'Startup' enterprise software application, question about ownership between investors and developers

Over the past four years, my business partner and I founded a company that is planning on selling B2B software. We have been paying the developers to create the software, thus keeping full ownership. There have been a couple investors to keep us afloat for the time being, buying approximately 1% ownership for every $10,000 invested.

We are currently transitioning from our one developer, who was getting paid an hourly rate, to two new developers, who are working nights and weekends for ownership incentive.

Both developers are currently making right around $90K at their full time job. I was thinking that we could use an hourly rate that is somewhat equivalent to their salary rate, and then for every $10,000 worth of work, they would get 1%. Does that seem fair? If not, any ideas on how to structure it? An added benefit to the situation is that if they can get this company off the ground, both will be in position to be the lead developers of our company when this thing takes off.

The application, while functional, is in a very bad state code wise, and these two developers are putting in roughly 20 hours a week to clean everything up and getting it to an installable state. So while they aren't taking much risk at this point, they are key players in whether our company makes it or not.

The bells, the bells... Ok lets just get the alarm bells out of the way first. Your company is based entirely on an application that you and your developers have been developing for years and it is still in a 'bad state' and not yet released. You've valued yourselves at $1 million. From the information you've provided that just doesn't make any sense (hint: it's too high).

Is it fair... Lets say for a moment that your valuation is sound, and your developers buy into this valuation. That being the case, you could go for straight equity as payment. But it's not really about what is fair, it's about what the developers will take in exchange for their time. And that all depends on how much they belive that this company will get off the ground.

Do they want equity? Do they understand that they'll probably not see a dime for years, if ever?

Get the MVP out... If they are happy with that valuation, and happy being paid in stock, then you've surely got enough resource to get you a minimum viable product (have you read The Lean Startup yet?) and you'll still have a big chunk of equity.

Now read Joel's comprehensive answer on company ownership...

edralph,

I would have directly responded to your question, but my response was a little long winded. See below:

Current Market (The bells, the bells): The valuation we have used has been purely based on the potential market (as well as the $250K my business partner invested for developer salary), not necessarily the current state of our application. I won’t go into too much detail, but basically there are only two major players in the market. The market leader has old software, and is stuck with their current offering. The other major player (which was bought out 3 years ago for $45 million) just launched a web based version of their product and it bombed. Therefore, the market is ours for the taking.

Buy In (Is it fair): Both developers see the huge potential within the market, and I would say both are confident it’s not a matter of ‘if’, but a matter of ‘when’ (B2B sales cycles are never very quick). Both are fully aware that equity would not pay out for many years.

MVP (Get the MVP out): While the code is in bad shape, I think it’s only about 2 months away from being cleaned up and completely finalized. The core functionality is all there, it’s just a matter of doing some cleaning and refactoring. The hard part about the industry is it needs to be fully featured, fully functional to sell to the companies we’re targeting, hence the 4 years in development.

So in conclusion, the proposed equity incentive wouldn’t be insulting?

It's common for early-stage people to be compensated with equity. However, they might prefer to get stock options -- if you're paying them X shares, and claiming that those X shares are worth $10,000, then they will have to pay tax on $10,000. But, the IRS doesn't take shares, so they'd have to come up with ~$3K in cash to pay the taxes on that $10K. Stock options get around this problem.

Alternatively, you could give them deferred cash compensation that hinges on the project being completed and sold -- see an attorney about that because, if you don't do it right, the deferred cash would be immediately taxable to them PLUS a 20% penalty.

Note that you haven't said how your company is organized -- if it's a traditional startup, and the investors received Preferred Stock, then their shares might be worth a lot more than the common stock that your programmers get.