Every entrepreneur struggles with how to best allocate founding equity to partners and future staff. Equity ownership is viewed as a measure of value to the company, and making such judgments can be inherently divisive, leading to team tensions right from the start – a time when such tensions are truly a distraction. As the company grows, even relatively well thought out equity distributions come under question as the actual productivity of each team member becomes more evident. In fact, one of the greatest fears is that an early founder will simply skip out and take with them a large percentage of equity.
The problem with equity as a measure of value to the company is that value is such a fluid concept in a startup. What might be considered a “make or break” capability, skill or contribution at one point will be immaterial weeks or months later. As the ultimate value of the equity is as a measure of the company’s worth to a potential acquirer, the relative value of a particular person to the acquirer at the time of sale is likely to be far different than that person’s value as the company developed.
Since the founders themselves are large equity holders, it is also not realistic to expect them to provide an unbiased perspective on equity allocations as the company matures, which simply adds to the tension surrounding early equity allocations and negotiations.
There is an approach to equity allocation that can help to alleviate these issues – a board-level executive compensation committee that is not beholden to a few founder’s interests. If the company is set up such that a strong, independent advisory group with a clear set of criterion is put into place to periodically review equity allocations, everyone can rest comfortably that such allocations are being monitored and that there will be some attempt at fairness.
For those not familiar with equity re-allocation from a practical perspective, it turns out that through the mechanism of new share creation, a company can essentially reallocate any current share distribution. As an extreme example, if a company was formed with 1 million shares outstanding and fully allocated, the board could literally create 1 billion shares, devalue the existing shares by a factor of 1000 and distribute the new shares however they saw fit. Such extreme examples are very rare, as they can totally de-motivate the employees and destroy any built-up trust, but to some extent, such re-allocations can and do happen, particularly when outside compensation reviews are incorporated in the process to address egregious inequities.
If such a committee is in place, the level of equity offered at time of hiring new employees can be less of an area of heavy negotiation. This sets a much better tone for starting a new working relationship, and builds an environment of long-term trust and fairness that otherwise would not exist.
For people considering joining a new startup in which the founding team is not known to you: one way to ensure that the company is acting appropriately with regard to equity distribution is to insist on owning some actual shares of the company, rather than taking all options as part of your compensation package. All shareholders are required to be notified of changes in capitalization – including impending acquisitions, and are required to vote on such changes. Even though your vote has no value, the board cannot make changes to equity allocations or issue new stock without notifying everyone with shares – keeping backroom dealing to a bare minimum!
How to leverage being in a strong position
There are some cases where a founder is in a very strong negotiating position, such as when they bring extremely unique skills, exclusively own a key element of the company’s Intellectual Property, or are bringing major partnerships, financing or customers into the mix.
In this case, it is possible to avoid issues of future dilution by negotiating a “commission on equity sales” agreement rather than taking an equity stake. This is similar to what Investment Bankers, or Real Estate brokers do – they simply ask for sales commissions. Commissions on an equity sale can cover the cases of future investment, future sale through equity transfer or IPO. As a commission, it is payed “off the top” before the equity revenues are distributed, and thus avoids dilution. A truly flexible structure enables the key founder to trade commission for preferred shares if an IPO is imminent, as it may be more lucrative.
Another strategy is to negotiate a commission on product sales. Such royalties on sales can be anywhere from 1%-30% of gross revenue and provide early sustained cash flow to the founder. It is critical in these cases to take commission from “gross” sales rather than “net profits” as net profits can be easily manipulated by the company through asset and materials purchases and high executive salaries.
Commission agreements can be designed to ensure the company’s early success through mechanisms such as “ratchets” where the commission changes over upon time, gross revenue values or equity infusion rates.
It is critical for founders to understand the tradeoffs and pitfalls during equity negotiation prior to signing up as an employee, as it is considered “bad form” to attempt to re-negotiate at a future date. It is usually futile, as once a founder has become an employee of the company, all negotiating power is lost.