What is the Pie Slicing model?
At the start of an entrepreneurial adventure, the partners of a startup often decide to allocate equity based on forecasts. However, the evolution of a startup is rarely linear, making equity allocation forecasts imprecise and impracticable. Traditional allocation models, such as the fixed allocation model, often lead to disagreements and legal disputes.
To remedy this, the vesting schedule model was developed. This model enables equity shares to be released according to predetermined periods or objectives, thus offering a more flexible approach. However, this model remains based on forecasts and is still subject to legal disputes between the partners.
The “slicing pie” or, dynamic equity model proposes a more equitable and evolutionary approach that determines the distribution of equity according to the contribution and risk taken by each individual. Unlike traditional models, equity is adjusted in real time to accurately reflect everyone’s contributions.
This model aims to quantify and fairly reward the risks taken by each individual for the startup’s success. For example, every hour of work or dollar invested and spent by the company is considered a contribution and is translated into a “slice of the pie”, the pie thus representing the company’s eventual earnings. Shares are calculated by taking the market value of the contribution and multiplying it by a factor that reflects the level of risk taken.
It’s important to note that these “shares” are not stocks, but rather fictitious units of measurement of the risk involved. Only when the startup reaches its breakeven point are these shares frozen, and the proportions of equity become fixed.
In short, the “slicing pie” model offers a fair and transparent approach to distributing equity in a startup, taking into account the contributions and risks taken by each individual. This avoids disputes and ensures that, in the future, each party receives its fair share of the profits generated by the company.
How does the dynamic equity model work?
The dynamic equity model is based on the principle of rewarding the risks taken by each individual for the success of the startup. To do this, each contribution is quantified in equity “shares” according to its market value and the associated level of risk.
Typically, these contributions are quantified in terms of money and items. A cash contribution is considered riskier because of the relative difficulty of making it. As such, it is recommended to assign a multiplier factor of four. On the other hand, a non-monetary contribution is generally perceived as less risky, hence the recommendation to use a multiplier factor of two.
Each hour of work is considered a non-monetary contribution and is quantified in terms of the market value of the work provided. Similarly, each dollar invested and spent by the company is quantified in terms of its market value. These contributions are then multiplied by the factor that reflects the level of risk taken by each individual.
Monetary contributions
For monetary contributions, it’s important to specify that it’s every dollar invested and spent that will be taken into account. Indeed, it’s essential to distinguish between money invested in a startup and money spent by it. The money invested constitutes a “well” which does not translate directly into equity shares. Only the actual expenditure of the common fund gives entitlement to shares.
For example, if Alex and Beatrice have invested $20,000 and $10,000 respectively in the pooled fund, and the startup spends $3,000, Alex, having invested two-thirds of the pooled fund, contributes $2,000. Beatrice, having invested one-third, contributes $1,000. These amounts are then multiplied by four to determine each person’s total number of shares. Thus, Alex will receive 8,000 shares (2,000 * 4) and Beatrice 4,000 shares (1,000 * 4). This method allows shares to be distributed equitably according to investors’ actual contributions, without the money invested being converted directly into equity shares.
Non-monetary contributions
For non-cash contributions, such as hours worked, it is necessary to set up a system to record the hours worked by team members. Each hour worked is considered a contribution, but to qualify for equity shares, it must represent a risk. So, if workers receive a salary equivalent to their fair value on the labour market, no risk is perceived, and no equity share is allocated. On the other hand, equity shares are granted to a team member who works without remuneration or at a salary lower than his or her fair value, i.e. the salary he or she would normally have received in another established company.
Fixing and valuing shares
Once the startup reaches its financial break-even point, equity shares are frozen and equity proportions become fixed.
Individual shares/Total shares of all partners = Individual proportion
The individual share may take the form of shares or rights to company profits, depending on the terms of the agreement. This choice will obviously have certain legal implications to consider.
Why might the dynamic equity model be preferable to traditional models?
The dynamic equity model has several advantages over traditional models for distributing equity in a startup.
First of all, as previously mentioned, it allows the actual contributions and risks taken by each individual to be taken into account, unlike traditional models which are based on often imprecise forecasts. This helps avoid disputes and disagreements between associates, ensuring a more equitable distribution of the company’s earnings.
What’s more, the dynamic equity model is flexible and scalable. Equity shares are adjusted in real time to reflect the contributions and risks taken by each individual as the startup evolves. This ensures that everyone receives their fair share of the profits generated by the company. The mechanics involved in keeping track of everyone’s contributions means that companies need to equip themselves with management tools that promote efficient, transparent management.
Additionally, the dynamic equity model avoids the problem of “dead equity”, i.e. equity shares held by partners who are no longer actively contributing to the company’s success. The particularity of the “dead equity” management proposed by this model mainly concerns the period before the shares are fixed, i.e. before the company reaches its breakeven point. During this period, the most common situations of “dead equity” in a young company generally arise when a partner leaves his or her active role in the startup. The model provides for the management of such departures, whether justified or not, as well as cases of departure linked to dismissal, with or without cause. Unjustified departures and dismissals for cause are treated in the same way: they are considered detrimental to the company, and the person concerned loses all his or her shares. On the other hand, in the case of justified departures and dismissals without cause, the damage is considered to have been suffered by the individual, who then has the right to keep his or her shares or ask the company to buy them back.
Conclusion
In short, the dynamic equity model offers a fair and transparent approach to distributing equity in a startup, taking into account the actual contributions and risks taken by each individual. This helps avoid disputes and disagreements between partners, ensuring that everyone receives their fair share of the profits generated by the business.
The model has developed various strategies to meet the challenges faced by startups. We believe that this model is suitable for certain types of startups operating in favorable sectors. It is important, however, to highlight and explain certain legal issues associated with this approach. We encourage you to stay tuned, as a series of articles will be published shortly. Several concepts and questions require further exploration. For example, what happens when a startup seeks outside investment? Could this model discourage some investors?
This article is intended to be informative and does not constitute legal advice. The Propulsio 360 team is here to support and advise you throughout the process. Please do not hesitate to contact us by telephone at 514-558-1201 or by e-mail at info@propulsio360.com.
For an appointment with a member of our team to explore your needs, click here:
Sources:
Todd TAYLOR, “Grunt Funds and You,” Medium, January 24, 2017, online: https://medium.com/@cleantechczar/grunt-funds-and-you-c774b2e3cb59
Maxine CHOW and Deborah GRIFFITHS, “Choosing your Slicing Pie legal structure, FairSquare LLP, April 5, 2023, online: https://www.fairsquarellp.com/choosing-your-grunt-fund-legal-structure/
Luc BRETONES, “Slicing Pie: l’équité en tranche et en mouvement”, Aneo, May 31, 2022, online: https://www.aneo.eu/blog/slicing-pie-equite-tranche-mouvement
Michael D. MOYER, “Slicing Pie Handbook: Perfect Equity Splits for Bootstrapped Startups“, [online], Lake Shark Ventures, Lake Shark, Eureka, 2016.
The slicing pie model: a new era in equity distribution