I received this interesting detailed question from the ask me form on my website. I’ve decided to answer it here. I think my answer might be useful for others with similar questions. I’m putting the question in quotes, paragraph by paragraph, and adding my response directly where it comes in the question. 
It starts like this:
A person ‘X’ owns 15% stake in a startup company – not by investing money but purely by virtue of having dedicating hours for building a product for the company. No salary was to be paid as per an initial agreement. The 15% stake was deduced by a simple calculation: (value of company) / (number of hours worked) x (dollars per hour).
Was it clear in the initial agreement that the formula here was to be used in future buy-sell transactions? Was that agreed to by all?
The question continues:
The value of company is therefore, sum of [(number of hours worked) x (dollars per hour)] and [hard cash invested by a person ‘Y’, also taking into consideration year-on-year appreciation of this hard cash]. Lets call that VC.
No, it’s not. The value of the company is what somebody pays for it when they buy it. And if nobody is buying it, then the value of the company is an estimated value. There are lots of formulas for estimating it, and estimates will vary widely. I’ve got more on that below, in my specific recommendations.
However, it could be valued like you propose, for purposes of a buy-back transaction, if there was a buy-sell agreement that set that formula in the beginning. That’s if and only if. Issues like these are the reason experts recommend that partners and cofounders talk about the eventualities and agree, before the business starts, on how they’ll be handled. You have to agree beforehand or you’re stuck with arguing and negotiating the valuation afterwards. And when you try to pull it apart afterwards, without the benefit of an agreed-upono buy-sell formula, then many formulas might apply.
And here’s the heart of the question:
The company is not profitable yet. Person ‘X’ decides to give up his 15% stake of the company. My questions:
– How much is ‘X’ entitled to receive as the value for 15% stake?
– Calculating backward, would X receive as much as [(number of hours worked) x (dollars per hour)]?
– How does this change if the only buyers of the 15% stake are also two other stake-holders within this company, one of them by virtue of cash invested in the company, and the other by virtue of hours spent working for the company?
Normally, unless otherwise specified, owning 15 percent of a company means you own some shares that amounted to 15 percent of the total shares issued when they were issued. Ownership privileges are defined in company documents. You might have a seat on a board of directors, or not. You might get dividends when that’s relevant. And you’ll be able to sell those shares subject to securities and exchange regulations.
Just hypothetically, as an example, say you agreed two years ago that you got 15% because you had put $15,000 worth of work on it for free and the founders agreed then that it was worth $100,000. If it’s launched and very successful now, with sales of $1 million annually, then it’s worth something like one or two times revenues, less a discount for debts, less a discount for not being liquid. In that case your 15% is worth something like $100,000. On the other hand, if it launched, has no sales, no profits, and has spent all its money, then your 15% is worth about zero. Companies are almost never worth a formula based on hours worked.
So unless you have that buy-sell agreement stipulating the formula you’re using, then it doesn’t apply. Here’s what I recommend.
- Agree on an estimated valuation. The formula you’re suggesting seems like it might be one-sided and self-serving. Good luck with it because it’s going to be hard. Expect disagreements. Depending on how much money is at stake and how severe the disagreement, you might need to work with an attorney and a valuation expert you can agree on. Here are some posts on this blog about valuation. This one is particularly relevant: 5 things business owners need to know about valuation. Sales, sales growth, profitability, and scalability and defensibility make it worth more. Debt, and not being liquid shares, low growth, and losses make it worth less.
- Take 15% of that valuation and negotiate with your cofounders based on that value. I hope for your sake and the sake of your cofounders that things are going well for this business and they’re happy to buy you out. If they aren’t, then you’ll have to keep discounting until you get to an amount they’ll pay you. Or just keep your 15% of the shares, stop working for the company, and hope that someday they’ll be worth something.
The moral of the story: please, the vast majority of business marriages (partnerships, startups with founders, etc.) end in divorce. Do a business pre-nuptial agreement, which is what they call a buy-sell agreement.
Greatly appreciate your response and all your help!
if they agreed to 15% for idea generation and number of hours worked in building the product, so that means the 85% that the vc owns is the amount of hours the money could support in the company.
i think 15% was a bit too low, he should have got 40%
Chris, respectfully, your addition here is baffling to me. We have absolutely no information to second-guess the initial 15%. We don’t know the business or the idea or the valuation on which that was based or what contributions from the other parties. All the question gave us was that all parties agreed on the initial 15%. The question is anonymous. You have no information beyond what’s shown here. On what basis could you possibly say it should have been 40%?