Friday, October 28, 2011

Ten Legal Mistakes Made By Start-Ups: Giving Away the Store (#5)

For the 5th installment of my posts regarding the Ten Legal Mistakes Made By Start-Ups, I am addressing the willingness of founders to give away too much equity in exchange for services to be provided to the company.

Myth #5:  "Equity Has Very Little Value in a Start-Up so it is Cheaper to Give Equity than to Pay Cash to Consultants/Employees/Service Providers."

I completely understand that start-ups often face the quandary of needing certain expertise or services and not having the financial resources to pay for them.  And so, start-ups invariably turn to the only currency they believe they have, namely equity in the business.  I am not suggesting that offering equity instead of money is a mistake, but rather it is the nature of the offer where many founders go array.

First, founders need to consider the monetary value of what they are willing to offer.  In simple terms, you need to understand the value of what you are receiving compared to the value of the non-cash offer you will make.  So, before making an offer, determine how much it would cost the company to just purchase the services or pay the consultant/employee.  Then try to get a sense of the value of what you are offering, which means understanding what the potential value of your business could be the coming years.  Use these metrics as the jumping off point to determine what to offer in non-cash compensation.  Of course, the other party is taking risk by accepting equity (or a similar interest) instead of money and that might be a reason to sweeten the non-cash terms a bit, but remember the value of your business will also presumably increase and with it the value of the interest granted to the third party.

Second, consider the nature of the non-cash compensation:

    (a) Stock/Membership Interests:  If you grant stock in a corporation or membership interest percentage in an LLC you are giving not only financial but also ownership rights in the company.  Do you really want this person to be an owner, even if it is a minoirty interest?

    (b)  Economic Interests Only:

            (i) LLC:  In LLC, like a corporation, you can have different classes of interests.  One alternative, then, is to create a class of interests that only have economic rights and no voting rights.  The person gets the upside but has no say in the operations.

            (ii)  SARS/Phantom Stock:  Stock Appreciation Rights (SARS) and Phantom Stock are methods of offering economic rights without granting any ownership (voting rights).

Third, make sure whatever you grant is subject to vesting based on milestones.  For example, if the person will be designing a webpage and then maintaining it, restrict the vesting of the interests based on milestones like acceptance and final uploading of the website, and then annual grants for website services.

Fourth, include a clawback, giving the company the right to clawback the grants upon certain triggering events (like breach of a material performance goal).

Fifth, try to get a Buyout Option/Shotgun Clause, giving the company the right to repurchase the interests for a consideration based on a triggering event and a defined mechanism of valuation (hint, this is for another posting, but don't just say "fair market value").  

The Take Away:  Just because you are a cash-strapped start-up, do not undervalue your business by giving away the store in the form of a large percentage of equity.

Disclaimer:  This site is for discussion purposes only and does not constitute legal advice.  You are urged to seek the advice of an experienced attorney with respect to any legal matters.

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