Baer Business Law – Greater Philadelphia Area – Intellectual Property Law – Business Law – E Commerce – Contracts – Trademarks – Copyrights

BE STINGY WITH THAT EQUITY. So I tell my entrepreneurial clients who plan to provide the ideas and initial cash (such as it is) for a startup, and want to give out equity in exchange for help with the administrative and technical side of things.

Not that I don’t understand. If the startup is your brainchild, you want to get a prototype in the works, move ahead with alpha and beta testing, and start to market the product and talk to investors at the earliest possible date. You can’t allow yourself to be distracted setting up a payroll, talking to accountants or doing all of the coding yourself. Furthermore, if you’re like 99.9% of startups, you don’t have a lot of cash, which seems to make giving out something other than dead United States presidents an attractive option. Plus, your prospective partners may be your co-workers or roommates, and you want to do right by them. Right? Right?

Unfortunately, being too generous with equity is a common mistake made by startups. Naturally, it seems like an effortless and expedient way to get the ball rolling. Remember, though, that when you give out equity, you make partners of people whose commitment to the startup and time horizon may not be the same as yours, and whose contributions, while genuinely needed, may be more generic and easily replaceable than what you’re contributing (money, patentable ideas, reputation and stature as an innovator, connections with investors, etc.) Another risk is that the potential partner who seemed cool and focused at the last Philly Startup Leaders happy hour may turn out to be a certifiable flake who sees kabbalistic messages in Drupal.

These partners may lose interest in a few months, fail to perform as anticipated or hold different views from yours on the management and goals of your startup. Yet, being partners, they have legal claims on the assets of the startup, the right to access business records, and the right to have a say in (or even block) certain strategic decisions. Or they may want to sell their equity to third parties with whom you’d rather NOT be in business. The situation gets even messier and more unpredictable when (as frequently happens) the initial buy-in transactions and the partners’ rights and obligations with respect to their equity stakes and their roles in the startup are not well documented (or documented at all) in, say, an LLC operating agreement.

As with romance, it’s easier to get married than divorced. In my own legal practice I’ve seen a steady flow of what I call “app divorces” — that’s when two people without a long prior working relationship form an LLC to develop iPhone or Facebook apps, quickly encounter irreconcilable differences and decide to part ways. The story normally goes like this: one partner just is not putting his all into the relationship (”you’re not there for me!”). The other partner comes to me, and I have to figure out a way to unwind the partnership and cash out the wayward partner while keeping the intellectual property (ownership and practical control of the app) and as much cash as possible in the hands of my client.

So be stingy with your equity, dear startups. If you’re the primary innovator and/or source of funding, and the other guy is basically bringing labor and moxie, ask yourself how well you know him, how well you work together and whether a strict pay-for-services or commission-based relationship might be better. If the skill set you need is not particularly unique (say, coding or website design), could you get a freelancer or other independent contractor to do it under an agreement where they assign all intellectual property rights in the work product to your company? Or, as with payroll, is there an affordable third-party turnkey solution on the market?

Of course, sometimes you have no choice but to give out equity in order to get the services and skill sets you need, particularly where they’re not all that fungible or require a high degree of trust and comfort. In these situations, give out as little equity as possible, both to preserve your control as well as your ability to bring in other investors without diminishing your ownership stake too much. Don’t immediately offer 50-50 because it seems fair.

You could also create two classes of equity, one for yourself and other investors, and the other for service providers you need to woo. The first class of equity could have an exclusive claim to all distributions from the startup entity up to $XX, with holders of the second equity class only being entitled to their proportionate share of distribution proceeds over and above $XX. This is a good way of ensuring that a service provider partner doesn’t end up claiming a share in the investors’ money.

Furthermore, consider time and performance vesting for the equity you give out. Time vesting is meant to incentivize the equity holder to stick with the job. Vesting is typically accomplished through scaling back of a right by the startup entity to buy or take back the shares. For example, the startup entity could have the right to buy or take back a certain number of shares where the number diminishes over time (say, 100% of the shares might be subject to buyback or forfeiture in year 1, 75% in year 2, 50% in year 3, etc.) as long as the equity holder is still serving in the desired capacity with the company. Time vesting can be straight-line, frontloaded or backloaded (e.g., 10% vests in year 1, 20% in year 2, 30% in year 3, and 40% in year 4).

Performance vesting is tied to achievement of certain milestones — for example, 25% of the shares vest on successful testing of a prototype, another 25% on sales reaching $XX, etc. Combinations of time and performance vesting are also possible, so that, for example, 25% of the shares would vest if the holder is still employed after one year AND has successfully tested a prototype.

Where equity is shared among multiple partners, transferability and exit issues (if someone wants to get rid of their shares, to whom may be they be sold and how should they be priced?) also need to be carefully discussed and dealt with in a legal document such as an LLC operating agreement. Having multiple owners means you will need more legal consultation in the startup process, yet another reason to be stingy with your equity. (And don’t try to draft the documents yourself to save on legal fees; if your startup ends up doing well, that’s a great way to buy a litigator a new yacht.)

Don’t get me wrong — I’m not saying NEVER hand out equity. Just be cautious and, if you have questions or reservations, talk to a business lawyer. When you give equity for services, you’re buying more than those services; you’re also buying the service provider.