Equity is not Monopoly Money

by Coach Davender on July 20, 2014

I’ve met more than a few startup entrepreneurs who consider their idea to be the next billion-dollar sure bet, and who propose equity in lieu of cash to their new team members and to the professionals who provide them services.

At the beginning stages of a startup, cash is precious, yet there is so much to be done. Bartering services for stock can seem like a effective way out of this situation, however if the founders are not careful, it will cause many more problems down the road.

What is equity?

Equity is a percentage of shares in the company. As a startup, equity is worth very little, because no outside money has been put into the company yet (money that the founders invest in the company basically doesn’t count). Equity is granted to people other than founders in two ways: as stock options (the right to purchase a certain amount of stock at a specified price at a future date, called a “vesting period”), or restricted stock (which gets paid on exit after those who hold preferred stock, which is reserved for external investors).

A certain amount of equity (15%-20%) is reserved for employees, this is called the “option pool”. The value of the equity depends on many factors, including how much money has been invested by external funders (seed, friends-and-family, VC, etc), and how much debt the company carries.

I’m not a lawyer, however I’ve seen (and personally experienced) enough situations to provide some guidance on this complicated subject:

1. Giving equity is a promise, a commitment, and a responsibility

The moment you give equity to someone, you create a permanent connection to them. Whether or not the stock or options they hold give them a direct say in your startup, they can make a lot of trouble for you if their priorities are not aligned with yours. In particular, make sure they understand fully what they are getting into by accepting your offer of equity (including tax liabilities), and make sure you are comfortable with the idea of having to explain to them why your startup is not making them rich, especially when the going gets rough.

2. Equity is not to be given, it should be earned

Equity, either in options or restricted stock, should be only given to those who contribute in some fundamental way to the success of the startup, and only after a certain period. I’ve seen too many startups give equity to the first people who come on board, hoping they will become “co-founders”, but who leave (or are kicked out) soon after. The problem is that these first ex-employees now have equity which is difficult to take away from them.

Always have a vesting period to see if the new team-member is a good fit, to see if they are able to contribute meaningfully, and if they are really committed to the project.

I highly recommend the book “Slicing Pie” for a complete description of how to create a system where founders’ equity goes to the right team-members in the right proportions. (Also see the video at http://www.slicingpie.com).

3. Service providers should never receive equity

You need legal and financial help to get your business started, however you probably don’t have the money. Some lawyers and accountants may accept equity as consideration for their initial services, in the hopes of “locking” you in for the long term, where you will need more of their services and you will be able to pay cash.

There are two problems with this:

- You will need many service providers during the lifespan of your project. The lawyer you use for incorporation will not necessarily the best one for your intellectual property, funding rounds or your overseas expansion. I suggest starting out by hiring (for cash) an inexpensive solo-practice lawyer to do a basic incorporation, and as you grow, sooner or later you will need to get the paperwork redone.

- The practice of service providers who accept equity in lieu of cash for their services raises some sticky ethics questions, especially for lawyers and financial consultants. They could be in a conflict of interest if it is alleged that the advice they provide was biased towards increasing the value of their equity so they can cash out earlier, instead of being in the best interest of the client and of the business.

Having your lawyer, your accountant and other service professionals in your capitalization table does not provide a favorable impression to seed investors and VCs.

4. The more people you have in your cap table, the harder it is to raise money

Your “capitalization table” is the document which shows who owns how many and what kind of shares and options. Your first external investor (seed or super-seed) will want to only deal with a limited number of shareholders.

Also, depending on the type of incorporation, you may run into problems with your provincial, state or federal securities laws if the number of shareholders exceeds a certain number – for example, in Quebec, if you have 50 or more shareholders then you no longer qualify as a closely-held corporation and the annual reporting requirements become a lot more expensive. Fifty shareholders may seem like a lot, but consider if you are getting money from family to keep your project alive, and you have team members who are coming and going, you can reach that number pretty quickly (the “worst” case I’ve seen was a startup with over 40 shareholders who had raised a couple of hundred thousand dollars over the years)

5. Don’t give equity to family

Family money is a dangerous source of capital, because it comes with emotion. Can you face Aunt Betsy when you tell her that her retirement fund is wiped out because the stocks she bought in your startup are worthless?

Instead of equity, consider negotiating personal loans with interest and deferred payments of capital, or convertible notes (loan to be converted to equity at a fixed amount when you receive an external investment of a certain amount).

6. Equity is not free money

The bottom line is that equity is not free money that you can hand out. The hard reality is that your startup will most likely fail. Keep the circle of people who hold equity in your startup small and select – in this way the people who count will take as much responsibility to make your startup a success, as they will take responsibility if it flames out.

