Equity Promises, Promises, Promises

“Your ego is writing checks your body can’t cash.” – Stinger – dialogue from” Top Gun”

When I started this blog over four years ago, I promised myself I would not repeat a topic, and to prevent that, I keep a file of all my blogs. Well today, I have to break that promise. The reason is simple; I spent a great deal of time on three new clients (and prospects) recently dealing with this issue. So I thought maybe visiting it again will prevent at least a couple of early stage companies from having to confront this dilemma. So let’s just take one case.

An entrepreneur contacts me for help with a series of acquisition transactions. He and his team of three have been working on this project for a little over a year – – none are taking salary but all have a promise of “a piece of the pie” once they get a bit further along. The good news is the CEO is calling to tell me an investor believes in what they are doing and just invested $200,000 for 10% of the business. They are also close to a Letter of Intent on the first target. We proceed to spend the next 2 – 3 hours talking structure, due diligence, and deal points and start to lay out a roadmap to completing the first transaction. All good so far.

Being obsessed with equity, I ask about the other three team members. The CEO had made a de minimis investment to get started and the other three joined shortly thereafter. I asked what their “deals” were, and as usual, there was nothing in writing, but verbal agreement that they would each get 5% of the business. Of course, they would all vest and all were expecting to get in at “founders’ share” (i.e. de minimis) prices.

So I asked the first question; was the new investor aware of the “promises”, and unfortunately, he was not. So in the end, the 15% (and perhaps more) will probably have to be taken out of the CEO’s shares. The next question was what would be the mechanics of the key employees’ deal? The answer was that now that there were funds, they could afford to get legal counsel to draw up the paperwork and issue the shares. I was amazed to find that though there was a bona fide transaction for the recent investment which valued the Company at about $2 million, the CEO thought he could issue these shares at the de minimis value.

The lesson here is while there are investment vehicles that may not establish value (convertible notes – often cited as “kicking the can down the road” on this topic), pure equity deals due create economic value that have to be considered when granting equity. In all of these cases, solving this issue is going to take money and time; two rare resources for an emerging growth company. So as I have said before, nail down the equity issues first and treat it like gold because I believe that though cash is king; today equity funds the monarchy. Be very diligent (use advisors) when determining when and how much equity others get because you do not want to “write checks your body (company) can’t cash.”

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