The combination of the allocation and recovery frameworks provide a universal structure for awarding equity or profit interests in a bootstrapped startup. By agreeing to the rules, in advance, and holding all participants accountable to the rule, each participant is treated fairly with proper recognition of their contribution.
The Slicing Pie model is best suited for early-stage companies who don’t have much cash. As the company grows and develops, it will start generating cash and profits (hopefully). When that starts to happen, it can simply pay for everything it needs and the model will stop allocating new slices. It will, in effect, “freeze” and the ownership of the participants will no longer change. When and if the company distributes profits, the model will tell you how much each person gets.
Here is how the freezing scenario will unfold:
The Slicing Pie Model always aligns people’s incentives so that they make the right kind of decisions. Managers and employees will be aligned in their interests to get to cash flow breakeven as soon as they can so they can freeze their share. In a fixed split model it doesn’t really matter when the company gets to breakeven because it won’t impact shares.
As the company begins to generate revenue, the management team may choose how to reinvest the revenue into the company. This means they can use the money to pay for contributions, instead of using slices.
The best use of company funds is to use it to pay for things that would have otherwise consumed cash from the Well or used cash to reimburse employees for expenses. When cash from the Well or an employee is consumed, it converts to slices using the higher cash multiplier making it “expensive” relative to non-cash contributions.
When the out-of-pocket cash needs of the company are met, the management team can use what’s left to start paying for non-cash contributions such as rent, commissions, royalties and salaries. The amount paid towards the fair market rate for these contributions will reduce the number of slices allocated for that input. If the company pays 100% of the fair market rate for the contribution there is no need to provide slices.
At this point—when the company is paying for everything--the model will no longer allocate slices for contributions and the model will stop changing. It will stay frozen unless the company’s financial situation requires it to use more slices, instead of cash, in the future.
A frozen pie is a good thing. In fact, it’s the point of your work! This means the people who worked to get the company to breakeven and beyond will each have what they deserve to have and will, as you will see below, share in the profits of the company. When new members come on board you can pay them their market rate and you won’t have to feel obligated to give them slices at all.
When the company is paying 100% of its expenses it will generate profits. After the IRS takes their fair share, the company can either reinvest the profits into the company or distribute the profits to shareholders. When and if profits are distributed, the Pie will determine how much everyone gets.
Profit distributions are made after all other financial obligations have been met. This includes fair market salaries. This means that each participant will not only get their fair market salary, but also they will receive their fair share of the profits when and if the company decides to distribute profits. I hope your profits far exceed your fair market salary!
If someone joined the company after the company could afford to pay, they would get their fair market salary and would not get a portion of the profits. This is fair because they did not take any risk.
This can happen in perpetuity. Participants can continue to enjoy their fair market salary and a portion of the profits that properly reflect the contribution they made before the company could pay.
Although no more slices are being allocated, the rules of the recovery framework will still apply. However, if you are using a “loyal employee” option as described above, an employee leaving for no reason might retain their equity depending on how long ago they earned it.
Series A Investment
If your company cannot get to profitability on its own, or if it needs money for growth, it will have to raise money from outside investors. Any investment that covers a part, but not all, of the company’s cash requirements is an angel investment and should be treated as a loan and included in the Well. However, when a substantial amount of money is raised that will meet the cash needs of the company in the foreseeable future this is a Series A Investment. At this point, you can freeze the Pie and all participants will be subject to the terms of the Series A investors. These people will likely be professional investors with professional term sheets that outline all sorts of things.
One of the most important things the term sheet will outline is the valuation of the company. This will determine the underlying value of the shares. This has nothing to do with the number of slices in the pie and everything to do with how good your management team is at negotiating a healthy valuation. If you have good employees, provide good value, and (most importantly) have real traction showing a predictable marketing model, you should be able to negotiate a high price.