Managing Equity

While splitting the equity in Phase 3 may seem like the most important step to get through, that’s really only half of the challenge. The initial split of equity assumes that everyone knows exactly how significant of a contribution each person will make and what their long-term trajectory at the company is.

In fact – we have no flipping clue how the rest of this plays out!

Not convinced things might not change? Here’s a quick rundown of people who thought things wouldn’t change:

• Steve Jobs (Apple) – Invents the Mac. Gets fired. (Not a bad comeback, though)
• Travis Kalanick (Uber) – Grows Uber to $70 billion in valuation. Gets fired.
• Martha Stewart (Martha Stewart Living) – Builds billion-dollar brand. Goes to jail.

Understanding the need to plan for change is ridiculously important. These plans mean creating mechanisms to re-distribute equity, pay out equity, and in some cases fight to get it back. Very few companies avoid any version of these fates, and therefore if we’re going to figure out how to split up the equity, we need to figure out how to manage it once it’s distributed.

In order to properly understand why being able to manage equity is so important, we need to understand what happens if no provisions are in place long term. We run into problems like “dormant equity” which leaves the folks who stick around essentially working for the folks that don’t.

Right now it’s hard to consider all of the possible changes that can occur, so before we get into the different provisions for how to manage equity, we’re going to spend a quick minute on why these provisions need to exist in the first place. There’s a 99% chance they won’t happen to us - but if they do – they are damn important!

Once we realize what can go wrong, we’ll want to put a plan in place to handle the change. And we’ll want to do this ahead of time, while our team is still agreeing on stuff.

Managing equity really just comes down to “What happens when someone leaves?”. If the company sells and we all get a giant check there’s not much to disagree on. But if someone leaves we need to figure out what happens to their stock and how the affects the rest of the people that stayed.

We’ll learn to manage our equity with 4 tools:

Each of these tools will prompt us to address a few key decisions that collectively will give us the foundation for our equity split. We can then present this to our attorneys as a way to have a healthy conversation around how we want our documents drafted. Also, it may save us a few dollars which we are certainly going to need!

If we can be certain of anything, it's that whatever we think the makeup of founding partners and contributions looks like today, it will all change. It almost has to, given the fact that the needs of the business in its formation are often starkly different than the needs of the company as it grows.

My cousin Mildred might be willing to help out with bookkeeping now, and she may be providing 20% of our labor force, but that doesn't mean she should own 20% of the company long term.

The key to understanding how equity splits work long term is to recognize from the start that nearly everything will change and evolve over time - so the decisions we make now need to account for the dozens of major changes in value and contribution that will exist over the next decade or longer.

I may be the "CFO" right now because I'm the only person in the room that took a finance course in college. But that doesn't mean that my long-term role will be CFO, or that I can or should be compensated "like a CFO" in the open market.

It's typical that in our early days we'll all be taking on the roles of entire departments or C-level executives, but the overall value or skill level of our contributions may be largely based on the fact that there's no one else to do them!

Right now, we're both super pumped to be working on this startup. We're putting in every waking hour, working weekends, and giving up our favorite holidays. It's awesome (right?)!

But a few months from now, another awesome event happens - I found out that our family is expecting our first child and I'm going to need to focus my “non-existent free time” elsewhere. On top of that, the prospect of forgoing income becomes a real problem and I realize I'm going to need to get at least a part time job to supplement my new costs.

In a moment, my time investment can go from "every minute, all the time" to "whenever I can find the time." To assume that no life events will ever occur and that our time commitments will never change isn't very realistic. Therefore, we need to know what to do when and if our time commitments in the future are different than our time commitments today.

The amount of capital the company will need will change dramatically over time. $10,000 of investment might sound like a landslide of capital today, but in a few years, it will be a day's pay. While there is definitely a premium someone can and should earn from investing early, there's also a reasonable limit on how big of a chunk of the cap table someone should get.

Typically, the percentage of stock a capital contribution yields is commensurate with the "valuation" of the company which will be an entire discussion throughout this course. Suffice it to say, the first $10,000 should definitely provide a healthy return for being the riskiest capital, but within a limit on stock ownership that reflects the future of the company, not just the present.

