Equity Grants for Company Advisors

September 24th, 2009

Clients frequently ask me how much equity they should give out to advisors.  It’s a multi-layered question and worth pulling apart a little bit.  Here is how I think about it, following by my basic rule on how to allocate equity in an early-stage startup.

Low Value Proposition – to the Company and to the Advisor
Most startups are cash-constrained; many get enormous benefit from informal advisors on business models, finance, sales strategy, etc.  The companies want to reward these people for giving their time; they also want to reward the behavior so that the advisors will be more likely to continue helping.

At the same time, most advisors have only limited capacity to donate their time so most advisory stints are short term.  On top of that,brand-new startups are about as risky as any investment gets and the return on equity for most advisory-level stock grants is incredibly low.  If I start out with 1% of a startup and I hold on to as much as 0.1% by the time of a sale, the sale price needs to be $100M in order for me to get $10,000 out.

So- potentially big short-term help for the company; low return to the advisor in most situations.  Everyone needs advisors and fortunately there are plenty of people will to help others along, but be aware that the principal reward is not economic.  Every once in a while someone does a good deed and gets a big windfall for it, but that is not and should not be the norm.

Where Does the Advisor Equity Grant Fit In?
I am a rules-oriented guy, especially when it comes to equity.  My rule here is that an advisor’s equity should be proportional to his/her contribution to the company and should fit in the cap table scheme.  The typical early stage cap table should look something like:

* Founders at 60 – 80% ownership (depending on investment)
* Seed investors at 15 – 33% ownership (depending on investment amount)
* Equity pool for employees and advisors at 15%

Put the advisors in the equity pool, then compare their contributions to those of the employees.  Equity grants less than about 0.5% become meaningless really quickly and I don’t see companies going below that in most cases, but the amount of equity given to an advisor should be compared to employee grants.  If the lead engineer gets 2% and the person who made several introductions and advised on sales channel development also gets 2%, those introductions should be giving the company serious traction.

Advisor Equity is the Tip, Not the Full Payment
There is a balancing act here for sure: an advisor’s short-term help needs to be weighed against the long-term contributions of the full time team members.  In the end, it becomes unfair to the team to give out large advisor grants in most cases.  My favorite way to think about it is that advisor equity is like the tip paid at a restaurant- it is not the full meal ticket.  Sometimes the advisor gets her/his full bill paid in cash too, and sometimes the payment is in goodwill and the satisfaction of having helped out.  Equity grants that reflect this do the best job of treating everyone appropriately across the board.

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Winding Down a Co-Founder Equity Relationship

July 31st, 2009

I have had several questions about this topic recently from different angles, so here are the basic concepts when a co-founder or early employee leaves a company.  Note that there are overlapping employment, noncompetition and other issues here that I am not going to touch in this post.

The Setup

CloudWidget, Inc. has three co-founders.  They own equal 1/3 shares of the company and everything goes along swimmingly until Founder B moves away/gets a new job/has irreconcilable differences with Founders A&C.  Whatever the reason, B decides to exit CloudWidget and move on.

A&C come to me and ask questions that include:

-> Does B own his stock?
-> Can we get some or all of it back?
-> What should we do?

Threshold Questions

We start with the following key points:

1)  Does B own *stock* outright or stock options?  This is a critical point that many first-time entrepreneurs gloss over and that colors everything else that follows.

2)  Is there a vesting period attached to the stock/stock options?  If so, what is it?

Important Concept #1 – Earning into Equity

Every participant in a startup should earn into his/her shares over time so that if/when the person leaves s/he won’t get a free ride on the backs of the people still plugging away.  If B’s equity was stock options, then almost certainly the options are subject to vesting.  Leaving the company stops the vesting and B must exercise the option and pay the purchase price to get actual shares within 90 days (usually) or the option expires and all right to buy shares vanishes.

It is more common for co-founders to buy stock at the outset than to get stock options, though.  I encourage all my startup clients to put this founder stock on a vesting schedule as well.  This gives the company the right to buy the stock back at the price paid by the founder.  The right expires over time: typically 25% of the shares are owned outright and not subject to repurchase after 1 year, and the repurchase right lapses as to the remainder in monthly increments for another 3 years after that.

For some reason lots of people accept the idea of stock option vesting as a matter of course, but don’t put stock on a repurchase schedule.  Again, I highly advise that everyone do this.

Important Concept #2 – Getting the Stock Back

If B holds a stock option CloudWidget needs to do very little.  On termination the option automatically stops vesting.  Good employment practice dictates that CloudWidget give notice that any vested shares must be exercised within [90] days or will lapse, but that’s the extent of CloudWidget’s affirmative duties.

Let’s assume instead that B bought his stock outright, that it was subject to a repurchase right and that some, but not all of the right had lapsed.  CloudWidget needs to find B’s stock purchase agreement and read it carefully. Some agreements require that CloudWidget buy back the stock within a set period of time (90 days) and some say that the repurchase is automatic on termination.  It is important to know what B’s agreement says so that CloudWidget doesn’t blow its opportunity.

