The downside of using equity in your start-up to pay people

Too many shareholders can become problematic as start-ups grow.Virginia Star

When I launched my first business venture, I sought help. I didn’t have much money so I was generous with equity to investors and supporters. Five years in, I had 80 shareholders and a capitalisation (cap) table that was difficult to manage.

Everyone told me to be careful when distributing equity. But early on, I needed support and couldn’t afford to pay contractors full rate, so I subsidised payments with equity. I had to convince incoming employees to take a pay cut, so I gave them shares. And I needed capital, so I accepted investment from wherever I could find it.

Start-up law specialist Richard Prengell of Viridian Lawyers says this problem is widespread. “Minority shareholder issues are amongst the most common legal challenges we come across. It’s easy for entrepreneurs to sell the dream early on and give away equity to people who help get the business going. But two or three years later, a messy cap table can have regretful consequences.”

Potential investors

I discovered a large shareholder group made it difficult to raise capital. Larger venture investors were nervous about our ability to manage so many stakeholders. Would anyone hold the company to ransom when we needed a critical document signed?

Prengell says a full cap table may deter potential investors. “An oversized shareholder list can become a nightmare: incoming investors may wish to make decisions about issuing new stock, bringing in more investors and incentivising employees without having to get sign-off from 30 or 40 people. This can institute delays, even if no one becomes obstructive.” He also warns about dead-weight shareholders who no longer contribute to the business.

“Investors want the company to be owned by people who are doing the work now. A contractor who helped build an early version of a product but is no longer involved in the business is a drag on a cap table.”

Five years on and we’ve put measures in place to manage our large shareholder group. Fortunately, no one ever became obstructive, but I have lost weeks chasing signatures from shareholders camping in the south of France, kite-surfing in Brazil or skiing in Switzerland. The challenge should not be underestimated.

I’m now establishing a new venture and, like last time, I’m doing whatever it takes to get my vision off the ground. This will mean issuing equity to early supporters; it’s impossible not to. But I’ll set up structures to incentivise people who make a long-term contribution; ensuring early shareholders don’t put off later-stage investors. Here’s how:

Set long-term goals

In my first business, I awarded equity to the graphic designer who made our first logo, a lawyer who drew up our early agreements and so on. This time I’ll set long-term goals. Everyone will earn their compensations over four years with a one-year cliff. So, if the design firm is still supporting the business in two years, they’ll have earned half their allocation. But if they disappear in six months, they’ll get nothing. This ensures everyone is committed for the long-term and removes the risk of dead-weight shareholders.

Prengell says the best way to incentivise contractors and employees is with an option plan. “Always give equity as options rather than shares. Put an agreement in place upfront so that options can be bought back if the contractor or employee ceases to contribute to the company.”

Have the the future in mind

Richard suggests early-stage entrepreneurs take time to consider the implications of their shareholder’s agreement. “Too many founders use an off-the-shelf shareholders agreement and company constitution and don’t look at them until there’s a problem. One of the most important things to know about a shareholder’s agreement is that it can’t be changed without everyone’s agreement.”

Entrepreneurs need to turn their mind to the future of their businesses, designing agreements that will survive several capital rounds and an exit without modification. For example, don’t name board directors. A future large investor is likely to want a board seat, and if this means amending the shareholder’s agreement then 100 per cent of shareholders need to agree. This gives small shareholders a huge amount of power and is often where businesses get stuck.

Encourage investors to form a trust

Prengell advises entrepreneurs to have small investors participate in a common trust rather than as individuals. “It’s simple to set up a trust so related investors can register on the cap table as one unit. Keeping your shareholder numbers below 50 helps contain your financial reporting obligations.”

 

CATEGORY: Australian Financial Review, Capital Raising, Strategy

Related Posts