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.”
