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Equity is not Monopoly Money

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.

 

For more information

Must Read:

Slicing Pie
http://www.slicingpie.com

Some articles on this topic which I’ve found in my Evernote Web Clippings

Cash? Equity? How should a startup pay its attorneys? (Venture Beat)
http://venturebeat.com/2010/11/22/cash-equity-how-should-a-startup-pay-its-attorneys/

Equity Distribution in Startups (Angels Corner)
http://www.angelscorner.com/articles/equity_distribution_in_startups.htm

Why Vesting Is Your Best Friend
http://thenextweb.com/entrepreneur/2013/07/21/startup-founders-heres-why-vesting-is-your-best-friend/

How Paying Your Lawyer With Equity Works (The Neighborhood Entrepreneur – Sophos Law)
http://theneighborhoodentrepreneur.com/how-paying-your-lawyer-with-equity-works/

 

Image credit:
Matthew DeWaal on Flickr
https://flic.kr/p/2gR7
Used under Creative Commons Licence

 

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