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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Stock Books Are Not Checkbooks

Leo Bloom: “She also owns 50 percent of the profits.”
Max Bialystock: “Mrs. Alma Wentworth.”
Leo Bloom: “She owns 100 percent of the profits.”
Max Bialystock: “Leo, how much percentage of a play can there be altogether?”
Leo Bloom: “You can only sell 100 percent of anything.”
Dialogue from Mel Brook’s 1968 classic The Producers

When I first started consulting with owners on equity sharing (a long time ago in a galaxy far, far away) I never thought that four decades later I would still be giving advice on the same subject. But to quote Ronald Reagan, “There you go again.”

I was just brought in to consult with an early stage company that has concluded (and I agree) that the time is right to join forces with a larger organization in order to “ramp up” and maximize the potential of the product they have developed. We are helping with the efforts to prepare the company for sale. Quite honestly, in most cases the task at hand relates to analyzing and summarizing financial data. I am always amazed that so many (almost every) early stage companies I go into have an array of valuable financial data that could really help the owners more effectively run their business, but most do not want to spend the money to get it. So it is usually up to the accountants to either verify the data by completing an audit or analyzing the data as part of the due diligence process. But I digress.

One of the first questions I raised was if the company had any contracts with key employees or vendors. The first answer was no. Well, I soon learned that while in the owners’ minds there were no contracts, they did have letters outlining deferred pay and stock ownership for at least 12 current and former employees and vendors; everyone from an old landlord to the ex-CIO. As we started to put together a rough “cap table,” the dialogue above came to mind. We finally herded all the stray cats and assembled a very ugly picture. In addition to the dilution, it was fraught with business, tax and (dare I say it) accounting issues. A great deal of time and fees later, I sat down with the owners to understand how this had happened.

Their response harkened back to what I heard 40 years ago; they did not have the cash so they offered ownership instead. So here are my three reasons why this is a bad idea:

  1. Lack of faith – in most cases, these “deals” are exchanges on a 1 to 1 basis; like exchanging $5,000 of rent or pay for an equivalent number of shares in the company usually at or near founder prices. If you really believe in your company, how does this demonstrate your faith in its future value?
  2. Tax issues – without getting into the gory details, unless you do the right things at right time, there can be unforeseen tax consequences. Nothing says I appreciate you more than a tax bill with no cash to pay it.
  3. Control – unless you follow the right discipline, you can end up with stock ownership in the hands of someone who has underlying interests which may not be consistent with yours. This is never a good thing.

So if you are an owner, please treat your equity like a precious child and only use your stock book as a checkbook as a very last resort.

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 Sharing; Spread the Wealth and Spoil the Child?

Dark Helmet: “. . .  See there’s two sides to every Schwartz.” – Dialogue from Space Balls – a Mel Brooks film

As is the norm in my dealings with startups and emerging growth companies, the recent past has been filled with dozens of discussions about the concept of sharing equity.  This subject never seems to get old and it is increasingly apparent to me that there are really two different philosophies on this topic.  It never was that apparent to me until this past week when I had a discussion with one client on one night and another discussion the next morning with a prospect.  They were 180 degrees different and I realized it might make sense to shed some light on both points of view.

The first philosophy is what I call the “chicken in every pot” approach.  In this scenario, the key owner (or owners”) vision is that the company will reach unbelievable heights and as a result, the value will soar and every employee from administrative staff to key executives will become millionaires. The streets are paved with gold and all go off into the sunset carrying an enormous satchel full of money.  What a great vision and how emotionally rewarding it would be to enrich so many lives.

The second is what I call the “1% solution.”  Following this path, there is a more meaningful share of equity with the key people who drive the company.  In this scenario, challenging goals are set for exceptional leaders, they outperform the expectations and the economic rewards follow their success.  This is pay for performance at its best.  But, is one technique better than the other?  As with most things in life, I believe it depends.