Today, the most important thing is to get our initial website up so that people can order our new line of fragrances for pets. Therefore, the Web Designer is by far the most important asset to the company. She is willing to design the new site for our canine cologne for a mere 40% of the company. We have $0 in capital, so getting it for "free" sounds amazing!

Yet, once the site is up, our focus and capital won't be on building a website, it will be on marketing and refining the formulation for our product. We're going to need our stock to attract investors and new talent. But we gave 40% of the company away to a designer who was only critical to that one facet of our launch 3 years ago for an 8-week project.

It's important to calibrate the needs of the business today versus the needs of the business a year or two from now (or longer) and not give away the farm immediately.

The problem with confirming a "founding team" and the equity stakes that folks get is that often the only requirement for stock is that everyone suggests they will continue to stick around long term. But unlike working for a paycheck where our only commitment is showing up every day, working on a startup means we may never see a paycheck - and that tends to send people packing.

Just because people co-found a company doesn't mean they can't leave. They can, and they often do. There are just way too many unknowns going into a startup to allow every participant to stick around indefinitely. Therefore, it's imperative that no matter how strongly the Founders feel about their commitment to the company today, they provide some basic provisions for what will happen if that commitment changes.

The culmination of all these of these changes typically leads to one massive issue – dormant equity. Dormant equity is what happens when over time the Cap Table becomes filled with participants who own a stake in the company but don’t materially participate in its growth any longer.

A big reason this gets overlooked when forming a company is because as of yet – everyone is still there and still contributing! Yet over time as things change we are likely to run into more and more scenarios where we’ve granted equity to folks who aren’t around anymore.

The Absentee Landlord problem happens when we have people who own part of the company but are no longer contributing toward its growth. It happens all the time, and without proper planning, it can be a total disaster.

This is an awesome deal for Hansel. It's a straight up shitty deal for Mugatu.

This problem gets exacerbated with even more with time. If the company were to sell in Year 3, we could argue that Hansel put in 2 of the 3 years required to make the company successful, and while Mugatu had to put in an extra year - 33% more - it's not the end of the world.

But that's not how it usually goes. Instead, it's more like Mugatu works for the next 10 years, sending a check to Hansel who doesn't even work there anymore. How cool do you think Mugatu feels about that every year? Not cool, friends. Not cool at all.

The longer this problem festers, the more toxic it becomes.

That's not only a problem when it comes to splitting the profits every year (if there are any) but also begins to erode the motivation for Mugatu and all the of the other equity holders in the business. It's also a problem for future investors who don't want to invest in a business where half of the cap table is owned by absentee contributors. It's a bad deal for everyone (well, except Hansel!)

The answer to this problem is simple - provide a mechanism whereby Hansel can either hand back some of his equity or be otherwise compensated for his contribution monetarily. The rest of this section will cover the tools used by startups to recover their equity as well as ways to make sure that exiting holders are treated fairly for the contributions.

Giving away equity is easy. Getting it back – boy, that’s a different story altogether!

“Clawback Provisions” are designed to return equity (stock) to the company based on any number of provisions. No one likes giving their equity back, so for this reason, the Clawback Provisions are easily the most contentious of the bunch. They don’t even sound friendly.

Clawback Provisions are likely going to be the single most important part of how we manage our equity program long term. They are specifically what helps us avoid some of the “absentee landlord problem” which leads to a ton of dormant equity in the Cap Table. It also provides a bit of insurance against making poor stock grants.

For what it’s worth, most of these provisions will exist as standard fare within legal documents around stock options, our Operating Agreement, and other controlling instruments. Our startup lawyers will bore us to death with these details. But, as it happens, they really matter.

Within our team, though, we most definitely need to agree on these provisions before we get too far along or the discussion will turn into one person defending their particular situation versus the entire group agreeing on a hypothetical future.

