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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Equity Plans Part II – Are We There Yet?

Most of you will recognize this oft repeated question which parents have heard for years. Popularized in the movie and television show by the same name as well as the movie Shrek, it is the question that sends a chill down any parent’s spine; especially when asked by a 5-year old on a long road trip. So why do I use it here especially considering Part I of this blog cited “the time has come” from Dr. Seuss? Well as they say, timing is everything and so it is with Equity Plans as well. So let me explain.

Very few people would ask someone to marry them after just one or two dates, even if they believe that person may be the “love of their life.” Yet I deal with loads of startups where the second conversation an owner has with a key potential hire turns to sharing ownership. Worse yet, without thinking through what they are offering, many offer too much equity only to find they lack enough for others (fast forward to “The Producers” by Mel Brooks – “what percent of Springtime for Hitler do they own?”) or worse yet; that key hire does not work out.

So I spend a great deal of time fixing these issues and there is nothing enjoyable about it. Legal agreements are usually incomplete; the process turns into a he said he said deal and then there are tax consequences to muscle through. It always comes down to having a well-documented equity plan and in all cases, the company “wasn’t there yet.”

So what do I advise? Very simply, have a plan. (You can look at my blog of December 19, 2013 Equity Sharing 101 for Startups for more guidance.) Of course a good attorney is the key here and while many of the documents are somewhat “boilerplate,” you must have a handle on the key provisions. So two quick cases.

In the first, a CTO was brought into a startup, and within a month, the CEO thought enough of him to offer him 10% of the Company in “Founders’ Shares” (no vesting). The CTO was focused more on coding than job satisfaction and within a year, realized he did not want to be there anymore. Fortunately, the CTO was so focused on getting out he never considered the potential value of what he had, and he basically gave back the shares and moved on. No agreements were in place; that CEO just lucked out.

In the second case, it was a similar fact pattern except the key person granted equity had been there a bit longer and felt he had substantially contributed to the Company in the five years he was there. This was another case of an early grant of equity and no provisions for separation. There was a falling out and a “settlement” is still in process. The CEO is spending a great deal of emotional time addressing this not to mention legal and consulting bills. It is not a pretty sight.

So please consider a bit of a delay to provide time for thought to make sure “you are there” before you enter an equity plan. But once you decide, move quickly and purposefully in concluding your plan and getting it all signed and delivered.

Equity Plans Part I – The Sooner the Better

“The time has come, the time is now . . . ” quote from the book “Marvin K. Mooney Will You Please Go Now!” by Dr. Seuss

Hopefully many of you remember this fabled line and for me, it is what comes to mind when I think of the right time to finalize most equity plans. (I am using equity plans to cover anything which resembles ownership – from stockholder agreements to shadow equity plans.) Sooner is almost always better as delays always seem to have unwanted complications. To confuse matters further, my next blog is Equity Plans Part II – Are We There Yet? So before you conclude I have probably gone off the deep end (a concept constantly reinforced by my family) let me begin with a true story.

In the early 90s, leveraged buyouts (or LBOs as they were known) were the rage and I participated in my fair share. I was called in to help one group of four very qualified managers who were buying a half dozen plants from their parent company. The four covered different disciplines and were great at what they did – – they were just lacking in the skill set needed to buy and set up a separate company / operation. So we focused on the deal for about three straight weeks; long days with hard tasks and two days before closing, the five of us went to lunch. I brought up the subject of equity plans and shareholder agreements among the four. The CEO let me know that considering what was pending, bringing this up at that time was the “dumbest thing he ever heard.” I backed off but shortly after the close, I persisted and we finalized the equity plans. Six months later the CEO called with the heartbreaking news that one of the four had passed unexpectedly. While distraught over the loss, he came to appreciate the fact that all settlements related to ownership had been concluded during a less emotional time and he came to appreciate that fact.

Here is another situation which highlights why it is best to conclude on any equity plans as early as possible. Going through a transaction is stressful, and I have had a handful of situations where trying to finalize an equity type bonus when a sale was pending almost cratered a deal. Owners see the chance at monetizing their lives’ work becoming a reality while key employees believe they were responsible for creating that value and should be rewarded. Incentive and reward plans go from a thank you with benefits to a hard fought negotiated settlement and at times, transactions suffer. All of this stress can be avoided by addressing this issue earlier in the process when a sale is hypothetical and parties are more prone to have a logical view of how an equity plan should work.

So the punchline is that when you have concluded on the sharing portion of any equity plan, be it shares in the company, options, stock appreciation rights, etc., then the time is right to finalize the plan and complete the documents to avoid the hardships and risks that delay can bring. If you are an owner thinking of this issue, the time is now to address it.