As the brainchild of a start-up, it’s in your best interest to be one step ahead around decision making power and the effect new partnerships or investors could have on yours. If you don’t understand the legal authority given to each role player joining your business, your power can easily be diluted. This is overlooked by most start-ups, in favour of making tangible progress on product and sales.
In this article I will unpack how decisions are made in a company, who decides how to bring the business idea to life and what steps you should take to get there – all whilst maintaining your power as founder.
Company control – making sure you stay part of the process
Essentially, there are three groups with decision making power in a company. Each group has both special rights, and absolute limitations. Being completely clear on the rights and limitations of each group is perhaps a condition of your success, or even survival in your own company.
Group 1: Shareholders
The first shareholders are the founders of the business. They make a contribution to the business, usually in the form of cash or capital, effort, time or other valuable resources. Their reward is that they get a return on capital, as their shares grow in value and they receive dividends from the profits of the business. They have the right to appoint the custodians of the company: the directors.
Shareholders are consulted and have the final decision making rights on major decisions, influencing the value of the company. However, shareholders have no right to take part in the business of the company. They have no role in the operations, finance or other day to day business of the company. If this comes as a surprise to you, it’s probably because you are (like I was eight years ago) both shareholder, director and employee of the company. Read on.
Group 2: Directors
These are the custodians appointed by the shareholders. Carl Bates from Sirdar (a leading consultancy, focusing on company governance) once put it something like this: The shareholders provide the cash and set their expectations for a return on capital. Then they appoint directors and charge those directors with the task of building the road map, or “strategy”, for achieving that return on capital.
After building the strategy, the directors develop the practical steps that will result in its achievement. Then they monitor the company, which involves “fine tuning” monthly, quarterly and annual deliverables.
This is a big picture, conceptual role – directors don’t roll up their sleeves and descend onto the office floor, coding software, manufacturing car parts, or whatever the activity of the company is. They have the mandate of keeping a broader view. To see the wood for the trees, so to speak. Having a group of people who are not subjectively involved in the day to day work of a business is incredibly valuable. This is a reason why mentors or independent directors are so valuable.
Group 3: Employees
These are the sales people, the manufacturing or production people, the finance team, the HR, the digital marketing team – the people that take the practical day-to-day steps of creating a company (the same company that was funded by shareholders, conceived by directors and is now being set up and run by employees?)
Take note – this is where it becomes interesting and highly relevant for the archetypal client of our law firm: when starting up, the start-up client is all three of the above. She has the skills and capital, she develops the idea, she builds the product, leases the premises, hires the accountant and buys the milk and coffee every day. Sound familiar?
Although it would be great to have all three perspectives of the founder’s roles, this is usually not really necessary to kick things off. At the beginning stage of a business, it’s about making progress on the product, validating the business model, and finding the customers.
However, fast forward a few months and things will change radically as the founder brings on partners and investors. When this happens, additional people are involved in the decision making – and when THAT happens, who actually has the decision making power?
Who is really on top?
Looking at these three stakeholders, you will appreciate a bizarre inverse reality. The most “junior” members of the category probably think of themselves as most valuable, yet they have the least power over the bigger picture.
Employees are the face of the company, but they have no say at all when it comes to the biggest decisions of strategy, funding or even the sale of the company.
Directors are charged with building the strategy and making the essential decisions around the implementation (i.e. signing off all contracts, employing new staff etc.), yet they are appointed and can be dismissed by shareholders.
Shareholders have no employment role and have a limited say in the overall strategy – except if it will affect the overall value of their shares. That said, they are the only ones that can authorise major decisions such as taking on more funding, selling the business, merging the business, etc.
The danger then? Finding yourself in a situation where you feel that you are building up the business as an employee, but your power as shareholder and director have been diluted by other partners. This is why your shareholders’ agreement and MOI (memorandum of incorporation) is so critical – it clearly sets out these rights with no room for confusion. In essence, this is where a start-up lawyer plays a key role and can directly contribute to the value of your stake in the business.
Keep an eye out for my next article on funding your business and bringing on new shareholders. Here we’ll take an even deeper dive into how to best navigate your way around organisational growth and restructuring, without losing your power and voice.
Alan Knott-Craig Answers Your Questions On Money And Partners
From starting the right business, to managing business partners and finding your magic number, there is a secret to happiness.
If I get rich will I be happy? — JC Lately
Does money equal happiness? Mostly, yes. Research in the US shows that your happiness is proportionate to your earnings up until you earn $80 000 per annum. Thereafter, incremental income gains have a negligible effect on your happiness.
In other words: More money will make you happy as long as you’re poor. Once you break out of poverty and enter a comfortable middle-class existence, more money will not make you happier.
These are the top three for old folks:
- I wish I’d spent more time with family.
- I wish I’d taken more risks.
- I wish I’d travelled more.
Therein lies the secret to happiness. Spend time with your family. Take risks. Travel.
But first, make money. Don’t do any of the above until you’re making enough money not be stressed about money.
What is the magic number? — Mushti
The magic number is the amount of money you need to not worry about money ever again. If you don’t need toys like Ferraris, yachts and jets, the magic number is R130 million. Here’s the math: R130 million will earn R9,1 million in interest annually (assuming 7% interest). After tax that is R5,46 million.
Assuming you need 50% to maintain a good lifestyle, that leaves approximately R2,7 million for reinvestment, which is enough to keep your capital amount in touch with inflation for 50 years. The balance of R2,7 million (after tax) is for your living costs. In South Africa, R2,7 million will afford you a lifestyle that allows you to send your kids to a great school and university, to travel overseas a couple of times a year, and to live in a comfortable house.
Over time your living costs (and inflation) will eat into your capital amount. After 50 years you should be down to nil, assuming you earn zero other income in that time.
