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    After the Equity Split: Compete or Non-Compete

    By Matt Rossetti

    Original article written for SlicingPie.com

    One of the often-overlooked features of the Slicing Pie model is the logical outcomes regarding a person’s ability to compete with the startup after a separation. Getting a fair deal for everyone is more than just splitting equity correctly.

    In any company, there are four basic conditions under which a person can be separated from the firm:

    1. He or she can be fired for good reason
    2. He or she can be fired for no good reason
    3. He or she can resign for good reason
    4. He or she can resign for no good reason

    These are universal conditions, although they have different names in different places. In the UK and Europe, I often hear the terms “Good Leaver” for conditions B and C, and “Bad Leaver” for conditions A and D. I also hear fired or terminated for cause or no cause. Use whatever language works, the important thing is that different separation conditions have different logical outcomes when it comes to fairness. The outcomes should always do two things:

    1. Reflect the fair market value of each person’s contribution. This is their “bet.” Bets are always worth what they’re worth, they don’t have special powers.
    2. Align everyone’s interests so that each participant has incentives to act in the best interests of the business. No person should ever be given an incentive to act selfishly or greedy.

    You can read what happens to a participant’s slices here, but when it comes to whether a person should be free to engage in direct competition with a former employer, it breaks down like this:

    If a person is fired for good reason or resigns for no good reason, he or she should not compete with the company or solicit employees. This removes the incentive to deliberately undermine the company’s activities. For example, it wouldn’t be fair for someone to work for a startup during the proof-of-concept stage only to quit and start his or her own company once the business model is figured out.

    Conversely, if a person is fired for no good reason or resigns for good reason, the company should not take any action that would hinder the person’s right to engage in competitive activity. The company can, of course, enforce patents, trademarks, copyrights and trade secrets including in-process innovations, customer lists, and other confidential information. For example, it wouldn’t be fair for someone to work for a startup during the proof-of-concept stage only to get fired once the business model is figured out and then preventing him or her from applying his or her skills and knowledge to a new company.

    Enforceability

    Of course, companies ask employees to sign non-compete agreements all the time and enforceability varies in different states and countries. According to Slicing Pie lawyer, Matt Rossetti: “Non-competes are a severe restriction on commerce and an individual’s ability to make a living. Because of this, the prevailing trend is to limit or bar the enforceability of non-competes.”

    But legal isn’t the same thing as fair. It’s important to adhere to what is fair, even if local laws provide opportunities to act unfairly. Just because you live in a place where a non-compete isn’t enforceable doesn’t mean it’s fair to do so.

    (I should note, however, that breaking the law should always be avoided.)

    The Fair Logic in Action

    Merrily and Anson start a lemonade stand and developed a special secret formula for making lemonade.

    Scenario One: Anson slacks off on the job and, after two clear warnings, he is fired for good reason. It would not be fair for him to open a competing lemonade stand. If he wanted to be in the lemonade business, he should have corrected his behavior.

    Scenario Two: Merrily decides she no longer needs Anson, so she fires him for no good reason. It would be fair for Anson to start a competing stand. If Merrily did not want this, she should have thought twice before firing him for no reason. Anson may not steal the secret formula or any other intellectual property, but he is free to come up with a new formula and go into business.

    Scenario Three: Merrily decides they are going to sell kittens instead of lemonade. This is a different business, so Anson would be able to resign for good reason and, as in Scenario Two, would be free to start a lemonade stand. This probably won’t bother Merrily because she abandoned the lemonade concept, but Anson still can’t steal the secret formula. In this case, it would probably be more practical for Merrily to quit the lemonade stand, but she may want to return to selling lemonade, so she wants to retain the trade secret.

    Dealing with Ideas

    The next two scenarios are common sources of founder disputes because they deal with the idea upon which the company was founded.

    Scenario Four (it starts getting more interesting): Let’s pretend that during the planning stage for the business Anson invented the secret formula. Merrily decides she no longer needs Anson, so she fires him for no good reason. It would be fair for Anson to start a competing stand. Anson may not use the secret formula even though it was his idea. The company owns the intellectual property (IP) he developed on the job. Anson will have to come up with a new formula to go into business.

    The key legal concept here is called an assignment of rights or work made for hire. Slicing Pie logic assumes an assignment of rights. But all startups should have an assignment of rights contract or at least a clear policy in place.

    Scenario Five: Let’s pretend that Anson invented the secret formula prior to starting the business with Merrily who agrees to treat the formula as a trade secret. Merrily decides she no longer needs Anson, so she fires him for no good reason. It would be fair for Anson to start a competing stand. But this does not necessarily mean Anson can extract his IP. In this case, Anson’s rights would be defined by the license agreement he has with the company. If the license agreement was exclusive, he could not use it for his new company, but he would continue to receive the fair market royalties as allocations of slices or cash. If the agreement was non-exclusive, Anson could license the IP to his new company.

    Sadly, many founders with pre-existing IP don’t put an agreement in place with the new company. If you feel that you substantially own documented IP upon which a company was founded, it would behoove you to engage an attorney and do a licensing deal with the newly-formed company. This applies to trade secrets, patents, trademarks, and copyrights.

    If the fair market value of time and materials were included in the Pie, it should be treated as a work made for hire and the IP would assume to be owned by the company. The owner of the IP should decide, in advance, whether developing the IP was an independent act or simply part of his or her role in the business. In most cases, a person should be able to get slices for time and materials and a royalty.

    Startup companies are always changing, but Slicing Pie always delivers an objectively fair deal to participants.