I think the driving force behind a choice of approach is matching it with the culture of the company.  If one has a very inclusive, collaborative working environment where all believe that each person’s contribution is important, then the chicken in every pot approach fits.  While it can be successful, I see two potential downsides; one is that because there are so many participants and the pot is only so big, rewards for the key players may not be as significant and rewards for lesser players may not be perceived as meaningful. A second concern I have is since everybody gets some ownership (like a Holiday bonus) it is not seen as a motivational tool to drive behavior but just part of the standard compensation package.  Again, in a share and share alike environment, this may be a good fit.

On the other hand, if you have an organization where a small group of people are clearly seen as the leaders and drivers of the business, the 1% solution may be the answer.  The fear in this scenario is stirring up either the old “a few people are getting fat off our backs” syndrome or the even more concerning “us vs. them” attitude which can arise because of the disparity in rewards.  Rewarding the key players who get you to the goal line works in this case.

So, as Dark Helmet says, there are two sides to every Schwartz… Just make sure your equity sharing plan takes into account the DNA of your organization. That is the right answer.

The Liquidity Option for Equity Based Plans

“Winner must be present to win.” – common note on many raffle tickets

How many times have you participated in a raffle and noticed this “condition” boldly printed on your ticket?  I have been at more rubber chicken events than I care to acknowledge and I always cringe when I notice this warning.  My immediate reaction is always the same – is this event so bad that they have to bribe me to stay until the end?  We all know the winner is never announced before the very end of the evening – and once that lucky person stands up, we all head for the exits.

I think the parallel in business is ownership liquidity and in particular, the quandary many owners face to provide some cash to minority shareholders as they exit the business.  I have advised many long established enterprises and it does not matter what life cycle stage they are in, there is always this “Sword of Damocles” hanging over their head.  What happens if one of the owners leaves or passes on?  The remaining shareholders feel burdened by the commitment to buy out the departing party and it is this very concern that causes many shareholders to be silent about liquidity in their buy/sell agreements or not establish an equity sharing plan in the first place.  Perhaps the uncertainty as to growth and/or success also plays a role here.

Up until a few years ago, I had only seen this issue and mindset at more established businesses; usually in legacy type industries. Enter the current tech early stage growth phase (one of a few in my lifetime) and equity sharing is back with a vengeance.  However, this round, I have seen a different mindset sprinkled in with the plethora of discussions on stock options, restricted stock, etc.  There have been a good number of equity based schemes that really only have value upon a defined liquidity event.  No vesting or granting of ownership – simply stated – the holder of the ownership instrument must be present at the time of the liquidity event to benefit.  In essence the “winner must be present to win.”

Now, I do not mean to imply that equity in an early stage growth company is like a raffle ticket (actually, I think the raffle odds may be better) or that such an instrument should be seen as a bribe to keep you someplace that you do not want to be.  But, many would espouse that it is the team that creates the true value and unless the team stays until the end (liquidity) there may be no value.

So, if you are a young entrepreneur, you may want to think about this approach as one of the alternatives you consider.  As usual, please consult your professional advisor before reaching a conclusion.  While there might be some tax cost involved, think about the time, effort and expense you may have to endure to address that equity owner who has vested and now wants to leave and get fair value for what they feel they contributed.

Caution – Those Equity Promises Can Really Hurt

 “Nudge, nudge, wink, wink; say no more, say no more” – from a skit by Monty Python’s Flying Circus

My partner and I have been making the rounds in a series of Lunch & Learns at various co-working spaces around NYC.  Our normal fare is to discuss the pertinent accounting and tax issues startups and early stage growth companies face (after all, we are CPA’s) but we also discuss ownership issues and in particular equity splits or as it is commonly known, how to “divvy up the pie.”  This topic seems to dominate the conversation (it seems to be more popular than tax credits) and we are always intrigued by the questions and issues that get raised.  It is clear to us there is more education needed in this area and this blog is just one small attempt to fill this void.