In that future, we’re looking at a handful of typical scenarios:

1. Someone is terminated for cause. “For cause” means someone was fired for a valid reason – they did something materially wrong. That could range from job performance to criminal activity but would be stated as “out of bounds” in the Operating Agreement (for members), the Stock Agreement (for participants) or even the Employment Agreement (for everyone). Being terminated for cause typically invokes a much harsher Clawback penalty and in some cases can lead to the rescission of benefits altogether.
2. Someone is terminated without cause. “Without cause” means the member didn’t deliberately do something wrong. This could be a reduction in staff (“We ran out of money and we can’t afford to pay you anymore”) or someone simply quitting. In this case we may have a lighter clawback or none at all. These tend to be a departure on mutually agreed upon circumstances, or at the very least, ones that do no deliberate harm to the company.
3. Exercise Period expires. In the event of an “exercise window” expiring, the stock returns to the Cap Table. Typically this happens if a Stock Option is not exercised within the allotted time. In this case it may not matter whether there was a termination for cause (such as if it was an agreement with a contractor or advisor who is not employed by the company) but may simply be a matter of how the exercise window itself is provisioned and elapses.

Based on how the claw back is invoked, there will be a number of different outcomes.

Now that we know we are looking at two main scenarios for clawbacks – termination for cause and without cause - the million dollar question becomes, “How do we actually handle each of these scenarios as it relates to a clawback?”

Let’s take a look at two ends of the spectrum and decide as a team which way we want to lean. Instead of presenting the lawyer’s perspective, let’s take a look at how Darth Vader and Luke Skywalker view clawbacks in their respective organizations. This will give us an idea for how Founders think about their approach on either end of the “dark side” and “light side” spectrum.

Darth Vader and Luke Skywalker Debate Clawbacks:

As we can see, there are two very different ways to think about dormant equity and how it relates to managing a clawback provision. In the same way that we’ll need to determine what HR policies seem fair and equitable to our staff, we’ll need to make a personal decision on what we think is fair toward our staff and to the company as a whole.

All of this stock we’re handing out presumably has some level of value. Usually that value isn’t recognized until there is some liquidity event such as a sale or public offer. So what happens when someone wants to sell their stock before then? Where would that money even come from?

To this we present – the Buyback.

No surprise here – we’re talking about how to buy back stock. It sounds pretty straightforward, but comes with two really frustrating problems – we don’t have the capital to buy someone’s stock back and/or we don’t know what value to assign for the buyback.

Hence begins our journey to unpack this little enigma.

Similar to the Clawback of equity, the Buyback of equity can appear in multiple flavors. There’s generally a buyback on good terms and a buyback on bad terms, often related to how the breakup went down:

This can often be mapped back to terminated without cause (Good Terms) and terminated with cause (Bad Terms). We’ll assume in either case that the amount of stock has already been calculated in the Clawback provision. Now the question is what method will be used to value and pay for that stock.

The final price that determines the buyback value will typically use two considerations – the fair market value of contributions and, of course, the market value of the stock.

We can assume the math for calculating fair market value is straightforward. We total all the contributions that have been made (time, cash, etc) and then subtract any compensation that has been provided. The resulting total is what the participant “invested” and should be the basis for a buyback. If we apply a risk multiplier (2x, 4x) we would also be implying a return on that investment as well.

The second part, valuing the stock itself, frankly goes into an entirely other topic which is far beyond the scope of what we can cover here. That said, if the buyback also includes the market value of the stock (if there is a viable market value, if the stock isn’t “under water” with investor preferences, etc.) then we’ll begin working toward assessing a market value and determining what price that value has.

Splitting the valuations between “fair market contribution’ and “market value of stock” is done in this case to provide two mechanisms for pay back. The business may be too new to have any viable market for the stock, so in that case we’d default to looking at the value of fair market contributions as an alternative basis.

