Don’t Suffer from Premature Equity Distributions
Quote: “He chose poorly” – Knight guarding Holy Grail in Indiana Jones & The Last Crusade
The title got you, didn’t it? There is nothing more frustrating for an advisor than to be faced with an entrepreneur (young or mature) who is challenged by having distributed ownership to the wrong people early on. The quote above is the first thing that comes to mind. But, if you face this issue, you are not alone and I can tell you the issue is decades old. A quick story…
I was actively involved in a leveraged buyout in the early 80’s (yes, they did exist back then as did leveraged recaps). The CEO founder (an experienced executive) recieved 51%, the financing source 30% and 4 key executives split the rest. Everything was fine, except all the financing source did was ask the CPA (who shall remain nameless) for a banking contact. That contact ended up financing the entire deal (with no equity at all.) Receiving 30% never sat right with the rest of the team, and when some equity was needed for expansion, the 30% financing source did not participate or help in any way… resulting in lawsuits and failure.
So, what are the two big mistakes that entrepreneurs make?
The first is what I call, “let’s give everybody a piece of the pie.” Now, trust me, I am a big fan of sharing equity, but when owners start a company, they seldom see the growth and changes to come. They reward everyone who starts with them, creating an “all for one” culture, only to find certain people are not up to the task and often other resources need to be added with little or no equity left to share. We see this in more than half the startups we counsel, regardless of the experience of the entrepreneur.
The second is the “we know who the owners are” issue. In this scenario, equity is granted to the three or four key “founders” without vesting. Then, lo and behold, things do not work out (like the story above or the tech guy that can’t get the website or product to work) and wasted effort is spent negotiating out the party who has not performed to make way for the resource that can. A major time and cost distraction, usually with a major emotional toll as well.
So a few helpful hints:
- Everyone vests. If a problem does arise, it is better to address it when someone only owns part of their piece of the pie instead of all of it.
- A shareholder agreement is your friend. It is best to determine what happens if things go awry at the beginning, when all are on the same page vs. trying to solve it when tensions and emotions are at record highs.
- Consult advisors first. They have experience with who should get equity, ideas on %, etc. Once you give equity, unless you build it into the deal, it may not be easy to get back.
- Ownership is a state of mind. It has to be a two-way street and someone getting equity has to embrace ownership, not just economic rewards. Use your “gut” as to core values here.
- Avoid using your stock book as a checkbook. If you believe in your business, protect your most valuable asset; your equity.
Premature is rarely used in a favorable context, don’t make it define your equity strategy.
