The late American comedian, Jackie Mason, once joked that when he went to Hollywood, all he met was producers. Everyone he said was a ‘Producer’. The thing was, all they produced was business cards.
While anyone can hand out a business card with virtually no consequences, founders in start-ups would be wise to ensure that they treat the allocation of shares in their business a bit more carefully. The process of giving away shares can be easy, but if done badly, without planning or the proper advice it can be far more complicated and disruptive than many founders might first imagine – including putting at risk their opportunities for investment.
Accordingly, founders at the start of their growth journey full with good intentions could often benefit understanding the basic rights and risks around equity before giving it away.
Equity: Opportunities and Risks
When starting their businesses, many founders often set up a share (equity) structure often without any formal arrangements or advice.
Many, faced with limited cash flow, view the new shares in their companies as an easy currency to use. They sometimes offer these shares to others without any formal arrangements, almost indiscriminately, not appreciating the consequences their actions may have on them and their companies at a later stage.
When structured correctly, the allocation of equity between founders, employees and the right consultants can lead to great results, including motivating founders and their teams and providing a clear road map and incentive model towards an eventual exit.
However, when this equity, particularly at the early stage of a businesses is managed badly or allocated without proper planning, it can cause countless problems, including leading to disagreements and fall out, and even dissuading investors from investing at the critical point when the business needs investment most.
What is Equity? And why is giving it away a problem?
In the UK, once a Company is formed a founder can allocate a company’s shares simply by completing forms from Companies House. Many founders then feel that they can do everything themselves including giving the equity to others, including co-founders, employees and/or consultants who are attracted to start-ups and may agree to work for equity if cash is tight.
At first glance, the idea of giving away this equity seems like a good idea, harmless enough, particularly as it is so simple to do. However, that is where it can be misleading, and founders would do well to understand the potential pitfalls of giving away shares too indiscriminately and without formal arrangements in place.
At the most basic level, founders need to establish which type of shares they are giving, how they are giving them away and what types of agreements they might need in place with those who are receiving them.
They should also be aware that at the start of their journeys, depending on how and when they give the shares away, they could be creating latent tax consequences for both the company and the recipient.
It is advisable, therefore, for founders to consider their reasons for giving away equity and to get some initial legal, tax and accounting advice so that they can fully understand the consequences of giving equity away and the agreements they need in place should they ever need to get the equity back.
How Issues with Equity can arise
It is understandable that founders try and do things themselves and save costs.
However, often by trying to do things quickly, founders give away equity without clear conditions which may pose risks to them which they don’t first imagine.
If things go well, these hasty arrangements may be fine, but if things don’t go to plan, which they often don’t, the problems can be quite dramatic. Typically, this becomes apparent to founders when their co-founders, consultants or new employees, don’t deliver as they had hoped and they are stuck with an acrimonious situation with no clear way to get the equity back.
Sometimes these problems are ignored or postponed as the founders don’t have time to deal with them, but investors do not like investing in companies with problematic shareholders who are adding no value and who are often reluctant to agree anything if they have fallen out with the founders.
With a little initial planning and a simple agreement, founders would be able to address these problems before they arise which would likely save them significant time and costs in the long run.
Furthermore, where there are potential liabilities in a company relating to its shares, most investors will either choose not to invest or will look to the founders to assume the costs and risks for sorting them out.
The optimum situation for founders therefore is to start planning as soon as possible on how to give away their equity and to have the right arrangements in place before it is granted
Questions to ask before giving away equity
Some simple questions that may help founders when they are dealing with their equity should start with “What is the reason for giving away shares?” and should probably also include:
- Who is going to be given the shares?
- What types of shares will they be granted and what rights will those shares have?
- What conditions need to be satisfied for the recipient of the shares to keep them?
- What agreements need to be in place to deal with those shares or get them back?
- Has the value of those shares been considered?
By addressing these questions and prioritising planning at an early stage, founders will be in a stronger position to both avoid problems and to set out a clear equity model which should enable those in their team to work towards clearly defined goals.
If used correctly, equity can attract and retain the right people and can also be used to engage and motivate key employees and consultants that founders need to attract investment. The key is to treat equity even at the early stages of a company with the importance it deserves.
So before handing equity out too quickly, founders should take some time for planning and to consult with their advisers in order to give themselves and their teams the best chance of success and be ready for when the right investor comes along.
If you need advice around equity and your business, please contact Peter Weiss.