No Free Ride For Free Riders
Here’s what I love about today’s guest post: it’s about the Free Rider Problem that happens in entrepreneurship. It’s a problem no one talks about, but every entrepreneur will experience at some point or another. Whether you join another entrepreneur, or one joins you.
The bottom line: there is no free ride for free riders. Mike has had a lot of experience with this issue, so if you are even thinking about starting up with a partner, it’s a must read beforehand:
No Free Ride for Free Riders
Of all the plethora of popular economic concepts, none is more aggravating to the hard-working entrepreneur than the free rider problem. This occurs when someone enjoys the benefits of an activity without paying for it or, in the case of a start-up company, without working as hard as others. Of course, this is a problem in all aspects of life, but especially poignant when a start-up team member, having received equity compensation, reaps the benefits of a liquidation event even though their contribution to the company’s success was smaller than the others.
The free rider problem is prevalent in start-ups because we lack a model for allocating equity to the right people at the right time. The right people would be those who participate in the success of the company, the right time would be when they actually make their contribution.
The Fixed Equity Split Model
Most start-up companies use a fixed model to allocate equity to founders and early employees. In this model equity is doled out to members of the team based on what the founders think the other team members will produce based loosely on past performance and promises of future commitment. This method is widely used, yet fraught with danger when founders are forced to renegotiate equity splits when changes occur as they inevitably do in a start-up company.
For example, three founders with similar backgrounds and abilities decide to start a company and split the equity 1/3 each. One founder works hard, the next founder works really hard, and the third founder slacks off (our friend the free rider). The first two founders will eventually get tired of the behavior and attempt to renegotiate the equity split with the third. To make matters worse, there is an imbalance of effort between the first two founders creating a very awkward negotiation to say the least.
The Dynamic Equity Split Model
The solution to the free rider problem in start-up companies is the dynamic equity split model. A dynamic model allows for changes that occur during the early stages of a company’s life and allocates equity based on the contributions of each participant. Using this model, for example, the person who makes 25% of the contribution will ultimately receive 25% of the reward when it comes.
To use a dynamic equity split managers track the various contributions from participants. Contributions include not only a value for time, small investment, intellectual property, equipment and supplies, but also a premium for risk given the likelihood individuals may not get paid. A Grunt Fund is one such model. It applies a theoretical value to the various ingredients. Because start-up equity has virtually no value, a theoretical value allows managers to make meaningful calculations with regard to the contributions of the team.
Although a dynamic equity model is intrinsically fairer to participants, fixed equity splits will continue to be the norm because
1) dynamic models are a relatively new concept and
2) fixed models allow experienced entrepreneurs to take advantage of less experienced entrepreneurs.
For more information about how to create a dynamic split model for your company visit www.SlicingPie.com.
Mike Moyer is the author of Slicing Pie, a book about dividing up equity in early-stage companies. He is an entrepreneur who has started a number of companies including Bananagraphics, a product development and merchandising company, Moondog, an outdoor clothing manufacturing company; Vicarious Communication, Inc, a marketing technology company for the medical industry; Cappex.com, a site that helps students find the right college; College Peas, LLC which provides publications and consulting on college admissions; and Trade Show Samurai, LLC a company that teaches trade show exhibitors how to capture lots and lots of leads. In addition to his experience as an entrepreneur he has held a number of senior-level marketing positions with companies that sell everything from vacuum cleaners to financial data services to motor home chassis to luxury wine.He has taught entrepreneurship at both Northwestern University and the University of Chicago. Mike is the also the author of How to Make Colleges Want You, College Peas and Trade Show Samurai . He has an MS in integrated marketing from Northwestern University and an MBA from the University of Chicago. He lives in Lake Forest, Illinois with his wife, two kids and the Lizard of Oz.