Equity Sharing 101 for Startups
Guard: “The warden would like to make a little investment in your production.”
Bloom: “Tell him he owns 50% of the show.” Last scene from The Producers (original version)
So, another week has passed and I am reflecting on the content of meetings with new clients and prospects. Not surprisingly, equity sharing techniques were discussed at virtually every gathering. I still find it amazing that most of the focus on this subject is about form (options, restricted stock, etc.) or tax consequences and very little on the true substance of allowing someone the privilege of sharing in ownership. I have blogged about being careful as to the timing and amount of equity sharing and these discussions tend to bring me back to this final scene from another of my favorite Mel Brook’s movies. So, here are five key thoughts you might want to keep in mind as you consider sharing equity in your startup:
- Use an organization chart. Even though you may have a number of spots which are “TBD”, you need to make your best guess as to who you want to reward now and in the future. Consider owners and their role. If you designate one of the owners as a CFO because they have one business course and will not cut it in the long run, provide for that eventuality. Some diligent consideration here will pay off in the long run.
- Have a plan. Any type of equity distribution should be clearly communicated and be understood as part of the overall compensation of an individual. We see too many people who make commitments, which at times, are in shares and, at times, in percentages which creates pure havoc when it comes time to execute the underlying documents. It is wise to use some of those scarce resources on professional advisors and get it right.
- Value equals stage of development. This makes sense from both a logic and tax perspective. If an entity is in the very early stage and you want to reward people, the concept of founders’ stock is a wise choice. However, for that person who joins you sometime later when, perhaps, the idea has been validated, you have a minimal viable product and are starting to get traction, using a founders’ shares valuation does not make sense. For example, if you are using stock options, pricing these latter options at founders share prices is both unfair to those who began with you as true founders and also creates tax problems as you are granting someone ownership rights at a price below the current fair value of your business. That is a no-no.
- Vesting is good. The standard vesting scheme today is 25% at date of grant and the balance in equal amounts over the next four years. In addition to retention, vesting allows you to address on a timely basis that “owner” who you subsequently find out does not quite fit in.
- Your stock book is not a checkbook. As I have noted many times before, you should be protective of what may become your most value asset – the equity in your business. Using it to reward people because of a cash shortage is not the right answer. Notes and deferred payment plans in situations like that trump equity every time.
So, please keep some of these thoughts in mind as you begin your startup journey and consider sharing equity in your business. Doing so can help avoid much more cumbersome and complex problems later on. And remember, keep innovating!
