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Have You Heard the Rule of the Thirds?

By: Dave Berkus

 

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Think of startups and early stage businesses whose entrepreneurs you know. How many of them, particularly in technology, were able to start a company, supply all the funding, and share no management tasks or equity with others, and still grow the company to any significant size, worthy of a multi-million-dollar opportunity to cash out at exit?  Nearly none, if statistics and experience are key to the answer.

The sum of three parts

We should think of the creation and growth of a high valued company as the sum of three parts, with three distinct classes of participants helping to make real value out of a raw start-up.

One: The entrepreneur

First, there is the entrepreneur, the visionary, and force behind the venture from start to finish.  The reward for the entrepreneur, after years of effort, time and sacrifice, is measured by what portion of the total pie s/he retains at exit, how much the person continues to participate through that time, and how many other resources are brought in to get to that point.  Most importantly, the reward is measured by how much added value the total process creates over time.  It is the old story of “100% of nothing is worth far less than 10% of a large number.”

Two: Co-management

Few entrepreneurs can do it alone, with subordinate hired help and no expert management to share the burdens, skill sets, and efforts involved in growing the enterprise. So, co-management is the second group to share in the bounty upon a liquidity event.

Dividing equity among those that fill the management gap

Often, if not co-founders, this group is rewarded through issuance of stock options from a pool of available options that usually totals 15-20% of the total company’s equity divided among all employees.  Those who receive options but leave the company before a liquidity event may either purchase those shares represented by the options upon exit from the company, or lose the right to those shares, often 60 days after their exit.

Three: Outside investors

The third group is made of the total number and types of investors, other than the founder(s).  From friends and family early on, to angels that are not related to the founder(s), to venture capitalists for larger opportunities, these investors have risked their money in the venture for only one reason – to eventually profit from a liquidity event.

How much equity to early investors?

It is normal for the first round of organized angels to expect to purchase between twenty and thirty-five percent of the company with their investment.  Second rounds, if needed, often drive the founder(s) into a minority position, unless the company has grown significantly by that time and can command a higher pre-money valuation, giving less stock for the same amount of investment.

Reward for early risk

Investments in small companies involve a much greater degree of risk than investment in public companies, which provide immediate liquidity if needed and a ready measure of value at any time.  That risk deserves reward if there is a profitable sale or even an initial public offering, rare as that event is.

So, remember that there are three slices to the pie to consider when creating your company and again when considering a sale or liquidity event.  All three deserve recognition for the risk, time and effort in driving the company to its ultimate value.

Think of it as the rule of the thirds.

Published: February 16, 2021
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Source: Reprinted with permission of Berkonomics

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Dave Berkus

Dave Berkus is a noted speaker, author and early stage private equity investor. He is acknowledged as one of the most active angel investors in the country, having made and actively participated in over 87 technology investments during the past decade. He currently manages two angel VC funds (Berkus Technology Ventures, LLC and Kodiak Ventures, L.P.) Dave is past Chairman of the Tech Coast Angels, one of the largest angel networks in the United States. Dave is author of “Basic Berkonomics,” “Berkonomics,” “Advanced Berkonomics,” “Extending the Runway,” and the Small Business Success Collection. Find out more at Berkus.com or contact Dave at dberkus@berkus.com

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