Don’t give away equity

One of the first pieces of advice I offer my clients is to resist giving away equity in their company. Oftentimes, however, clients have already granted or promised shares of stock in their corporation (or membership interests in their LLC) to an early benefactor who provided something of value to the company, an employee who helped build early iterations of the company’s product or service, a business adviser or member of the board of directors.

A large percentage of these startups, early-stage and even growing midstage companies, believe that equity is a cheap and easy alternative to the cash they often lack. However, using equity in this way can be a grave mistake if not done carefully. Unfortunately, founders often fail to pay particular attention to an individual’s personality and consider the consequences of having that person in their enterprise as a shareholder with associated rights. Without attaching specific rights and restrictions to equity grants, it is nearly impossible to claw that equity back once it has been issued. Consequently, the company can only hope that without the express right to remove them as a shareholder, it has not bound itself to someone who causes more harm than good.

HBO’s Emmy-nominated comedy series Silicon Valley provides an excellent visual context for the potential pitfalls of indiscriminately giving away pieces of your company.

One character, Erlich Bachman, stands out as the singular embodiment of why it is important to know a person’s character, strengths and weaknesses before giving him or her equity. Erlich’s character flaws and shortcomings, and the aftermath of his actions provide a comical, yet not entirely exaggerated, pictorial of the consequences of compensating individuals with equity.

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Erlich, in spite of his general incompetence and social gracelessness, is a self-made millionaire who shrewdly uses his home as an “incubator” for tech startups, claiming only a piece of equity in return for the use of his living room; in this case, 10 percent of Pied Piper, the show’s fictional startup.

As a consequence of being in Erlich’s incubator and held hostage to the 10 percent equity he owns and never hesitates to remind everyone of, Pied Piper is mercilessly subjected to Erlich’s injection of himself into all the company’s important moments, from hiring and firing, public presentations, news interviews, and meetings and negotiations with potential investors.

Generally, companies with inept or disruptive employees or advisers would not hesitate to terminate their engagement. However, when that individual owns equity without a defined process for the company to reclaim and recover it, the company and its founders often become consumed with the distractions caused by a disgruntled, painfully oblivious, or worse, exploitative employee-shareholder.

Companies can implement various equity-like alternatives that provide the same or similar upside incentives as outright equity, but without the associated shareholder rights. Such awards can be structured so that they are automatically forfeited and revert to the company upon a termination of an employee’s employment or an individual’s association, as the case may be.

Some plans can also be tax-advantaged for the recipient; however, tax and accounting considerations for the company must also be reviewed and considered when determining the best alternative for an employee incentive plan. •

Lawrence Sheh is of counsel for Providence-based Partridge Snow & Hahn LLP.

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