In 50 years, you will probably be dead. If you’re not dead, your kids will be able to support you (because they love you and they have a great university education).
I am the sole director of a company (the others still have full-time jobs and don’t want to be conflicted) and there is pro-rata shareholding based on our initial shareholder loans. However, I am putting in most of the hard work, together with one of the other actuaries. How best do I manage the director/shareholder dynamic? I obviously want to make as much progress as possible but there are times when I need the input from the others (and their responses aren’t always as quick as I would like). — Mike
If you have any perception of unfairness regarding effort/risk vs reward, deal with it NOW! You can’t do so later. The best approach is honesty. Call your partners together. Explain your thinking. Perhaps argue for 25% ‘sweat equity’ for yourself. Everyone dilutes accordingly. Ideally cut a deal whereby you have an option to pay back all their loans, plus interest, within six months, and you get 100% of equity (unless they quit their jobs and join full-time).
Equity dissent must be resolved long before the business makes money, otherwise it will never be resolved.
What do you think of WiFi in taxis?— Ntembeko
It’s a good idea, but not original. Before embarking on a start-up, you should survey the landscape for competitors. Just because there are none doesn’t mean no one has tried your idea.
It just means that everyone that tried has failed. You need to be 100% sure that you have some ‘edge’ that makes you different from everyone who came before you (and failed). Otherwise you will fail. What is your advantage that is different to everyone who came before?
Read ‘Be A Hero’ today
What You Need To Know About The Lean Start-up Model
The Lean Start-up philosophy was developed by Eric Ries, a Silicon Valley-based entrepreneur who also sat on venture capital advisory boards. He published The Lean Startup in 2011, igniting a movement around a new way of doing business.
The model follows key precepts that include:
Taking untested products to market
The fact that too many start-ups begin with an idea for a product that they think people want, spending months (or even years) perfecting that product without ever testing it in the market with prospective customers.
When they fail to reach broad uptake from customers, it’s often because they never spoke to prospective customers and determined whether or not the product was interesting. The earlier you can determine customer feedback, the quicker you can adjust your model to suit market needs.
The ‘build-measure-learn’ feedback loop is a core component of lean start-up methodology
The first step is figuring out the problem that needs to be solved and then developing a minimum viable product (MVP) to begin the process of learning as quickly as possible. Once the MVP is established, a start-up can work on tuning the engine. This will involve measurement and learning and must include actionable metrics that can demonstrate cause and effect.
Utilising an investigative development method called the ‘Five Whys’
This involves asking simple questions to study and solve problems across the business journey. When this process of measuring and learning is done correctly, it will be clear that a company is either moving the drivers of the business model or not. If not, it is a sign that it is time to pivot or make a structural course correction to test a new fundamental hypothesis about the product, strategy and engine of growth.
Lean isn’t only about spending less money
It’s also not only about failing fast and as cheaply as possible. It’s about putting a process in place, and following a methodology around product development that allows the business to course correct.
Progress in manufacturing is measured by the production of high quality goods
The unit of progress for lean start-ups is validated learning. This is a rigorous method for demonstrating progress when an entrepreneur is embedded in the soil of extreme uncertainty. Once entrepreneurs embrace validated learning, the development process can shrink substantially. When you focus on figuring the right thing to build — the thing customers want and will pay for, rather than an idea you think is good — you need not spend months waiting for a product beta launch to change the company’s direction. Instead, entrepreneurs can adapt their plans incrementally, inch by inch, minute by minute.
Start-Up Law: I’m A Start-up Founder. Can I Pay Employees With Shares?
Bulking up employee salaries with equity is a common method to attract, retain and incentivise top talent.
Every early stage start-up company battles with restricted cash flow and not being able to pay market related salaries to their employees. Bulking up employee salaries with equity is a common method to attract, retain and incentivise top talent.
Can I pay salaries with shares?
South African labour laws require that employees be paid certain minimum wages, and “remuneration”, as defined within the Basic Conditions of Employment Amendment Act, either means in ‘money or in kind’. ’In kind’ does not include shares or participation in share incentive schemes, as determined by the Minister of Labour. As such, there is no room for start-ups to completely substitute paying salaries with shares or share options. However, there is no restriction in topping up below market related salaries with equity via an employee share ownership plan (‘ESOP‘).
Employee Share Ownership Plans
There are a variety of ways in which employees can be incentivised, and it will always be important for the start-up founders to consider what goal they wish to achieve by incentivising their employees.
ESOPs can be structured in several ways, for example: employees may be offered direct shareholding in the company, options for the acquisition of shares in the future; or alternatively, a phantom / notional share scheme can be set up.
ESOPs permit employees to share in the company’s success without requiring a start-up business to spend precious cash. In fact, ESOPs can contribute capital to a company where employees need to pay an exercise price for their share options or shares.
The primary disadvantage of ESOPs is the possible dilution of the Founder’s equity. For employees, the main disadvantage of an ESOP compared to cash bonuses or bigger salaries, is the lack of liquidity. If the company does not grow bigger and its shares does not become more valuable, the shares may ultimately prove to be worthless.
Some key features to consider when setting up an ESOP are:
- ELIGIBILITY – who will be allowed to participate? Full time employees? Part-time employees? Advisors?
- POOL SIZE – what percentage of shares will be allocated to incentivise employees?
- RESTRICTIONS – will employees be able to sell their shares immediately?
- VESTING – will there be a minimum period that service employees will have to serve with the start-up to receive the economic benefit of his or her shares?
Employee share ownership plans are great corporate structuring mechanisms for attracting and retaining employees, as well as fostering an understanding of the company ethos and encouraging loyalty and productivity. It is essential when implementing an ESOP that all the tax implications are considered and that the correct structure and legal documentation are in place.
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