One of the biggest mistakes that company founders make when starting a new company is failing to treat equity like the precious and finite resource that it is. When companies are just starting out and have no revenue but plenty of expenses, granting equity often seems like a good way to purchase goods and services while saving cash. It is frequently only years later, when the equity has significant value, that all of those small, early grants create problems.
There are many reasons why founders should be careful about granting too much equity too early.
1. Depending upon the applicable state law, owners of closely held business entities may have heightened duties to one another. As an example, under Massachusetts law, owners of closely held businesses have been found to owe one another a fiduciary duty. The impact can be significant – for instance, terminating an employee who is also an equity owner can give rise to a claim for breach of fiduciary for an attempted freeze-out of the individual from the company.
2. Lenders and investors typically prefer to lend to or invest in companies with uncomplicated ownership structures. The reason is simple; the fewer owners a company has, the easier it is to obtain equity-holder approval and the less likely it is that equity holders will dispute company actions. Companies with many minority owners can end up spending a significant amount of extra time and money either obtaining necessary consents from equity holders or buying out minority equity holders to simplify their ownership structures.
There is no easy way to remove [a] nonperforming individual from the company.
3. Even where the company founders may begin with similar responsibilities and levels of contribution to the company, it is not uncommon for founders’ commitment levels to diverge. Founders who grant equity to individuals who are not as committed to the growth and success of the business often find themselves carrying the load of a partner who just wants to come along for the ride, and absent a well-drafted shareholder agreement or operating agreement specifically addressing these issues, there is no easy way to remove the nonperforming individual from the company.
4. Although granting a small amount of equity in the company’s early stages may seem like a way to save money on goods or services, if and when the company becomes successful, even a small amount of equity is likely to become much more valuable than the goods or services that the equity holder originally provided. No founder wants to work for years to build a business and achieve a multimillion-dollar exit, only to be forced to share the proceeds with minority equity holders who have barely contributed to the growth of the company.
5. Finally, the more equity that founders grant early in the company’s life, the less equity there is available to grant to investors and employees down the road without diluting the founders. If a founder grants equity early on, there is an increased likelihood that the company will need to authorize and/or issue more equity in the future, diluting the founder’s interest in the company. This issue is compounded if the company needs to seek outside investors, who will typically require the creation of a class of preferred stock that will dilute the founders further. Equity should be reserved for recruiting and retaining those service providers and investors who are essential to the company’s growth and success.
Although granting equity interests to friends, family and service providers might seem like a good way to expend company resources in the early days when cash is tight, doing so often comes with major risks and unanticipated costs down the road. Choosing business partners strategically and sparingly is the best approach to ensure long-term harmony between and among partners.
Colin A. Coleman is a partner and Brian J. Reilly an associate attorney with Partridge Snow & Hahn LLP.
