In business and the corporate world, it’s all about who know. When bringing an invention idea to fruition, it’s all about whom you partner with. There are tangible, financial benefits to finding partners who offer services vital to your new company’s survival. These services may come from a designer, prototyper, patent lawyer or manufacturer. In other words, they bring to the table more than the deep pockets of a venture capitalist or angel investor.
For example, you were quoted $40,000 for plastic injection molds needed to manufacture your invention. You already spent $10,000 on the patent and prototype, and you cannot afford this additional cost. You have two choices: find an investment partner to cover the cost, but will subsequently want a stake. Or partner with a plastic molder who would contribute a mold and perhaps some early production in exchange for a stake of your startup.
Distributing shares in your limited liability company (LLC) or “small” corporation (S-Corp.) is complicated. You’re confronted with the puzzle of how to allocate shares in fair proportion to each partner’s contribution. One way to determine the value of a strategic partner’s contribution is to receive a formal price quote for the work he or she is to provide, prior to considering offering him a share in your company in lieu of cash.
The common denominator of all partners’ potential investments is the dollar. And while the arguments of whose contribution is worth most may never be settled, at least you have a rationale for such arguments.
The ideal progression of a startup is to grow in value as you reach specific milestones and confidence in your product’s profitability increases. When a patent is filed, you value your company at an estimated $50,000 or you would sell out at this amount.
A year later, you may have a refined prototype and you’ve learned from your marketability surveys that your finished product will have substantial demand. Your company may be worth an estimated $200,000. If you were to take on a financial or strategic partner at this point you would owe less than if he or she had invested at the start of the venture.
Once stock has been issued for each initial investment, ongoing partner contributions should not be paid in stock, if possible. An account should be set up for each partner to keep track of his hours and rates. When the company is acquired or sold, these accounts will be settled prior to the cashing out of the stock held by the partners.
Take this example within an emerging startup: the founder/inventor holds 30 percent of the stock and works 3,000 hours a year at a typical CEO wage of $30 an hour. The marketing director holds 10 percent of the stock and works 1,000 hours per year at $25 an hour. Two other strategic partners hold five and 10 percent of the stock, but have made no ongoing work contributions. The remaining 45 percent of the stock was sold to an angel investor for $300,000.
At the end of five years, the company is sold for $5 million. After all liabilities are paid, $4 million remains. The founder/inventor claims $450,000 past unpaid wages. The marketing director claims $125,000 past unpaid wages. This leaves $3,425,000 to be divided among all investors. The founder/inventor walks away with his 30 percent: $1,027,500. The marketing director takes his 10 percent: $342,500. The other two strategic investors take five and 10 percent. The angel, who held 45 percent, takes $1,541,250. The angel did quite well, earning about 50 percent per year compounded.
The example above is entirely fictional, and is offered only to explain the complex issues you face in taking in partners. Be sure to get the counsel of an experienced attorney or investment banker who has expertise in setting up a small LLC or S-Corp, including the issuing and dividing of shares. But now, at least, you know many of the questions to ask. Keep asking until the experts turn red and stutter.