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:

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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!

Perfect Pitch – Get Your Mechanics Right!

Moses: The Lord, the Lord Jehovah has given unto you these fifteen…

[drops one of the tablets]

Moses: Oy!  Ten!  Ten commandments for all to obey!  From the movie History of the World

 

It seems popular to use lists to convey ideas and 10, for some reason, is the most common number for list content.  I was looking for a more creative way to introduce my list of 10 items to consider for that “perfect pitch” and could think of no better alternative than this scene from my favorite Mel Brook’s film.  Not original, but I think it works.

I apologize in advance for all the sports analogies, but for those that follow baseball, you often hear an analyst comment on a pitcher’s mechanics.  A knowledgeable observer can pick out improper arm motion and other factors in suggesting why a pitcher is effective or not.  Just like a pitcher, I believe there are rules or mechanics to follow which will improve your pitch (and the related results.)  This blog is not about the components of the pitch (you can refer to Withum.com\startup to learn more about that) but about the presentation process.  Again, no scientific data here – just observations from seeing hundreds of pitches over the last 30+ years.  So, here it goes:

  1. Confirm logistics such as number of people attending, time allotted to you and any other relevant data.  Have a back-up plan for technology required for your presentation. Think of it as grooming the mound before you get started with your delivery.
  2. Do your homework on your audience.  What good pitcher doesn’t study opposing hitters and pitch accordingly?
  3. Limit your presentation to one presenter; the one who has the best understanding and is the clearest communicator.  A multi-presenter show which looks like Run-D.M.C. on steroids is not going to cut it.
  4. Good energy and passion are helpful but don’t come across as if you just had a batch of 5-Hour Energy drinks. Moderation in all things.
  5. Stay on point; keep within time allotted and don’t get distracted.  Good pitchers never allow base runners to make them lose focus on the batter.
  6. Practice until you feel you are as comfortable as that pitcher who never seems to get rattled regardless of the situation. They may not be expecting a major league performance, but, act like you are in Little League and you may not get a second chance.
  7. Spend some time explaining how you will overcome the toughest challenges.  Like a pitcher facing a good batter, you may have to work around the corners of the plate.
  8. Keep in mind, you are not trying to seal the deal with this presentation. Your objective should be to generate some interest; think more like the setup man than Mariano Rivera.
  9. Leave time for questions and try not to be defensive when responding to them.  You should talk 60% of the time and be listening 40%.
  10. Plan for the wrap up – have concluding comments and make sure you cover next steps.

Keep in mind, there is a reason that pitchers report to spring training early and get rest in between starts; it is a tough job.  Stay focused on your mechanics and you will do just fine.  Good luck.

There Are No Dumb Questions

Harry Dunne: Just when I thought you couldn’t possibly be any dumber, you go and do something like this… and totally redeem yourself!  –  From the movie Dumb & DumberDumb-Dumber-s-Harry-Lloyd-Laughing-At-A-Burger-Joint

I think of this scene when I am in a meeting and a client or prospect raises a question and prefaces it by saying  “this might seem like a dumb question, but . . .”  So, let me be clear; as an owner  you have the right – I might even say the obligation – to ask whatever questions are on your mind about any issue being discussed.  This is particularly true when you are dealing  with any of your professional advisors.  You should feel very comfortable being open and honest about any doubts you have and if you are not, find a new advisor.  The response to that simple question may prove to be the most important point of the discussion.  Let me give you a few examples to get you more comfortable with the idea.

We work with many of the companies at ERA in New York and TechLaunch in New Jersey.  They feel free to ask us all types of questions.  They have ranged from, “Is the investment ERA or TechLaunch makes in us taxable income?” to “Is my product taxable?”  Some are pure business basics (should my people be employees or independent contractors) and some are just nagging concerns (I promised my people some ownership, but, I am not sure how or when to give it.)  Trust me, there is no professional worth their salt that does not live to answer questions their clients may have… so, please take advantage of this relationship.

I can think of loads of situations over the years where audit staff thought something did not make sense and they asked a question that they thought reflected poorly on them since they thought it indicated a lack of knowledge, only to find their observation uncovered a significant problem.  I was consulting on an IPO and the CEO, who had his doctorate in engineering plotted certain items on the P & L only to find the graph of one of the amounts did not make sense.  The result was “counter intuitive” in his words.  Well, guess what – in the last draft, someone had dropped the brackets around a rather large expense and proofreaders had failed to pick up the error.

But, what prompts raising this subject now?  Well, I recently had a meeting with a new client who had a term sheet they were considering signing.  I asked a few basic questions and then the obvious one – did they know the terms of the deal?  The two owners looked at me in a sheepish way and admitted they relied heavily on their attorney.  The deal had a participating preferred and also indicated it would contain “standard” antidilution provisions.  While not always bad, these are red flags to professional advisors.  We decided to call the attorney for clarification and while one provision was fine, the other was definitely not what they thought.  We managed to get it changed and the deal went on.  The entrepreneurs conceded they had talked to some fellow owners who admitted they, too, had relied on legal advice for deal terms.  I had heard of this before, but this was my first live encounter.

So, please keep in mind that if something does not seem right, ask to get clarification.  I cringe when I think of the trouble entrepreneurs have gotten into by abandoning this basic instinct.  A clarification trumps a giant “oops” every time.  Good luck.