Startup Equity: You’re Coming With Me, or maybe NOT (Part 13 in an n part series)

Stickman Startup Drag Along Tag AlongWe’ve covered a lot of ground in this series, but there is always more when it comes to equity compensation. Sharing ownership can be messy and participating in a liquidity event can be even messier. Companies, majority shareholders, and minority shareholders have defined tools to help avoid some of this messiness. Three of the most important provisions to consider in a startup equity plan are 1) Rights of first refusal, 2) Tag along rights and 3) Drag along rights. Often these are defined in your lawyer’s boilerplate document and never addressed during the design and approval phases of your plan.

1) Rights of First Refusal:

These are designed to protect the company from unwanted shareholders. They can be the bane of, or boon to, employees and other equity plan participants. The most basic form allows the company to buy shares from a potential seller for the same terms and conditions offered by a third party prospective purchaser. If someone wants to cash out, finds someone willing to buy their shares, and is not otherwise prohibited from selling their shares, they must first offer the shares to the company for purchase. If the company decides not to buy, the third-party can become a shareholder.

Rights of first refusal can be designed to allow the company to buy back shares at the most recent valuation price instead of the price offered by the third-party. This can ensure that the company is not “held over a barrel” by a seller who has found someone who passionately wants to become and owner and is willing to pay top dollar. This can be upsetting to a seller who has not read their agreement. This is especially true when the “investor value” far exceeds the value the company currently deems reasonable pursuant to a valid valuation.

Very few companies WANT a shareholder they do not know or with whom they are not on friendly terms. Most companies will exercise their right. But, what if they can’t? Not every company has the cash to buy back shares on a whim. Savvy equity holders can use this to their advantage by timing their potential sale to occur when the company is cash poor. It is critical that a company consider every possibility before simply signing off on a basic equity compensation plan.

2) Tag Along Rights

These are designed to protect minority shareholders. Imagine a majority shareholder decides to sell their shares. Imagine also that you are employee #5 and have purchased and held your shares for a while. When the majority shareholder sells, a tag along right ensures that the minority shareholder(s) can sell an equal percentage of their shares at the same price. If you are the minority shareholder, this can be huge. It helps ensure that the control and value of the company isn’t sold out from underneath you, especially if the purchaser is someone with whom you may disagree.

3) Drag Along Rights

These are designed to give additional power to majority shareholders. In many cases, a potential acquirer will balk at having to negotiate individual terms with minority shareholders. A well-designed, “drag along right” allows the majority shareholder to require minority shareholders (often equity compensation plan participants) to sell a pro rata portion of their shares to the acquirer for the same price, terms, and conditions as agreed to by the majority shareholder. This can be especially powerful if someone is looking to acquire 100% of a company. Negotiating with only the majority holder while guaranteeing the participation of every shareholder can smooth the process considerably. It also gives the majority shareholder significantly more negotiating power.

Lacking control of future transactions makes everyone a bit uneasy. Everyone should know whether they can leave the party, join the party or be forced to shut down the party. Building your equity compensation program to reflect your potential future transactions is a way to ensure all parties are treated in a way that can be both expected and relatively conflict-free. Most companies and plan participants do not pay attention to these details until the conflict has already started.

Startup Equity: But Can’t I Pay Less Cash? (Part 12 in an n part series)

Stickman Startup Cash ValueThis series of articles has covered a lot of ground, but this particular article touches on a critical component that we have not really discussed. When equity first began to be used in Silicon Valley, prior to the boom of the late-1980’s, the goal was getting senior players to have some skin in the game. This is still a major objective of equity.

As the stock market took off in the late 1980’s and flew through the 1990’s, equity became a cheap replacement for cash. The accounting rules ensured equity barely touched companies’ books. The stock market ensured that equity delivered far more, far faster that any form cash compensation. These high growth companies were able to keep cash pay low. This allowed the to easily compete for talent against large mature companies. This is no longer the case.

Many things have changed since the 1990’s. When it comes to equity compensation, the biggest change is that you only see lower cash pay at the earliest of startups. Far more Angel and Venture Capital money is being spent on staff than in the past. This means that less is going to research and development, or larger investments are required to build companies with no better potential than those in the past.

Remember that the accepted “value” of startups is based on recent investment rounds. Very few consider that a far great percentage of these investment rounds is being spent on staff than ever before. In fact, below the very top roles, we see very little differentiation in pay between public and private companies. The startup discount no longer exists for most industries.

What does this mean if you are an executive, HR leader of compensation professional? First, you need to budget the essentially the same base pay, and perhaps cash short-term incentives regardless of whether you have just finished your B-Round or your IPO. Second it means you need to be far better at using equity intelligently and efficiently. You can no longer throw a basic equity plan out there and expect to also get away with sub-par salaries.

Add to all of this the rapidly changing workplace and experience. Companies are spreading out more quickly. Employees at all levels are looking for more workplace (and time) flexibility. Housing prices are skyrocketing in nearly every location where equity compensation is a strong component of total rewards. The fundamental equation has changed and companies, and their leaders, must learn and adapt. They must understand that the bargain garage-based startup is far different when a garage now costs $1 Million.

So, in answer to the question: “How much less can I may my employees if I also give them reasonable equity?” If you are a typical startup, equity will not give you any direct cash savings. Of course, if you are in any industry where equity is uncommon it may still have some capability to reduce cash pay, but those industries are becoming increasingly rare.

