Don’t ‘Sweat’ the Equity – Avoiding Costly Mistakes for Start-Ups

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Darwin Gray BannerStarting a new business is an exciting time with many questions to be answered and decisions to be made.

If you are a founder, you will most likely be working for free, perhaps alongside an existing job, until you can take the plunge to go full-time when the business starts bringing in money, whether that’s through investment, debt finance or early sales.

However, in addition to the founders, many businesses (particularly in the tech sector) will need other talent and skills to take the business forward.

In the early stages, there will be little, if any, money available for wages; you will therefore need to consider how to get the right people on board whilst not being able to pay them. This is why, particularly in the early days, many start-ups give away “sweat equity”, being shares in their company, in lieu of wages. Alternatively, they may put into place more formal and tax efficient employee share options schemes. However, particularly with the more informal arrangements, this is usually done without giving too much thought to future plans, particularly investment.

Risks to giving away equity early

Further down the line in the growth of a company, those early decisions to hand over sweat equity shares, without fully considering future growth strategies and plans, can have serious implications when it comes to seeking serious equity investment.

There is also the risk that not every employee works out in the long run. If you have given an employee a stake in your company and have no way of easily getting it back then that is going to present you with a big problem.

It’s also worth considering it will weaken your negotiating position with investors if you’ve given away lots of equity to early-stage employees but want investors to pay a large price for a small portion. It might also reflect poorly on your commercial judgement if you’ve given away a large amount of value without the employee contributing proportionately.

Serious investors will usually require the existing shareholders to sign up to a detailed investment or shareholders’ agreement. If you can’t get all of your shareholders on board or you have troublesome minority shareholders, then this may put a serious dent in your future plans for development, even potentially de-railing your entire plan for the future of the company.

The Good News!

The good news is that there are ways to manage the above risks but they do involve investing some time and money in obtaining the right advice in the early days of your business. These are the kinds of things that you can do to avoid having a problem going forward:

  • Always have an eye on your future strategy and plans
  • Make sure that if you are giving away sweat equity the person has earned it – don’t give away equity too soon
  • Don’t give away too much equity – what seems like a relatively small percentage now may be much more valuable going forward and seriously reduce the amount that you have to offer to future investors
  • Always attach vesting periods to equity. It’s quite common for equity to vest over 3-5 years. Some founders only allow equity to vest if the company achieves an exit to stop employees who are no longer committed walking away with equity upside.
  • Make sure that you have a professionally drafted shareholders’ agreement in place. You can build in the right to get back sweat equity if people leave the company, particularly if they are “bad leaver”

By taking sensible and reasonable steps at an early stage, you can hopefully avoid making the costly mistakes that some start-ups make in the early days.

Contributors:

Stephen Thompson, Managing Partner, Darwin Gray

Alexander Leigh, Investment Executive, Development Bank of Wales