Decide Ownership Stakes

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Decide Ownership Stakes

This is one of the first tests of a management/founding group 's ability to run a venture. Addressing questions of value, worth, and controlWho deserves what? When should they get it? Who has ultimate decision-making authority?can hit primal nerves, and must be done tactfully and rationally. This section will give you a list of questions to get the discussion started and help you evaluate your respective contributions as unemotionally as possible.

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Choose an Entity for Your Business

How your business organizes itself legallyas a corporation, LLC, or partnershipaffects the taxation , administration, and asset protection of your business, among other effects. This section will describe the behavior, benefits, and detriments of each entity type and help you determine which is most appropriate for your business.

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Issue the Ownership Stakes

Once you have decided how the company will be owned and controlled, and know which entity makes the most sense for the business, the ownership stakes must be distributed to the founders, and the rules of owning those stakes must be established in an agreement. These rules are primarily occupied with the purchase and sale of ownership, addressing issues such as what happens when a founder becomes disabled, or wants to sell his stake to an outsider. You will get an overview of the legal issues and concerns surrounding each, and can see a sample restricted stock purchase agreement at the end of the chapter.

The author would like to thank Jim Eberz of Meiselman, Denlea, Packman, and Eberz P.C. ( www.mdpelaw.com ) for his assistance with preparing this chapter.

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Deciding Ownership Stakes

The three core questions in allocating ownership among a group of founders are

Who deserves what?
When should they get it?
Who has ultimate decision-making authority?

Who Deserves What?

Now is a good time to understand how each of your co-founders understands his individual role and contribution, as well as how he sees the contributions of others. To focus the discussion during negotiations, ask each party to answer the following questions:

What will each founder contribute up front? A respected name in the industry? Cash? Fundraising experience and contacts? Property, real or intellectual? Other rights (such as an exclusive license to a property or a development contract)?
What will each founder contribute in the near future? More cash? Real or intellectual property (say, the development of an engine)? Sweat equity? Experience? A network? (These contributions are always "discounted" slightly to reflect the bird in hand/two in the bush principle of future returns).
How should you value each of those contributions in light of the company's individual needs? In valuing the contributions, a useful index is to consider the opportunity cost of each donor. If a founder is donating cash, what return could he expect from other forms of investment? For someone donating experience, what is that experience worth on the job market? For one donating intellectual property, what would a license for that IP bring?
If you plan to share ownership with employees, or have yet to hire key personnel who will require some stake in the company, what share of the company needs to be set aside for future employees ? (Generally 10 to 20 percentan experienced CEO alone will require 5 to 10 percent.)
Do you plan to raise capital in the future? How much, when, and in roughly how many rounds? Many, if not most, game developers fund their operations with retained earnings. However, some elect to fund expansion plans (development of new IP, breaking into new businesses) with outside investment.

NOTE

NOTE

Some developers elect to isolate new ventures , and even every game, with a separate business entity. Example: A development company, Devco, wants to develop an original IP called NewGame , but needs to raise $300,000 to fund a prototype. Rather than selling a piece of Devco and all of its assets to investors in the NewGame property, Devco creates a new wholly -owned subsidiary corporation called NewGame, Inc. and sells shares of that company to investors.This strategy has pros and cons for both sides, but it has the effect of mak ing sure that investors are impacted only by the success or failure of NewGame and not the success or failure of other Devco operations.
Professional investors will frequently demand as much as 40 to 60 percent in an early fund raising round, though this number should be significantly lower for a developer with a track record and, best of all, a development contract.
Finally, carefully consider if there are any parties who may emerge "out of the wood-work" to lay a claim to the company or its IP. Think back on everyone with whom you talked over a story idea or game design, everyone who worked on code that became part of your engine, or anyone to whom any founder said anything that could have been construed as a promise of involvement in the venture. 'Tis a far far better thing to pay 1 or 2 percent up front than to have a release held up by litigation.

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TIP

A new business is everyone's baby, and it is not uncommon for every one to think he gave birth to it. Like Solomon, the founders' job is not to split the baby, but to devise a plan whereby the baby remains intact and all the parents are adequately motivated to act in its best interest. It seems obvious, but can get lost in the deal-making shuffle: Never negotiate a deal that is too lean to keep your counterparty happy for at least the next three years .

