The Four Horsemen of the Equity Apocalypse
Bad equity agreements are extremely common. The prevailing wisdom—worldwide—about how equity is split is virtually guaranteed to cause problems. I take calls and get emails literally every day from people trying to figure out a fair split within the flawed logic of conventional wisdom.
What’s really scary is that the conventional wisdom is perpetuated by smart, well-meaning, experienced people who, at their core, think they are providing good advice. The good news is that there is a founder equity split model that creates a fair split.
There are four major problems with the way most equity splits are created in early-stage, bootstrapped companies. These are the “Four Horseman of the Equity Apocalypse” because the presence of any one of them can easily doom a fledgling startup by causing disputes between founders and other participants that have nothing to do with the actual business. A tragic tale told over and over and over…
If you’re a party to an equity split with any or all of these fatal flaws brace yourself—things are going to get ugly!
Horseman Number One: Fixed Equity Splits
The most common and most dangerous of the Four Horseman is a fixed or static equity split. This is when fixed chunks of equity are doled out in percentages to founders, usually in advance of any real work being done. A chunk for the founder, a chunk for the first few employees, some little nuggets for lawyers and advisors, and a “hold-back” for future employees and investors. The most common type of split is the dreaded even split where the equity is split evenly among the founding team such as “50/50” or “25/25/25/25”.
At the core of the fixed equity split problem is the fact that it will not accommodate unforeseen changes in the team, strategy, funding or any other future events. In other words, getting a fixed equity split right requires the founders to accurately predict the future, which, of course, is impossible. So, when something inevitably changes, the team must renegotiate the split. A painful, often hostile, experience which only leads to yet another fixed split creating a downward spiral that can easily require costly and distracting legal intervention.
Horseman Number Two: Time-Based Vesting Schedules
People implement fixed equity splits with a tacit understanding that things may change even though their fingers are crossed. In an attempt to mitigate the possibility that someone will leave the company with a huge chunk of equity it is quite common to slap on a time-based vesting schedule. The usual terms are a four-year vesting with a one-year cliff. This means the individual receives restricted shares that are subject to forfeiture in the event they leave the company. Unvested shares return to the company’s authorized share pool whereas vested shares are owned by the employee. A portion of the shares (usually 1/48) vest each month except during the first year which is subject to the “cliff”. The cliff means that no shares vest during the first year, but ¼ of the shares will vest on the first anniversary. I’m not sure who came up with this. During the dot-com bubble it seemed that a five-year vesting schedule was more common, but it doesn’t really matter. Time-based vesting schedules do nothing but confuse people’s incentives.
A time-based vesting schedule implies that time is the only thing that really matters with disregard to an individual’s actual contribution during the time period. And, because the commitment levels of early-stage company participants can vary widely, this becomes a real problem. Under this agreement, the only thing that matters is that a person keeps his or her job. It provides no direct incentive to perform well. Sure, people are supposed to do a good job so that their equity will someday be valuable, but the basic terms of the deal do not reflect that sentiment. A good business deal should reward participation and performance, not just treading water until the clock runs out.
The real incentive is for a person to keep his job until the stock vests and then he is free to consider other options. It’s kind of like a mobile phone contract. Once you’re out of the contract you might stay with the same carrier, but you have no obligation. I once worked for a startup company with a five-year vesting schedule with annual vesting. People routinely quit on their fifth anniversary. It was a sad joke in the company.
To make matters worse, with time-based vesting schedules managers have an incentive to terminate employees before they vest. This, too, is quite common.
Because incentives are conflicting and time-based vesting does not reflect actual contributions, conflict often arises when employees separate from the firm. Which leads us to….
Horseman Three: Lopsided Stock Purchase Agreements
Stock purchase agreements are designed to do a number of things that aren’t all bad, but too often they are designed to protect the business and not the employees. For example, many stock purchase agreements allow the company to force a buyback of shares from a departing employee. As stated before, when an employee leaves a company their unvested shares are forfeited. Their vested shares, however, may be subject to a buyback. This means that even after you fully vest, the company can buy your shares back. The price is usually defined by the agreement and not based on current market price. So, if you receive shares with a par value of $0.01, you may be forced to sell the shares back to the company. Imagine you forgo a $100,000 annual salary for four years and fully vest. When you leave, the company buys your shares back for $10,000. Smells like a lawsuit waiting to happen and when it does, the terms of the agreement are pretty clear and employees are the losers. Remember, just because it’s legal and just because you signed it doesn’t mean it’s fair. I’ve been a victim of this before, it’s not pretty.
