Intro

While splitting the equity in Phase 3 may seem like the most important step to get through, that’s really only half of the challenge. The initial split of equity assumes that everyone knows exactly how significant of a contribution each person will make and what their long-term trajectory at the company is.

In fact – we have no flipping clue how the rest of this plays out!

Not convinced things might not change? Here’s a quick rundown of people who thought things wouldn’t change:

  • Steve Jobs (Apple) – Invents the Mac. Gets fired. (Not a bad comeback, though)
  • Travis Kalanick (Uber) – Grows Uber to $70 billion in valuation. Gets fired.
  • Martha Stewart (Martha Stewart Living) – Builds billion-dollar brand. Goes to jail.

Understanding the need to plan for change is ridiculously important. These plans mean creating mechanisms to re-distribute equity, pay out equity, and in some cases fight to get it back. Very few companies avoid any version of these fates, and therefore if we’re going to figure out how to split up the equity, we need to figure out how to manage it once it’s distributed.

Plan for Change

In order to properly understand why being able to manage equity is so important, we need to understand what happens if no provisions are in place long term. We run into problems like “dormant equity” which leaves the folks who stick around essentially working for the folks that don’t.

Right now it’s hard to consider all of the possible changes that can occur, so before we get into the different provisions for how to manage equity, we’re going to spend a quick minute on why these provisions need to exist in the first place. There’s a 99% chance they won’t happen to us - but if they do – they are damn important!

4 Keys to Managing Equity

Once we realize what can go wrong, we’ll want to put a plan in place to handle the change. And we’ll want to do this ahead of time, while our team is still agreeing on stuff.

Managing equity really just comes down to “What happens when someone leaves?”. If the company sells and we all get a giant check there’s not much to disagree on. But if someone leaves we need to figure out what happens to their stock and how the affects the rest of the people that stayed.

We’ll learn to manage our equity with 4 tools:

The Clawback

The mechanism to return equity to the company in the event that we don’t buy out the stock.

The Buyback

The terms at which we buy back the stock in the event the company has the means to do so and a member wants to sell.

The Lookback

A way to extend the window of time someone can enjoy the benefit of their stock after they have left.

The Lean Back.

Fat Joe and the Terror Squad show up and begin doing da Roc-Away. Just kidding, that’s not really a provision, but if someone is able to put that in their Operating Agreement they win at life!

Each of these tools will prompt us to address a few key decisions that collectively will give us the foundation for our equity split. We can then present this to our attorneys as a way to have a healthy conversation around how we want our documents drafted. Also, it may save us a few dollars which we are certainly going to need!

Plan for Change

If we can be certain of anything, it's that whatever we think the makeup of founding partners and contributions looks like today, it will all change. It almost has to, given the fact that the needs of the business in its formation are often starkly different than the needs of the company as it grows.

My cousin Mildred might be willing to help out with bookkeeping now, and she may be providing 20% of our labor force, but that doesn't mean she should own 20% of the company long term.

The key to understanding how equity splits work long term is to recognize from the start that nearly everything will change and evolve over time - so the decisions we make now need to account for the dozens of major changes in value and contribution that will exist over the next decade or longer.

Skill Value Changes

I may be the "CFO" right now because I'm the only person in the room that took a finance course in college. But that doesn't mean that my long-term role will be CFO, or that I can or should be compensated "like a CFO" in the open market.

It's typical that in our early days we'll all be taking on the roles of entire departments or C-level executives, but the overall value or skill level of our contributions may be largely based on the fact that there's no one else to do them!

Time Investment Changes

Right now, we're both super pumped to be working on this startup. We're putting in every waking hour, working weekends, and giving up our favorite holidays. It's awesome (right?)!

But a few months from now, another awesome event happens - I found out that our family is expecting our first child and I'm going to need to focus my “non-existent free time” elsewhere. On top of that, the prospect of forgoing income becomes a real problem and I realize I'm going to need to get at least a part time job to supplement my new costs.

In a moment, my time investment can go from "every minute, all the time" to "whenever I can find the time." To assume that no life events will ever occur and that our time commitments will never change isn't very realistic. Therefore, we need to know what to do when and if our time commitments in the future are different than our time commitments today.

