would need to invest in the company. When they got the answers to these queries, they tried to figure out the ultimate rewards or returns they will get from the contributions. In this situation, the above formula of the Slicing Pie model would be a perfect fit. This formula applies until the company raises enough capital to pay the participants or breaks down due to limited resources. In this situation, the split “freezes” and subsequently determines the distribution of dividends or the sale proceeds.
This is how the slicing pie model worked for both the investors. That’s why the slicing pie model is used all over the world among entrepreneurs. Slicing Pie is the fairest way to split equity on the planet!
Final Thoughts
By now, you would get a better idea about how the Slicing Pie method works for the organization. Slicing Pie offers a straightforward and practical approach to solve the serious business problem shared by all early-stage startups. If you have been dealing with the equity splitting among co-founders, slicing pie would be the best choice! For more information, start reading about books, and watching videos about slicing pie method!
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