Figure 2.1. Founders must decide both how much each equity each will own and whether that equity is subject to vesting.

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When Should they get it?

After deciding each founder's share of the company, you should consider the timing of actual transfer of ownership. Frequently, the ownership agreement (see the "Ownership Agreements" section later in this chapter) will state that founder-employee stakes will vest over time, meaning that, while the entire amount is allocated to the stakeholder, he will only gain full legal ownership to the stake after a certain period of employment.

Example: Devco, Inc. is a corporation with four founders who plan to share the equity (stock) equally. Founders A & B will be contributing services, Founder C will contribute cash up front.

Founder C, since he has performed his contribution, receives ownership of all of his stock. Founder A, because he has a very prestigious name in the industry, will be receiving part of his stake free and clear and part subject to straight line vesting . Founder B will receive his stock subject to a modified cliff vesting schedule. According to the schedule, each will get

Founder	Signature of Shareholder's Agreement	End of Year One	End of Year Two	End of Year Three	End of Year Four
C (fully vested)	100%
A (vests at the end of every month)	10%	22.5%	22.5%	22.5%	22.5%
B (vests at the end of every year until Year Three; monthly vesting for Years Three and Four	5%	5%	10%	40%	40%

Why Use Vesting Schedules?

The idea behind vesting is to defer delivery of ownership until the grantee has delivered all of the services contemplated by the parties when they signed the agreement. When ownership is granted in consideration for future services, there is risk that the services will not be rendered. Vesting matches that risk by allocating the full amount of ownership to be granted, but only delivering the amount proportionate to the delivery of services.

Vesting gives those working for the company an incentive to continue working for the company, and it keeps ownership of the company in the hands of those most interested in the success of the companythe employees. Two scenarios in which vesting can be a helpful tool:

Scenario One: A Founder-Employee Leaves the Company Earlier than Anticipated.

What if you start a company, give each of the founders one quarter of the equity, and then after three months, one of them quits, gets fired , or goes otherwise AWOL? Is he then entitled to 25 percent of everything the company makes going forward? Probably not. Where a founder will be contributing sweat equity, the other founders will probably want to protect the company by enforcing vesting and giving the company rights to re-purchase any stock that has vested.

Scenario Two: A Founder Wants to Prove Himself and Gradually Earn More Control of the Company.

What if one of the founders is relatively unproven, but the other founders believe he has much potential and want to keep him happy if he works out well? Here is another scenario where a wisely drafted ownership agreement will help all of the parties achieve their goals. A steep vesting cliff (most vesting is deferred for a few years and then granted in larger chunks ) can give the other founders time to evaluate the young turk's progress while giving said turk the comfort that his efforts have a clearly defined reward.

Who has the Final Word?

Ownership bears two primary benefits: profits and control. While the two are often intermingled, they can be separated if it suits the owners . This may be desirable where a party wishes to make a passive investment (an investment not accompanied by significant effort in the venture, such as employment) and does not want to exercise control in the venture. Different owners have different preferences: a cash investor will probably be more interested in return on investment, while a sweat equity investor may be more concerned with control.

How is control exercised? The answer to this question varies with entity type. Each business entity has its own prescribed method of control and management of the business, described below. For example, a corporation divides control among three groups: the shareholders, the directors, and the executives. Shareholders elect directors for a term . Directors hire and fire executives. A founder seeking control would be well advised to have not only ownership of shares, but a voting agreement guaranteeing him one (or more, which he can fill with an ally) seat(s) on the board, particularly if he is an executive. It is important to match the dynamics of your founding group (if indeed there is more than one founder) to the management mechanics of the entity.

Be aware that you may not be granted the final say in a company simply by virtue of owning the largest stake in the venture. Every business entity (covered in detail below) has some mechanisms by which minority owners can restrict the majority's ability to take certain actions (such as terminating the minority owner, or the majority owner's selling his or her stake to an outsider).

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CAUTION

In some respects, the most impor tant negotiations are not over money but over the provisions of the agreement governing relations among the business owners.These are covered in the "Issuing Ownership: Owners' Agreements" section, later in this chapter.