Capital Investment Changes

The amount of capital the company will need will change dramatically over time. $10,000 of investment might sound like a landslide of capital today, but in a few years, it will be a day's pay. While there is definitely a premium someone can and should earn from investing early, there's also a reasonable limit on how big of a chunk of the cap table someone should get.

Typically, the percentage of stock a capital contribution yields is commensurate with the "valuation" of the company which will be an entire discussion throughout this course. Suffice it to say, the first $10,000 should definitely provide a healthy return for being the riskiest capital, but within a limit on stock ownership that reflects the future of the company, not just the present.

Critical Needs Change

Today, the most important thing is to get our initial website up so that people can order our new line of fragrances for pets. Therefore, the Web Designer is by far the most important asset to the company. She is willing to design the new site for our canine cologne for a mere 40% of the company. We have $0 in capital, so getting it for "free" sounds amazing!

Yet, once the site is up, our focus and capital won't be on building a website, it will be on marketing and refining the formulation for our product. We're going to need our stock to attract investors and new talent. But we gave 40% of the company away to a designer who was only critical to that one facet of our launch 3 years ago for an 8-week project.

It's important to calibrate the needs of the business today versus the needs of the business a year or two from now (or longer) and not give away the farm immediately.

Founding Team Changes

The problem with confirming a "founding team" and the equity stakes that folks get is that often the only requirement for stock is that everyone suggests they will continue to stick around long term. But unlike working for a paycheck where our only commitment is showing up every day, working on a startup means we may never see a paycheck - and that tends to send people packing.

Just because people co-found a company doesn't mean they can't leave. They can, and they often do. There are just way too many unknowns going into a startup to allow every participant to stick around indefinitely. Therefore, it's imperative that no matter how strongly the Founders feel about their commitment to the company today, they provide some basic provisions for what will happen if that commitment changes.

Dormant Equity

The culmination of all these of these changes typically leads to one massive issue – dormant equity. Dormant equity is what happens when over time the Cap Table becomes filled with participants who own a stake in the company but don’t materially participate in its growth any longer.

A big reason this gets overlooked when forming a company is because as of yet – everyone is still there and still contributing! Yet over time as things change we are likely to run into more and more scenarios where we’ve granted equity to folks who aren’t around anymore.

The Absentee Landlord Problem

The Absentee Landlord problem happens when we have people who own part of the company but are no longer contributing toward its growth. It happens all the time, and without proper planning, it can be a total disaster.

Let's say we have 2 Founders, Mugatu and Hansel who split the company 50/50 at the time of founding. In Year 2, the second Founder, Hansel, leaves to take on another job. He still owns 50% of the company yet is no longer contributing toward its growth. Every year that follows after Year 2, Mugatu is working 100% on the business for the same outcome that Hansel gets for working 0% on the business. Hansel is the absentee landlord who's getting a check without actually having to be there.

This is an awesome deal for Hansel. It's a straight up shitty deal for Mugatu.

This problem gets exacerbated with even more with time. If the company were to sell in Year 3, we could argue that Hansel put in 2 of the 3 years required to make the company successful, and while Mugatu had to put in an extra year - 33% more - it's not the end of the world.

But that's not how it usually goes. Instead, it's more like Mugatu works for the next 10 years, sending a check to Hansel who doesn't even work there anymore. How cool do you think Mugatu feels about that every year? Not cool, friends. Not cool at all.

The longer this problem festers, the more toxic it becomes.

That's not only a problem when it comes to splitting the profits every year (if there are any) but also begins to erode the motivation for Mugatu and all the of the other equity holders in the business. It's also a problem for future investors who don't want to invest in a business where half of the cap table is owned by absentee contributors. It's a bad deal for everyone (well, except Hansel!)

The answer to this problem is simple - provide a mechanism whereby Hansel can either hand back some of his equity or be otherwise compensated for his contribution monetarily. The rest of this section will cover the tools used by startups to recover their equity as well as ways to make sure that exiting holders are treated fairly for the contributions.

The Clawback

Giving away equity is easy. Getting it back – boy, that’s a different story altogether!