Sometimes the problem won’t be how much to pay back, but how to pay anything back at all. It’s rare that a company has a bunch of cash sitting around they don’t know what to do with (if we did, that’s probably an issue!) Therefore, payouts can be negotiated in different ways. This goes a little bit beyond the scope of this course, however let’s at least look at what some alternatives could be when and if a buyout was initiated:

1. Extend the Lookback Period. We’ll cover this in the next section, and this is mainly for stock options (not equity which this doesn’t apply to) but we could extend the period of time by which a holder’s options are still valid to whatever date we want. For example, we could extend the lookback period from 18 months to 4 years as part of a negotiation. The additional time has tangible value for a future sale and upside.
2. Setup a Payment Plan. Chances are we don’t have the full amount of cash to pay today, so we could offer to pay the participant back over some period of time, like a loan.
3. Full Cash Settlement. While this is the easiest to orchestrate, it’s also the least likely for most companies. This is sometimes more viable if the company has taken on a large round of financing and the new investors are open to a buyout of other members.
4. Combination of Each. What may work best in order to achieve the goals of the participant and the company is to create a buyout that’s a combination of all of these. This could include a small lump sum payment up front, a payment plan over time, and an extension of the window in which the participant can share in the upside of a sale.

There’s a high likelihood that the agreement we make will be a combination of terms, but it helps to know all of these terms are potentially on the table. Given that most people have never gone through a buyout process, it’s not always obvious what the opportunities are.

There are a few instances where getting through a buyback process gets held up. It’s worth understanding them both as the buyer and the seller. The assumption that “If this doesn’t work out the company will just buy me out” is an inexperienced one.

Most legal agreements will state that if the buyer and seller cannot come to an agreement on price, that the matter will move to arbitration which can be slow and expensive. While arbitration is considered the most obvious legal recourse for finding a valuation and settlement, that still doesn’t mean the company can actually make those payments.

If the company cannot pay, that’s where the payment options will start to become a critical component of how to create a settlement. In most cases, both parties will be working within the realm of what a startup can actually afford in a buyout, so the conditions of the buyout are typically modified to the ability of the startup to pay.

In some cases, we may want to allow our stockholders to have an extended period of time to decide if they want to exercise their options, or in other cases, grant them a longer window in which their equity value is still valid.

The “Lookback period” allows us to set a window of time whereby the stock recipient can enjoy the same benefits of their stock plan as when they initially were granted it. Here’s an example:

We’ve got a few instances where a lookback period makes a lot of sense.

• Concerns around when we sell. Inevitably someone will ask “What happens if I leave today (or get fired) and then the company gets sold a month later?” The basis for the concern is that their departure may simply be mis-timed, at which point all of their years invested will be for naught. For this reason, the lookback period could be adjusted so that in some time period after their departure (let’s say 18 months) if a sale happens, they still can enjoy the benefit of their stock. If the company sells after 18 months, they then officially lose their benefit, however an argument can be made that they were no longer materially participating in the final outcome at that point.
• Not financially ready to exercise. Another common issue is whether the participant has the financial wherewithal to exercise their stock options. Remember that a stock option may have a hard financial cost associated with exercising it. Most stock options are exercised during a liquidity event (like a sale or public offering) so the proceeds pay for the stock. But in some cases a participant may need to purchase the stock without a near term benefit, such as if they wanted to hold the stock beyond their lookback window. As such, they may need more time to put together the funds to execute the sale, in which case a lookback period can provide some cover.

There’s no hard and fast rule on how long a lookback period should be, although an 18-month window isn’t unusual. What tends to drive this window is a consensus between the participants and Founders as to what a “fair window” would look like as it relates to the amount of commitment requested. For example, if someone were forgoing all cash payment for years on end, a longer lookback period may be extended to compensate for the increased risk.

The methods for recovering equity, whether it’s a clawback or buyback, are intended to provide a well-understood structure for “what happens in the event of…” situations. It can really help if all of us know well beforehand what the repercussions and processes are for existing so we have a mutual understanding of how things would go.

Many of these provisions are actually baked into most boilerplate Operating Agreements which manage how members are handled in the organization. The purpose of this section of the course is to get everyone familiar with what some of the key triggers and considerations are. The actual legal document is a whole other matter, but again, most of what we’ll find in almost any document will provide even more detail.

Now that we’ve had a chance to see what all of the key decisions are, let’s run through a final checklist to review all of the major decisions we need to make.

Now that we understand the full spectrum of issues around splitting up equity, let’s put together a comprehensive action plan so that we make sure we capture all of our key decisions.

To make our lives a little easier, here’s a list of every key decision we need to make that was explained in this course. It may be helpful to use this as a guide amongst the team, so we can determine what decisions are left to make.