The next pieces of this series will touch upon some of the most technical equity issues that are often not included in terms of compensation. These include: Call and Put Rights, Drag Along and Tag Along Rights and Rights of First Refusal. Let me know what else interests you in the space as I am wrapping up this series in the not so distant future.

Startup Equity: Staying Private in a Public World (Part 11 in an n part series)

Stickman Startup Private CoIt is readily accepted that an IPO is Nirvana to a startup. Of course, a fantabulous acquisition will also work in a pinch. Most startups design their equity plans around one or both of these possibilities. The events increasingly trigger vesting events, earn-out periods, house purchases and early retirements. But, what if you want to build something far longer-term? What if you only want to grow, make money and accomplish some important goal? Do equity plans even work for these companies?

The short answer is, they Continue reading

Startup Equity: What About Performance? (Part 10 of an n part series)

Stickman Startup Performance Dashboard“But, how do I make sure that the person is a great performer before I am forced to give them equity?”

This question gets asked by nearly every Founder, Investor or Compensation Committee Member very early in the development of an equity compensation plan. Sometimes it is expressed more genuinely as, “I don’t want to give away part of my company to someone who hasn’t carried their fair share.” Either way, the concern is valid. Sometimes the answer is very simple, and sometimes it is not.

Your equity compensation plan should be aligned with Continue reading

Startup Equity: Three Crucial Variables (Part 9 of an n part series)

stickman startup three crucial thingsStartup equity has approximately a gazillion moving parts. But three of these variables are far more important than all of the others. These three components are what make your plan uniquely yours. They are the things that require real thought. They are also the elements that are most commonly viewed as “plug-and-play” in the world of startups.

  1. Vesting Schedule

Stock options are grants with four-year vesting schedules. Everyone knows this. RSUs have a three-year schedule. Everyone knows this as well. However, while these are the most common vesting schedules, they are not as “standard” or as scientific as you may think.

The truth about vesting is a bit more complex. Vesting should align with Continue reading

Startup Equity: No. They Don’t Get It. (Part 8 of an n part series)

stickman they dont get itDuring a recent presentation I did for industry professionals, an attendee claimed that his employees didn’t need additional education on their equity compensation because they worked in tech and “already understood” these plans. I pointed out that he was mistaken. I stated that most, and perhaps nearly all, employees misunderstand, or do not even try and understand, their stock-based compensation. This is especially true for startups.

Check out a site like Quora, or attend a Technology or Human Resources conference. The questions about stock options, restricted stock units, dilution, values, taxation and more are wide-ranging and numerous. For almost 30 years, equity compensation and startups have been a ubiquitous combination. This long-term relationship has lead us to believe that Continue reading

Startup Equity: The Most Common Mistake (Part 7 of an n part series)

untitledHere is my 2017 gift to you. I truly believe that equity compensation helped build the technology industry, and therefore the world as we know it. But, an unfortunate number of startups make the same error when using this complex and powerful tool that drive corporate success.

If you browse the internet, ask entrepreneurs or receive guidance from someone at a VC firm, you will get similar answers when asking about equity awards for the first twenty, or so, employees. This information, while accurate at a generic level, is likely to be incorrect for your specific circumstances.

The answer looks a bit like this. Outside of the founders, the C-level hires should each get Continue reading

Startup Equity: Isn’t It Refreshing? (maybe not) – (Part 6 of an n part series)

untitledThe historically long periods between the startup and “big event” for companies has given rise to many issues that were never considered when stock options and other equity tools first became the preferred startup incentive tool. Among these unplanned issues are things like:

  • Wealth inequality between the first 20 employees and employee 5,000 or 12,000 or more
  • Grants expire when the company has not yet made its move to IPO
  • 409A Valuations
  • Dilution and burn rate issues long before IPO
  • Grants becoming stale
  • Downward movement in stock prices
  • (Ugh, this list can take the maximum 800 words allowed for this post)

This post we will discuss the controversial issue of “refreshing” grants for long-term employees. To clarify, these are not grants for promotions or company-wide performance. These are equity compensation awards that are given simply because Continue reading

Startup Equity: Synthetic Equity or Sharing Without Sharing (Part 5 of an n part series)

untitled4When you hear “equity compensation” and startups, you immediately think of stock options. More recently RSUs (restricted stock units that settle in company stock) have also been popular. But, what if you aren’t the “sharing” type? Or what if your company doesn’t have stock? LLCs are a good example. How does your business compete when it doesn’t have access to the same tools? Synthetic equity is becoming an increasingly popular answer.

Synthetic equity refers to any type of incentive plan where the value delivered to participants fluctuates based on the value of the enterprise. For corporations, the most common tools are Continue reading

Startup Equity: Comparing Your “Currency” to a Competitor’s (Part 4 of an n part series)

untitledComparing base bay is relatively easy, equity not so much. A dollar is a dollar. And, if a dollar isn’t a dollar (let’s say it’s a Franc), there are published exchange rates to help convert values. But, with equity compensation, the base currency is your stock, and its value is not easily translated (or even agreed upon). This fundamental disconnect is one of the most challenging issues faced by anyone dealing with equity compensation at a start-up.

Let’s start with the oversimplified example above. There are exchange rates from dollars to francs, but they are not as consistent as the prices available for Continue reading