Internal allocation of shares

The only way to achieve harmony within a founder team is to distribute founder shares equally, ideally right at the onset of the venture. None of the other terms commonly found on an investor term sheet can achieve this harmony within a founder team. Discuss this statement, illustrating your answer with details from any of the cases studies in class, and with reference to the sources on the reading list.

The statement that a founder team needs to distribute founders shares equally is an emphasis on equality. However, equality is not justice. Equity is justice, where everyone is rewarded proportional to their work and given what they need to be successful dependent on their individual circumstances. How can it be fair that one founder who has worked twice as hard, spending twice as much time whilst also investing more of his own hard owned cash be rewarded the same as another founder who has only invested a little in terms of time and finances. In fact, in this situation, an equal split will only make the founder who has invested more resent their colleague for being rewarded the same for less work. Consequently, it is absolutely unjust to distribute equally if there have been different contributions to date. Furthermore, Da Rin and Hellmann (2017) emphasise the importance of considering both future and past contributions when deciding internal allocations between founders.

Additionally, Nobel Prize winner Holmstrom discusses the importance of incentives and asserts that the most productive members should have the largest allocation to provide the largest incentive to perform the best (Da Rin and Hellmann, 2017). Whilst this is logical in terms of maximising performance and productivity in the firm, it may not be the best at achieving harmony. Productivity is a subjective measure as it is difficult to determine how much future contributions will contribute to performance. Furthermore, it only considers future contributions as historical demonstrations of productivity does not necessarily mean that those same founders will be as productive in the future and historical productivity does not have an impact on future performance. The argument for incentives based on productivity is based on optimising allocations to maximise performance of the firm, but it assumes that founders will be satisfied with their allocations considering it may not consider their previous contributions. Humans are emotional creatures and do not always act rationally to maximise performance and growth, and this is best demonstrated in the sunk cost fallacy where previous investments affect future decisions. Resultantly, if the founders were all equally invested in maximising the future performance of the firm and this was their fundamental objective then, optimising by future productivity would be the best method of allocation. However, this is often not the case, and founders with reasonable justification want to be rewarded for their past contributions.

It is important to consider different contributions from the founders in the past and the projected contributions in the future when making internal allocations. As long as this can be discussed openly with honesty and trust amongst the founders then this can achieve the highest level of trust and harmony. For instance, Bharat did not want to give it up his PhD in the Workhorse case study and was willing to accept half the salary to do this when negotiated. The other founders understood and accepted. If it was not discussed there could have been more friction if Bharat was being paid equal whilst continuing his PhD as other founders would feel they have made sacrifices whilst others have not. Furthermore, there are other terms in the term sheet that can help achieve harmony and mutual satisfaction such as vesting of founder shares. This means that founders have to earn back their shares which can be dependent on how much they contribute in the future. This allows founders to be satisfied that they will be rewarded proportionally to how much they contribute which also provides incentives for productivity. However, it is also important to adjust for previous contributions in terms of time and money.