Equity Makes the World (or at least Businesses) Go Round

Equity Makes the World (or at least Businesses) Go Round  
Know What You Have Before It Stops Turning 

You’re an entrepreneur. You wake up one day with a brilliant idea on how to make people’s lives easier and/or make the world a better place – and you cannot wait to get started. Congratulations! On that day, you own 100% of the equity in that idea. But as that idea solidifies into something tangible, equity becomes a bit more convoluted.  

Most likely, you will not be able to transform that idea into a product or service on your own. You will need some help. And unless you have boatloads of cash laying around (that would be nice), you will have to figure out another way to compensate others for their expertise. Many times, that exchange agent is equity. But before you rush off and give it away, risking devastating consequences, up to and including, losing any interest in your own idea at all, there are some important issues to consider.  

All in the Family Equity 

Oftentimes, you are not dealing with an angel investor or capital venture firm right off the bat. It is far more likely that your first experience with equity discussions will happen with friends and family who “want to you help you” with your new venture. Now, my quotes do not mean they don’t actually want to help – of course they do. But when it comes to money and the idea of making a lot more of it because of someone else’s brilliant idea, situations tend to get very sticky, no matter how close you are to the other person. 

The best advice I can give when it comes to giving equity to family and friends is to think before you act. I mean really think before you act. You cannot afford to be impulsive here – literally cannot afford it. Don’t just think about the highs you will experience together. In fact, try not to think much about them at all (counterintuitive, right?). It’s far better, albeit unpleasant, to think about the extreme lows and what they would look like with the equity distribution you’re considering. 

What About Employee Equity? 

If your business has employees and you are considering an Employee Stock Option Plan (ESOP), you should start with your equity allocation to principal management. The rule of thumb for the allocation of equity to senior management and advisors is 15 – 20%, but as always, it depends on several factors and even timing. For example, perhaps you plan on hiring a CEO/President in the near future. In that case, you will want to reserve some equity for that person. 

Employees in technology and financial positions are critical in most companies, especially as they are in a growth phase. As such, the majority of the allocation should go to these positions. In contrast, when you think about sales executives, you should take into account their commissions (that most management won’t receive) when considering a lower allocation of equity. 

Another consideration is vesting equity ownership as an employee incentive to perform well and stick with it while the company evolves from start-up to success. My advice is to keep these agreements simple and the terms the same for each group.  

But Wait … There’s More  
Other equity considerations include: 

• Equal split of equity and decision-making with a Partner(s).  Proceed with caution and have everything laid out in your agreement. Remember clear leadership for the team and company is crucial for progress.  
• Conduct proper due diligence and background checks before giving equity to anyone. Otherwise, you not only risk losing equity, you also risk damaging the company’s reputation. Due diligence should include speaking with other entrepreneurs with whom they have invested. The right investment partner will offer invaluable wisdom and advice. 
• Maintain accurate records. Every transaction should be documented – whether you are a one-woman company or a Fortune 500 company. Document everything, including initial capitalization. 
• Refusal to part with any equity. Some entrepreneurs refuse to give away any equity, which is not usually ideal either. Sadly, many end up owning 100% of nothing in the end. 

If, after all of these considerations, you decide that giving some equity away is in your (and your business’s) best interests, then the allocation should be clearly documented in a Stock Option Agreement. This will spell out the terms of vesting and all criteria, and can be a very simple document, as long as it clearly lays out expectations and terms. 

Remember, entrepreneurship is an emotional roller coaster that you have to continue to ride – there simply is no getting off when you need a break. And after that sky-high feeling of things going great, you often plummet back to earth – those are usually the times when you don’t have enough cash, start to jeopardize your own personal finances, and make quick judgments that have long-term effects. So, think through your equity considerations carefully and do your due diligence to keep your business going round. 

Barker Associates has extensive experience in equity allocation and agreements. If you need assistance, or have any other questions, please click here to schedule a 30-minute consultation at a rate of $100.