    Aligned Incentives

    Adhering to the competition logic in Slicing Pie employees think twice before slacking off or quitting and startup managers think twice before firing someone or breaking commitments (which provides good reason to resign). People are free to make their own decisions with full knowledge of the logical consequences that will result. Any agreement that goes against this logic will provide opportunity for one party to benefit at the expense of the other—that’s not fair!

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    The Truth about Slicing Pie

    Originally Published on Forbes.com here.

    Overcoming The Misconceptions Of Dynamic Equity

    By Matt Rossetti

    These days, most startup attorneys I meet have at least heard of the slicing pie model for equity distribution, but many have yet to use it. There are a few common misconceptions that cause them to steer clients away from slicing pie toward more conventional equity split models. In this article, I will address a few of the common concerns and hopefully dispel them as myths.

    Dynamic equity is not Impossible

    When I first learned about slicing pie I was, like many of my peers, skeptical of its promise to not only deliver a fair equity split but to also provide a framework for avoiding common equity disputes. I was fortunate to meet the model’s inventor, Mike Moyer, who referred a few clients and encouraged me to develop a legal solution. Since then I’ve done over 1,000 consultations on the model and it has become my default recommendation for equity distribution in bootstrapped startups.

    Before trying the model, I found that no matter how carefully founders planned, at least 50% of them had a dispute over their equity split that required legal intervention within the first year or so of formation. Many of my colleagues who serve early-stage companies are all too familiar with this exceedingly common problem. In my experience, the slicing pie model has virtually eliminated equity disputes among founders and problems that do arise can usually be addressed within the framework.

    There are three basic areas of concern that prevent attorneys and founders from applying the model: concerns about future issues, concerns about implementation and concerns about non-compliance with the model.

    1. Concerns About Future Issues

    Teams often express concerns about future issues that may arise, especially when it comes to how the model is perceived by third parties such as investors and taxing authorities. The fear is that future investors will view the model as too ambiguous or complex and that it might trigger undesirable tax events.

    Having seen companies using the model grow and move through multiple funding rounds, I have yet to encounter an investor who takes issue with the model or cites it as a reason to pass on an opportunity. On the contrary, the idea that each founder is entitled to equity in proportion to their contribution is usually viewed in a positive light by investors, especially when they explore the underlying logic and cut through the perceived complexity.

    A key point to consider is that not all resource consumption garners a higher valuation. For example, a company that hires a janitor to take out the trash for $20 an hour and 10 hours per week did not just become $4,400 more valuable. Similarly, since the model terminates before any major financial transactions that require a valuation, tax consequences are about the same as any other model.

    2. Concerns About Implementation

    The slicing pie model requires a tabulation of the fair market value of the contributions from each participant. The prospect of tracking these inputs is often distasteful for founders who relish freedom from the structure of corporate life. In practice, the model simply accounts for transactions that most companies track as a matter of course. For instance, most successful companies track payroll, expenses, sales, investments and other financial activities. A key difference, however, is that most monitoring systems are based on financial transactions and most founders do not feel the need to track non-financial events such as not getting paid or not getting reimbursed for expenses. Unfortunately, the absence of this discipline can skew the teams understanding of their own business model. Once teams understand how important this activity is, this concern is no longer a hurdle to implementation, especially given the availability of tools to manage slicing pie record keeping.

    Other implementation concerns focus on the conversion of the slicing pie hypothetical split into actual ownership of shares or membership interests in the company. This process, from a legal standpoint, is quite simple and often occurs in the context of a structural change in the organization as it matures or takes on professional VC funding. Once the shares or membership interests are formally issued, they are subject to more conventional terms set by management or the angel or Series-A investor.

    3. Concerns About Non-Compliance

    The last major area of concern deals with a series of what-if scenarios. For example, what if a participant reports more time than they actually spend. Or what if someone demands a set percentage of shares. Most of these fall into the category of management issues, rather than an issue with slicing pie. For instance, a person who is unproductive or dishonest will eventually be terminated for good reason and the model will impose logical consequences. The slicing pie model allows managers to make rational business decisions and provides protection for all participants.

    The other form of non-compliance, which is more difficult to manage, occurs when a participant attempts to renegotiate the terms of the deal in their favor, usually by holding the company hostage. A recent example from my own practice was a CTO who shut down the company’s software product and email system unless he was granted a fixed equity stake in the business. Sadly, this scenario is not completely uncommon under any framework and usually represents a situation in which one person overvalues their own contribution while undervaluing the contributions of others. Slicing pie’s alignment with fair market values most certainly mitigates this risk, yet some egos don’t respond well to logic. In my experience, a frank, lawyer-to-lawyer discussion can disarm what could otherwise be an explosive situation.

    In spite of what you may or may not have heard about the slicing pie model, the most common misconceptions can be easily addressed with a concerned client. The benefits of implementing the model far outweigh any perceived problems and going with conventional methods carries far too much risk. I highly encourage anyone who counsels early-stage companies to familiarize themselves with the benefits and help clients to implement so that they can avoid the common pitfalls of unfair equity splits and the infamous founder’s dilemma.

    If you are interested in using a dynamic equity framework to fairly distribute equity to your startup team, please contact us today via email to [email protected] or by phone at (312) 650-9087.

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    Matt Rossetti – Five Reasons an Attorney Should be Reviewing Your Business Documents

    Don’t just do it yourself! Here are 5 reasons to hire an attorney including commentary by the founder of Sentient Law and Forbes Legal Council Member, Matt Rossetti.

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    Matthew Rossetti: When should your startup consider consulting an attorney?

    Check out responses to this question from the Forbes Legal Council, including one from the founder of Sentient Law, Ltd., attorney Matthew Rossetti, here.

    Matthew Rossetti