Standard disclaimer: I am not a lawyer – just an entrepreneur who has learned this the hard way. Please check with qualified counsel before taking any action on this subject. And pay them cash.

 

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Dearest Correspondent –

I appreciate the anxiety you must feel for not having seen a response from me to your recent e-mail, voice mail, Facebook message or status, tweet or Twitter DM, LinkedIn message or update, Skype message, text, SMS, iMessage, wink, nudge or semaphore.

The purpose of this message is to provide context as to my lack of any sign of activity.

Reason 1: Any mode of communication which does not redirect to my inbox, I probably ignore.

If you left a voice message, it gets forwarded to my e-mail so you’re good there.

Reason 2: Which e-mail address did you use?

As to which e-mail address to use, it all depends. I have a main address and a special address I give to close associates. Messages sent to these addresses end up in my main e-mail box. I also have a huge number of aliases, disposable addresses and dead-end mailboxes I give to sites who insist I log in or newsletters or retailers or other commercial entities who want an e-mail address to do business. If you are using an address other than my main address (which is different than the main address I used a couple of years ago), then it has probably fallen in the cracks between mailboxes.

Reason 3: You may have been assigned an order of precedence.

The order of precedence in which I respond to messages is as follows:

  1. My biggest paying client (…who provides me with half of my yearly revenues. That’s why they’re at the top of my priority list.);
  2. My other paying clients;
  3. Direct inquiries from people or organizations whom I am targeting to become paying clients in the short to medium term;
  4. People I already know and with whom I want to keep a strong connection (which includes cute and smart women, interesting people, or people who can introduce me to cute and smart women or interesting people, not necessarily in that order, or maybe it is);
  5. Past clients who have moved on and who still keep in touch (maybe they should be at #4, and if they are cute and smart, they already are);
  6. People I don’t know but whose message is interesting or intriguing (tip: it’s your subject line);
  7. (a big gap)
  8. Invoices;
  9. Automated reminders;
  10. Messages from the government;
  11. People I don’t know who send me notes which read like spam, unsolicited e-mail, have blank subject lines, start with “Dear Mr. Or Mrs.”, from barristers representing millionaires or royalty and who need my help to get funds out of the country, or other communications which should be automatically filtered out.

Reason 4: I have better things to do than respond immediately to e-mail.

I am a very busy boy. And to appear busier, I may sit on a message for a while before responding. After all, if I respond to all messages equally and instantaneously, how busy will you think I am?

Reason 5: I’ve been working on a response.

I may have been thinking of a witty/insightful/inspiring (pick one) response and it’s not quite ready yet. Or your message got me so steamed that I’ve been rereading it, figuring out how to get back at you.

Reason 6: I may have started a response but was interrupted.

So that’s why I have so many unfinished – SQUIRREL!

Reason 7: I am Facebooking.

Reason 8: My eyes can’t stand the computer screen any more.

As I get older, I find the hour at which I want to turn off the screen gets earlier and earlier.

Reason 9: Your message has dropped off the first page.

I have set my e-mail reader to show the latest 200 messages, which is about a couple of days. I’m too intimidated by the backlog to go to the second page.

Reason 10: Your message got caught in my unread purge.

Once every few days I do a “select all / mark all as read” to get rid of that pesky unread badge. If it is really important, you’ll send me a reminder anyways, right?

Hope this clears up any misunderstandings. And if you happen not to respond to this reply, I won’t take it personally.

Sincerely,

Davender.

 

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Image credit: Stephen Rees via Flickr
Direct link: https://flic.kr/p/9UWkKp
Used under Creative Commons licence

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The measure of a successful validation: Surprise

by Coach Davender on February 12, 2014

The typical market study or validation process suffers from a fatal flaw: the entrepreneur is looking for data that proves he is right.

But are you looking for validation, or reassurance?

Too often people approach market research looking for clues to support their idea. The problem with this is that it is too easy to skip over important signs that the idea is not the right one, or needs to be refined in order to maximize its impact and its chances of success.

The real purpose of the idea validation process is insight – discovering something you didn’t know that you didn’t know. This means that your market study efforts should challenge your assumptions and hypothesis, attempting to disprove them.

Producing data that shows you’re right is easy. And if you base your business on just that level of analysis, then reality will disprove your assumptions and hypothesis for you, costing you big bucks. You want to uncover the hidden bombs before they blow up in your face.

You’re on a hunt to strip away the layers of mediocrity around your idea to find the diamond within. Because life’s too short to build something that’s just meh.

 

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