It is important to emphasize the basic fact that if you give someone something of value, even if it is not cash, there are usually tax consequences to the individual.  Reducing this to its simplest form, what did you give and what was it worth?  This is one of those “says easy, does hard” moments.  So, let’s look at an example.

Joe has started to develop a social media app and is in the early stages of proof of concept.  Joe works on this for a month or so and realizes he needs technical help.  He recruits in Jane, a tech pro who really accelerates the app development.  Joe appreciates her contribution and tells Jane he will give her 10% of the Company (for those of you following, that is the wink, wink; nod, nod part.)  A few months later, Joe and Jane present their concept to an angel who invests $100k for 10% of the company.  A couple of months after that, another investor approaches ready to write a big check.  He asks us to do some diligence, part of which is reviewing the cap table.  We see Joe at 90% and angel at 10%.  We ask about Jane since she appears to be a key player and find she was promised 10% but there is nothing issued or in writing.  You know what then hits the fan.  The investor now wants to know what other promises were made.  When someone invests, there is one thing they want clear – who owns what before and after the deal.

So, this has now created a credibility issue.  In addition, Jane now has a problem.  If she is to get her 10%, she can only get it at current value.  And, what about vesting; does she get credit for past time and effort?  There is nothing worse than getting a big tax bill with no cash to pay the tax and that is what is going to happen to Jane. The plan to give her an incentive has just become a disincentive plan.

So, I will state this as simply and strongly as I can.  If you decide to either give equity or have a partner invest in your Company, please get the right professionals involved to make sure it does not become a painful experience and that it accomplishes what you want it to.  With that, I will “say no more, say no more.”

Myths About Startup Equity

“Mr. Fuji as everyone knows, is a fountain of misinformation.” Quote from the late great Gorilla Monsoon a star from the World Wrestling Federation.

Here in the New York Metro area, we get the chance to hold sessions with loads of startup companies.  From incubators to accelerators to coworking spaces, we get the opportunity to meet with some of the best and brightest minds especially in the tech space. Their ability to question everything and absorb a multitude of ideas and observations is second to none and a unique skillset that many of us admire.

We are accountants and consultants and so topics we present tend to center around accounting and taxes. While I would love to think those attending are mesmerized by our subject matter, I have come to believe it is the free pizza and soft drinks which attract them. However, there is a subject we cover that seems to draw a bit more of a response than the equivalent of sitting through a root canal – – and that subject is equity. How to split up the pie; techniques to use to share ownership and pitfalls to avoid seem to get attendees to perk up. Like most things in life, when deciding on equity sharing, a bit of advanced planning helps; but who has the time when one is creating their MVP, trying to drive the community to their product or preparing for a Demo Day.

Unfortunately, we have heard a few myths over the last couple of months and I thought it best to take some time to clear the air a bit.

  1. “You can wait to issue equity” – actually when you issue equity is completely up to you; the value you have the use in the transaction is the issue. Just keep in mind assuming the value of your entity increases over time (or else why would you give up your life for it) the higher the value, the more difficult this task becomes.
  2. “Founders can always get shares at discounted rates” – one of the better tales we have heard. Founders’ shares only have minimal value before you raise financing and there is no near term proof of value (usually by some outside party.) However, once funds are raised, you may get more shares as a founder but the new (and usually higher) value has to be taken into account.
  3. “We don’t need no stinkin’ valuations” – unless you are in a clear founders’ shares startup situation or use the value of a recent transaction, yes you do need a valuation (referred to as a 409a as this is the IRS regulation that governs.) Without it, your tax exposure can make you the next Leona Helmsley.
  4. “I can always file an 83b” – as long as it is filed within 30 days of receiving the equity, it uses an appropriate value and you pay any related tax, yes you can. After that, you can’t put that genie back in the bottle and you are on your own.
  5. “Who cares if my company is an LLC or C Corporation?” Almost every investor does; and most prefer C Corporations.

Equity issues are complex and costly so please consult with your attorney and accountant before completing any equity transactions. Relying on a myth can cost you dearly.