Founder contributions are critical to entrepreneurial startups. There are three major contributions that founders provide to startup businesses: Money, Commitment, and Effort
These are the basic building blocks for creating a company.
Money, Commitment, and Effort. The difficulty arises in how to value these very different types of founder contributions.
A basic premise of economics is the idea that “money” today is worth more than the same amount in the future due to its potential earning capacity. It can earn interest in the market. This principle is a cornerstone to understanding startup financing. In fact, this principle applies to the entire process from initial organization through external funding or sale of the company.
Typically, uncertainty is greatest at the early stages of a business’ formation.
At this point, there are a significant number of unknowns: the exact nature of demand, whether regulatory approval can be secured and even the eventual cost of designing, producing and marketing the product or service. Uncertainty creates risk and risk demands a premium.
Dilution: The Real Meaning of Funding Success
Therefore, investment in the early stage is worth more than an investment later.
As time passes the uncertainty begins to lessen, for good or bad. Ideas are translated into concrete plans. Products and services are developed. A sense of the market and the ability to monetize the concept becomes clearer.
This clarity reduces risk. Therefore, valuations tend to increase over time. This effectively makes comparable investments in future rounds of funding worth less than before. In general, the greater the reductions in uncertainty, provided the information is positive, the higher the valuations will be.
A major question to consider is whether this principle should apply whether the money is actually transferred or simply committed by the founders or owners. The availability and “commitment” to fund can be a fundamental prerequisite for proceeding with a project. Founders need the confidence that the projected funds necessary to create the product or service will be there.
Likewise, “effort” in the form of sweat-equity, if recognized as an in-kind contribution, is worth more when expended at an earlier stage. There is a significant risk that if the project is canceled, those efforts will have no return to the contributor. This creates an opportunity cost. This is the value of what that time and effort could have produced but didn’t because you made this investment.
All of this relationship must be formally documented to reduce the possible risks.
- The physical contribution of money, the “irrevocable commitment” of funds, and the effort of sweat-equity can be treated as Capital Contributions and reflected as such in the Cap Table.
- Formal agreements must specify the magnitude and timing of the committed contribution. They should delineate how the commitments are to be made and altered. The time value of money concept (outlined above) indicates that any revision of funding commitment at a later date may be different than it would have been initially. This creates a potential need to revalue the company before such an event is transacted.
- Similar documentation can be created to specify the value, timing, and results of imputed sweat-equity. It should be noted that sweat-equity creates tax consequences for the contributor since it is treated as if they had been paid for that effort.
The way a company treats the contributions of founder Money, Commitment and Effort is a critical concept in the formation of a company. It not only identifies the initial company valuation, it also establishes the fundamental relationship between the owners. These factors affect the way in which potential future investors will view the company.
