There is often a temptation among founders, particularly cash-strapped ones, to give away equity to employees, service providers or advisors. If you’ve seen “Shark Tank” you know the drill: company founders give away chunks of their business for the pleasure of being advised by someone who claims to have the best interests of the company at heart (and maybe a little bit of money). But what if someone you hoped would contribute to the company over the long-term clashes with your vision, doesn’t contribute as you’d hoped, or leaves?
Founders should be aware of the various ways they can incentivize those who contribute to their business while also maintaining certain expectations and levels of control. Like always, it’s helpful to begin with the “end in mind”—not only the end of the equity holder’s contribution to the business but also the successful end of the company itself (through acquisition or merger). Before giving anything away, consider these various protections and alternatives to equity, keeping in mind they are likely subject to securities laws and may have serious tax implications for your business:
Ask yourself if there’s a good reason the person receiving equity should receive it all at once. What incentives will they have going forward? Are you ensuring they will contribute as promised? Even those who have the best of intentions may be sidetracked by other projects, life changes, or a decrease in interest. Most contributors to your company will be willing to accept a vesting schedule for their equity—they likely understand your situation, and want to be valued team members in the future. Except in rare circumstances, even founders should receive equity according to a vesting schedule.
Rights of First Refusal and Other Restrictions on Sale:
Equity is almost always restricted in some way. If your company’s operating agreement or shareholders agreement has rights of refusal in favor of the company and/or the existing equity holders, odds are that new equity holders should be made subject to such an agreement as well. This serves several purposes, not the least of which is that you can control who’s “in the tent”—you are able to keep tighter control of the company and create fewer concerns for future investors by limiting equity holders to those you know and trust.
Although less common than vesting or rights of first refusal, repurchase rights allow companies to buy the shares of certain employees or other equity owners, often when they leave the company. This is another mechanism for keeping a clean cap table and maintaining control of the business. The company can give itself the option to repurchase shares already granted, and may do so depending on its financial position and the company’s relationship with the departing equity holder.
Founders and companies have a number of choices for incentivizing employees that may work better with the company’s structure and tax scenario. Appreciation rights and phantom rights, for example, can be structured to mimic the economic rights associated with equity without founders relinquishing any ownership or control of their business. Options give employees and others a share of the upside in the business, as do profits interests in limited liability companies. Working with these alternatives, like granting equity itself, should happen after careful consideration and, of course, consultation with an attorney and tax advisor.
What is written here is intended as general information, and is not to be construed as legal advice. If legal advice is needed, you should consult an attorney.