September 12, 2012
In a recent Tech Cocktail article, Mike Moyer writes about slicing pie. In other words, how entrepreneurs should focus on splitting up equity in an early-stage startup. Moyer summarizes his concept of the Grunt Fund, in which equity in a startup is allocated to founders on an agreed basis relative to each founder’s contributions.
As a lawyer who assists founders with these issues, I really like Moyer’s conceptual Grunt Fund framework. However, his article fails to discuss a few issues that could be vitally important.
Lawyers and accountants (as much as I love them) don’t really help young companies grow.
This is (obviously) true in a literal sense. However, good fences make good neighbors. In other words, when everyone knows what the rules are at the outset, they can work within the defined boundaries and aren’t surprised when those rules are later applied. The most basic of agreements in which founders decide how each will earn an equity position inevitably leaves out many provisions that a simple, boilerplate agreement would include. Under the right circumstances, these missing provisions can be absolutely vital to the founders.
The problem with equity in early-stage companies is that it is worthless. So folks spend a lot of money legally protecting a worthless asset.
If you are a true, seedling startup and your lawyer or accountant is charging you a lot of money to figure these things out, you should find a new lawyer or accountant.
The time to hire the lawyers and accountants is when you actually have built something of value.
How do you know when you’ve created something of value? There can be many forms of evidence. But waiting until there is objective proof that your startup is valuable is probably the worst time to try to hash out a real agreement with your cofounders.
Why? Think about this. Your cofounder, who was involved in the first stage of development of your ecommerce site (only to pack up and go hiking in Nepal for the last year), is now much more interested in his equity participation in your business. In fact, he’s got a lawyer who is insisting that his client’s 5 percent is actually 25 percent, and he’s got the emails to prove it. If everyone had put their heads together at the outset, this traveling founder could have been better reasoned with when the value of the business was little or nothing.
The right rules, therefore, should lay the groundwork for allocating equity on a rolling basis based on the relative value of the contributions of the participants.
This is a great concept but could present tax and governance issues. For example, if a founder leaves and the startup is a corporation, are the other founders receiving more stock or just enjoying the benefits of the departing founder’s stock no longer diluting the pool? The difference is key for tax purposes, and the IRS may not agree that your startup has no value.
In the end, Moyer is right when he says that “[s]tartups are about trust and doing the right thing for those who help you succeed.” There is little legal substitute for picking the right partners, but working through the legal boundaries to begin with can be vital in more ways than one.
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