In an effort to protect against future problems, stock-purchase agreements are often full of terms like anti-dilution, claw-back, rights of first refusal and other terms that simply over-complicate the deal.
Unfortunately, because most stock purchase agreements are written by the company’s attorney, they usually provide protection for the company’s interests at the expense of the employee (I can’t remember if I’ve ever seen a stock-purchase agreement that doesn’t favor corporate interests at the expense of team members). Most start-ups won’t negotiate terms with individual employees on a one-off basis. These are usually take-it-or-leave-it deals that can easily lead to a destructive dispute.
Horseman Four: Premature Valuations
If founders sell X% of the company to one of their moms for $Y the implied value of the company is $Y/X%. So, if mom buys 10% of the company for $2,000 the implied value of the company is $2,000/10% = $20,000. This is a premature valuation because it was set early on in the company’s life with no grounding in reality. In most cases, a company is worth $0…until it’s not.
Premature valuations cause a number of real problems. Mom gets a fixed percentage for a fixed dollar amount. Her exposure is limited, yet the founders, who are not getting paid, have unlimited exposure. The more they work, the bigger their investment gets relative to hers, yet her percentage stays the same.
The next problem is one of dilution. Early friends & family deals are notorious for poor documentation, so when the next investor comes on board does mom dilute? If so, she might get upset, if not, the investor may walk away.
Yet another problem of premature valuation is that when new shares are issued, the IRS may decide to tax the individuals who receive them even though no cash changed hands. And, because most early-stage bootstrapped companies have a $0 valuation, the poor souls are stuck paying taxes on worthless shares.
Premature valuations lead to disputes because startup founders are not really qualified to assess an unbiased valuation for their own companies (neither are their moms).
Start-up companies should avoid setting a valuation until one of two possible events occur. The first is when the company has reached a breakeven point and can pay salaries and expenses. When this happens, a qualified professional can conduct a 409A valuation based on the revenue, assets, customer base or other observable elements of the company. Additionally, the employees and founders’ exposure is now limited to previously forgone salaries, investments and expenses.
The second possible event is during a Series A investment led by professional investors. Usually a VC or “super angel”, these are people who invest other people’s money or have obtained considerable wealth and are in the business of investing. These people will provide enough cash to cover expenses and salaries in the short to medium term (again, limiting the employee’s exposure). They negotiate the valuation and investment terms with the founding team.
Avoiding the Four Horsemen
The only way to completely avoid the Four Horsemen of the Equity Apocalypse is to use the Slicing Pie model for equity allocation and recovery. Slicing Pie is a logical alternative to illogical traditional equity splits.
You avoid the fixed equity horseman because Slicing Pie is a dynamic split model that automatically adjusts based on the relative contributions of each person. This means that no matter what changes, each person is guaranteed to have a fair percentage of the final outstanding shares at breakeven or Series A.
You avoid the time-based vesting horseman because Slicing Pie, in a C-Corp or S-Corp, becomes the basis for vesting, thus removing the arbitrary timeline. This means people’s incentives are aligned and each participant is adequately protected.
You avoid the lopsided stock purchase agreement horseman because the rules of Slicing Pie are perfectly balanced and ensure each participant is treated fairly.
Lastly, you avoid the premature valuation horseman because Slicing Pie works during the bootstrapping stage, before a valuation can be set. Allocations are based on a function of the relative contributions or “bets” placed on the company. Additionally, the Slicing Pie funding strategies, likewise, do not require a formal valuation.
After Slicing Pie terminates, the Four Horsemen of the Equity Apocalypse become friendly little ponies that will help, not hurt, your company. Equity splits naturally become fixed because the company will be able to provide fair market compensation and reimburse expenses to employees. Once everyone is getting paid, a bonus/option incentive program can be put in place and a time-based vesting schedule can help retain key employees. Stock-purchase agreements are replaced by option agreements or cash investors that can provide more logical terms. Finally, valuations can be set by professional investors and the stock price can be used to set the option strike price.
The Four Horseman of the Equity Apocalypse are a danger during the company’s early stage when it is still bootstrapping, the future path is unclear, participants are not compensated and the company is at its most vulnerable. It is during this critical time that conventional equity split models simply don’t make sense. Only Slicing Pie can allow your company to create a fair, conflict-free cap table and avoid apocalyptic equity disputes.