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In consideration of the most ethical distribution of shares for a startup business (via a public, initial investment event ie- IPO, ICO, or 'crowd-equity-fundraiser') the following occurred to me.

Consider this example business:

  • 1 founder
  • ~1 year of part-time work or 'sweat equity' invested so far
  • no physical assets, but soft assets and IP (ie- software or digital entertainment) near or ready for market release
  • no existing sales or revenues

Specifically I was wondering, how can the founder determine an appropriate valuation and distribution of shares; ie- the amount of equity to make available for public vs how much to reserve for him/herself.

Some might say that a purely balanced initial offering would entail making available 100% equity to the public, and that the founder should acquire shares in the same way the market will acquire them.

To me that seems like the most natural, practical, and ethical way to go about an initial offering. It levels the playing field from day one of the offering and encourages the entrepreneur to instigate investment with his/her own capital.

Is there any precedent in this happening (ie- some past IPO on a well known exchange or perhaps some other historic example) ?

Of course, this doesn't necessarily account for the existing sweat-equity invested so far. Also there is a dilemma if said founder has little or no capital of his/her own to invest - in which case the event may result in an undesirable outcome. Ie- results in giving up 100% or 99% of shares because they are unable to invest funds of their own.

Yet, without any sales/revenue or product on the market the value of said sweat equity is basically an arbitrary value as far as the public market/investors are concerned anyway. It may be in the best interest of everyone if any such 'arbitrariness' is removed altogether; to help establish a base of integrity for the business' economics from day 1.

So just pondering this, I have identified the following potential solutions (and would like input on or suggestions of other solutions):

A) Founder makes available 100% equity, but uses a reasonable amount of the proceeds to pay him/herself a salary (or wage) and from that salary invests in the same initial offering to acquire shares for him/herself.

  • this would imply a window of offering of say 30, 60 or 90 days common in more recent 'initial offering' formats (ie- Kickstarter style equity crowdfunding or ICOs) which serves to both allow time for more investors to participate as well as time for the founder to earn salary and buy shares

Receiving investment to simply re-invest that back in to the same investment seems unethical (and pointless given you could achieve the same outcome by simply reserving an (albeit arbitrary) allocation of shares for yourself initially) - but if the founder is actively working to advance the business it seems fair that he/she can pay thyself with the new capital as it flows in through the initial offering - and choose to invest those earnings while the window is still open.

B) Founder makes available 100% equity, sets a valuation / target fundraiser goal, keeping any equity/shares unsold

  • In this scenario, the founder launches the initial offering making available 100% equity, keeping only the equity unsold. Ex: $1m valuation / 100 shares / $10k per share - only 15 shares (15% or $150k) are sold during the initial offering and as such 85% shares will automatically go to the founder. Founder did not necessarily reach the capital target but has achieved some extent of new capital without having needed to risk or put everything on the table.

Combination of A + B may also work - though perhaps that could be imbalanced against the market (though I would contest, is still significantly better than simply choosing an arbitrary allocation of shares to make available for public)

Ultimately, if the founder is making his/her business available for investment to the public - they 'hold the deck' so to speak - and as such it is easy to 'stack the deck' if they want to - but by making an ethical initial offering fundraising/equity distribution model - in combination with transparent bookkeeping (and routine insight day to day operations) I feel like the founder can make a compelling case and use that to hopefully smash the initial offering.

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Founder makes available 100% equity, but uses a reasonable amount of the proceeds to pay him/herself a salary (or wage) and from that salary invests in the same initial offering to acquire shares for him/herself.

I see several problems.

  1. What is a reasonable salary?

  2. Also, this leaves the door open to the following scam: Founders say that they are going to follow this plan. However, instead of buying shares, they simply quit after being paid the salary. They use knowledge gained from this business to start a competitor. Investors are left holding an empty company.

  3. Tax consequences. The founder would pay income tax on the salary. By contrast, if the founder instead sells shares, that would be capital gains tax, which is lower in many countries (e.g. the United States).

  4. Why would I want to invest in a business where the founders don't believe in it enough to take a significant equity stake?

    Consider the Amazon.com example. Jeff Bezos makes a minimal salary, around $80,000 a year, less than many of his employees. But he has a substantial ownership position. If the company doesn't make money, he won't. Would investors really value the stocks with a P/E of 232.10 in 2016 if they didn't trust him to make the right long term decisions?

It's also worth noting that most initial public offerings (IPOs) are not made when the founder is the only employee. A single employee company instead looks for private investors, often called angel investors. Companies generally don't go public until they are established in some way, often making money. Negotiating with angel investors is different from negotiating with the public. They can personally review the books and once invested tend to have input on how the money is spent.

In other words, this is mostly solving the wrong problem if you talk about IPOs. This might make more sense with a crowdfunded venture, as that replaces a few angel investors with many individuals. But most crowdfunded ventures tend to approach things from the opposite direction. Instead of looking for investors, they look for customers. If they offer a useful product, they will get customers. If not, they never get the money.

Beyond all this, if a founder is only going to get a fair salary some of the time, then why put in any sweat equity? This works fine if the company looks valuable after a year. What if it doesn't? The founder is out a year of sweat equity and has nothing in return. That happens now too, but the possibility of the big return offsets it. You're taking out the big return.

I don't think that this is good for either founders or investors. The founder trades a potentially good or even great return for a mediocre return. The investors trade a situation where both they and the founder benefit from a successful company to one where they benefit a lot more than the founder. That's not good for either side.

  • The potential problems you highlight are great feedback - thanks. In the interest of finding the most ideal offering then, to address or alleviate them perhaps I could elaborate on each thereof (there may exist a good counter solution for each) though unfortunately I guess SX does not really accommodate for that kind of thing and as such this would be better in a discussion board format :/ It would be cool if they have a feature we could use to 'fork' a question into a discussion board for more detailed follow up comment/responses. – Derrick Nov 22 '17 at 10:29
  • To address your conclusion at least, I think that's fair reasoning but would contest that the gig is still out on this - hence, a historic example would be ideal to look at. If you or anyone can find some simmilar type of happening before, we can post the link here. – Derrick Nov 22 '17 at 10:34
  • The core premise against your conclusion is that, if the founder is passionate about acheiving the goals for the business (ie- developing & bringing a specific product to market) they may very well be willing to give up significant or 100% equity to do that if they can simply be compensated for their time - as well as to wield the capital necessary to - accomplish said goals. If in the process they can enrich the original investors while also acquiring more equity for themselves - all the better of course. – Derrick Nov 22 '17 at 10:34
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Specifically I was wondering, how can the founder determine an appropriate valuation and distribution of shares; ie- the amount of equity to make available for public vs how much to reserve for him/herself.

This is an art more than science. If markets believe it to be worth x; one will get. This is not a direct correlation of the revenue a start up makes. It is more an estimated revenue it would make in some point in time in future.

There are investment firms that can size up the opportunity and advise; however it is based on their experience and may not always be true reflection of value.

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