As attorneys representing startups, Milgrom & Daskam knows that early-stage businesses often have many needs and not much capital to meet them. This often results in startups bartering for services using whatever currency they have. Sometimes this results in interesting exchanges (two hundred pounds of Valencia oranges in exchange for a logo design being our personal benchmark); more often it results in founders giving away the most freely available form of credit they have—equity in their company.
Indeed, some businesses treat equity as a sort of credit card, and the consequences of doing so are every bit as bad as maxing out a credit card. Two situations we commonly see are:
- Equity is assigned to a contractor without an agreement, that contractor disappears before signing for it, and only reappears when the business is about to sell, demanding to be paid for his interest in the company.
- A company gives out more than 100% of its equity, forcing the annulment or purchase back of certain units.
In each case, the results can be catastrophically expensive for a new business and are likely to yield bruised feelings and litigation. With that in mind, here are a few general considerations whenever you sell control of part of our business:
- Proportionality—Your business may have an open-ended number of valuable employees, contractors, and contributors over its lifetime, but it will have only finite equity. Only the most important contributors should be given stakes in your business, and those stakes should be limited to small percentages. In all cases, start by assigning a monetary value to your business (or future business), and to the equity recipient’s contributions to your business. No equity offer, adjusting for other forms of compensation, should be for an amount exceeding this ratio of value to contribution. If you are not sure how much your business might be worth, then consider a SAFE (simple agreement for equity), which allows for equity awards without a clear dollar value of your business.
- Documentation—Most states’ laws require companies to document any change in ownership in multiple ways. Be sure to update your capital tables whenever there is a change in ownership or investment, and make sure to document each one with a unit or share award agreement. Most importantly, remember to sign everything.
- Equity Pools—The simplest way to limit the equity you give is to limit the equity available to give. An equity pool is a pre-determined percentage of your business that goes to rewarding valuable staff, contractors, and other contributors. Since the equity pool is effectively earmarked for contributions, use of equity pools serves to control the flow of equity.
Like money-producing snowflakes, every business situation is different and warrants different advice. Please feel free to contact us at Milgrom & Daskam for advice on any corporate or business-related matters. After all, it is best to learn from our past experiences, and not your future mistakes.