“Clawback Provisions” are designed to return equity (stock) to the company based on any number of provisions. No one likes giving their equity back, so for this reason, the Clawback Provisions are easily the most contentious of the bunch. They don’t even sound friendly.

Clawback Provisions are likely going to be the single most important part of how we manage our equity program long term. They are specifically what helps us avoid some of the “absentee landlord problem” which leads to a ton of dormant equity in the Cap Table. It also provides a bit of insurance against making poor stock grants.

Most Common Clawback Provisions

For what it’s worth, most of these provisions will exist as standard fare within legal documents around stock options, our Operating Agreement, and other controlling instruments. Our startup lawyers will bore us to death with these details. But, as it happens, they really matter.

Within our team, though, we most definitely need to agree on these provisions before we get too far along or the discussion will turn into one person defending their particular situation versus the entire group agreeing on a hypothetical future.

In that future, we’re looking at a handful of typical scenarios:

  1. Someone is terminated for cause. “For cause” means someone was fired for a valid reason – they did something materially wrong. That could range from job performance to criminal activity but would be stated as “out of bounds” in the Operating Agreement (for members), the Stock Agreement (for participants) or even the Employment Agreement (for everyone). Being terminated for cause typically invokes a much harsher Clawback penalty and in some cases can lead to the rescission of benefits altogether.
  2. Someone is terminated without cause. “Without cause” means the member didn’t deliberately do something wrong. This could be a reduction in staff (“We ran out of money and we can’t afford to pay you anymore”) or someone simply quitting. In this case we may have a lighter clawback or none at all. These tend to be a departure on mutually agreed upon circumstances, or at the very least, ones that do no deliberate harm to the company.
  3. Exercise Period expires. In the event of an “exercise window” expiring, the stock returns to the Cap Table. Typically this happens if a Stock Option is not exercised within the allotted time. In this case it may not matter whether there was a termination for cause (such as if it was an agreement with a contractor or advisor who is not employed by the company) but may simply be a matter of how the exercise window itself is provisioned and elapses.

Based on how the claw back is invoked, there will be a number of different outcomes.

How to Handle the Clawback

Now that we know we are looking at two main scenarios for clawbacks – termination for cause and without cause - the million dollar question becomes, “How do we actually handle each of these scenarios as it relates to a clawback?”

Let’s take a look at two ends of the spectrum and decide as a team which way we want to lean. Instead of presenting the lawyer’s perspective, let’s take a look at how Darth Vader and Luke Skywalker view clawbacks in their respective organizations. This will give us an idea for how Founders think about their approach on either end of the “dark side” and “light side” spectrum.

Darth Vader and Luke Skywalker Debate Clawbacks:

Scenario

Darth Vader (Stern)

Luke Skywalker (Friendly)

Someone leaves for cause

“You get nothing”
They failed at their job. We had a contract to perform and they failed to meet their performance requirements. They deserve nothing.

“You get what you earned”
While things didn’t work out, they deserve at least some token for their commitment toward the company, even if it’s a minor future payout.

Someone leaves without cause

“You keep a little stock”
They may get a token amount of stock but the reality is they are no longer part of this enterprise and we refuse to pay penance while they drift hopelessly in space.

“You keep all your stock”
We value their commitment to our organization and the time served should be well-rewarded now and in the future. They should be able to keep all of the stock they’ve vested without penalty.

Feeling toward Dormant Equity

“Only paid if you stay until exit”
Only the material and active participants in the future of this Empire should reap its rewards. Anyone else that is not there when we finally conquer the galaxy will not be recognized with the spoils of our victory.

“You get paid forever”
Our journey will be long and challenging and different allies will help us along the way. We need to recognize that each contribution, regardless if that member is currently with us, should be rewarded in the long term.

As we can see, there are two very different ways to think about dormant equity and how it relates to managing a clawback provision. In the same way that we’ll need to determine what HR policies seem fair and equitable to our staff, we’ll need to make a personal decision on what we think is fair toward our staff and to the company as a whole.

Key Takeaway

Determine how we want to handle clawbacks in 2 different scenarios – terminated for Cause and Terminated Without Cause. Then determine whether we want all of their stock to be pulled back or do we want a certain amount retained by the member?

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