If procedures are followed and the agreement is written correctly, B agreed to the repurchase terms when he signed the agreement, so his consent is not required now.  CloudWidget merely needs to exercise the repurchase right, cancel his stock certificate (hopefully in escrow with CloudWidget or its attorneys) and send him a check along with a new certificate for the vested, un-repurchased shares.  If B had vested in 1/3 of his shares he will end up with 1/9th of CloudWidget; A&C each own 4/9ths going forward.

Important Concept #3 – Not Burning Bridges in the Process

This is frequently the hardest part of the whole situation.  Companies need to know what their rights are, and then exercise them judiciously.  Circumstances vary dramatically case by case, and I always let my clients now that the agreement is the baseline for ending a relationship but is not definitive- everyone is free to reach any other agreement that makes sense, and it is often worth trading a little cash or equity in order to maintain a friendly relationship where possible.

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The Case of the Late Co-Founder

January 13th, 2009

This situation comes up for me all the time and it is really hard to manage in a way that makes everyone happy.

The scenario is that founders A and B start a company and split the initial shares.  Time passes, business happens.  The company may or may not take on investors or issue equity to employees, but the business grows one way or another to the point that even by the most conservative valuation methodology- free cash on the balance sheet- the company can no longer justify the super-duper-low stock price the founders paid.

Person C them comes into the picture.  C is an extremely high-powered executive who can bring tremendous value.  A and B want to treat C as effectively a co-founder and give her a share of equity equal to theirs.  The challenge is that since the company now has real value, C’s share of it can be expensive.

A, B and C come to me and say “please do your legal magic and make this all work out right”.  Sadly, there is no magic here, just a bunch of unhappy compromises.  There are three main intertwined issues: how much the stock costs, when to pay for it and what the tax consequences will be.  Here’s my shot at acknowledging them and pointing out the options in 500 words or less.

What the Stock Costs
This is simple on its face.  Per share value = company valuation / number of shares.  The valuation number is the toughest variable to work out, and the methodology we use depends in part on IRS rules.

When to Pay For the Stock
Wherever possible, we want to buy the stock early.  Owning stock outright starts the capital gains clock ticking and that can make a big difference when the company is sold (the SEC’s Rule 144 holding period starts at the same time).  Owning a stock option does not count toward the capital gains period until the option is exercised.

What are the Tax Issues to Dodge?
The two big ones are capital gains rules, which require the stock to be held for one year before it is sold, and Section 409A, which imposes a penalty on stock or options issued as “deferred compensation” (i.e. basically any equity issued now and paid for later) if the stock or options are issued at a price deemed below fair market value (more on 409A here).

And here are the preferred ways to handle this situation, with their attendant drawbacks.

Buy the Stock
This is the cleanest option.  Buying the stock outright avoids 409A issues completely and starts the capital gains clock.  In my experience, though, most people do the math and decide that a year or two of sweat equity is one level of risk, but cash is something else entirely.  Most people opt not to take this option, especially when the price is in the 5, 6 or 7 figure range.

Stock Options
This used to be everyone’s favorite way to handle this situation, and it may still be the best.  If the company has real value, co-founder C could have a huge bill to get her stock.  Options let her defer payment of the price until she knows the company is going to be worth something (esp. the night before the company is sold).

409A throws up one roadblock here.  To avoid the 20% penalties, the company will need a valuation of its stock.  This is often manageable, though no one likes paying ~$10,000 for the valuation.

The bigger drawback is that she will probably lose her shot at capital gains treatment.  She would need to exercise a year before the company is sold to get into capital gains land, and if the exercise price is high that may not be feasible.

Historically, more of my clients have elected this option than any other.  No one likes paying taxes, but at least this option limits the risks (assuming the 409A issue is handled well).

Promissory Note
Back in the dot-com days this was popular.  Executive buys the stock and gives the company a promissory note for the purchase price, intending that the company would either forgive repayment or Executive would repay it from sale of the stock in a merger or IPO.  When the companies hit the wall, however, bankruptcy trustees seized on these notes as collectible debt and a number of very unhappy conversations followed (“you mean I got almost no salary, my stock is worthless *and* I need to pay you $200,000?!?”).

A promissory note would work for C’s purposes, but it carries a lot of risk.  It is a promise to pay the company and if things don’t go as expected C can find herself not merely uncompensated for her time spent with the company, but actually owing money to it.  Once in a while a situation arises where this arrangement can make sense, but it is rare.

Is That It?
That’s what A, B and C always ask me when we talk through the possibilities.  Unfortunately the answer is yes.  We use the most favorable valuation we can justify to bring the price down (assuming we have any flexibility there), but in the end the whole purchase price must be paid.  C can pay up front or she can pay later, but there is no way to do what clients really want- which is to sneak C in at the original founder price.

The lesson?  There are two, I think.  (1) get in as early as possible; and (2) get your stock documented right when you arrive before the deal gets any worse.

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