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.

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