The Shadow CEO is an ongoing series with tips for entrepreneurs from serial founder and high-tech industry veteran Dennis Cagan, who has served on sixty-seven for-profit corporate boards, including ten publicly traded companies.
Many first, second, and even third-time founders get themselves into bad situations that could be avoided if they knew more about how corporate governance and equity distribution worked in early-stage companies.
Whether you hope to eventually sell your start-up to a larger firm or navigate through an IPO, if you plan on taking in investors—friends and family, angels, venture capital, or strategic corporate investors—you need to understand how to protect yourself and your management team.
The segments in this ongoing series can not only save you time and energy, but they could result in making—or saving—you millions of dollars.
Additional Equity Grants
The previous segment of this series covered protecting founders and special voting rights. Below we will look at giving founders additional equity grants as the company advances.
In most startup situations the founders do not receive additional equity grants beyond their original founders’ shares for a long time, if ever. They are simply left to watch their ownership percentage of the company diminish as additional capital is raised and new employees are granted equity. This segment explores a more founder-friendly way of looking at the situation.
Another tool for protecting founders relates to their compensation. It’s extremely common that after someone starts their company, and even puts in their own money, they—and often a number of colleagues—will work for no compensation (salary or stock) for some period of time, usually quite a while.
In most cases, this is not accounted for officially in any way. The justification in their mind, and supported by others, is that they own a large piece of the company, so make it worth something.
Let’s say that this continues for a year or so, and the company is up and running. It has raised some capital, launched its product, added more employees, and perhaps even has customers and possibly revenue.
Humor me here for a moment. The founder now just walks out the door and plants themselves on a beach somewhere.
Question: Do they own a single share less of the company than they did on the last day they worked? No.
However, back at the company, the other owners of the company, the investors and management, must now recruit a new person to lead the firm. Whoever that person is, they are unlikely to be willing to work for the same salary the founder was—zero dollars. Whether they pay the new leader a market salary with equity, or much less, it is guaranteed that it will be more than the founder was making.
Now consider this concept. The founder got their equity for starting the operation. Anyone that works there, including them, should get some form of compensation for their efforts. Yet entrepreneurs regularly initially work for a long period of time without any pay.
The point here is that they should be putting modest compensation on the books, for themselves and other contributors.
A new CEO of a tech startup may get up to $250,000 in salary, and perhaps an additional 5-10% equity in the company. That would be somewhat unreasonable for the founder. However, they could accrue $75,000 or $100,000 in salary and be awarded an additional 1-2-3% in equity.
Similar arrangements can be made for loans. These amounts accrue on the books. In the future, when there are investors scrutinizing the books for a possible investment, or the company is flush with cash, there will be a time to deal with these accrued amounts.
At any time, the board can award these things, and at any time the board can determine their resolution. Perhaps the cash is paid out, or some or all of it gets converted to additional equity. This is not only fair, but is an additional element of minimizing the dilution of ownership that insiders often suffer.
Additional equity awards, in the form of restricted stock or options, should be awarded to key contributors. In theory, everyone, including the founder, should have unvested equity in play as a continuing carrot out there—golden handcuffs, so to speak. Again, this is another element to help counter the natural dilution caused as companies advance in their evolution.
Don’t Be Left Behind
Hopefully, this piece gives aspiring entrepreneurs some valuable information. As many topics and as much detail as is included above, it only scratches the surface.
Every day, thousands of dreams are launched by entrepreneurs in the form of a company. Most of these individuals have no idea of what they are stepping into. Few seek advisors whose advice is up to the job. They embark on this journey knowing a fraction of what they need to know to increase the odds of their vision turning into a monetizable reality, and even less about how to retain their rights as founders, to continue to define its direction.
For every Zuckerberg, Dell, Bezos, Gates, Ellison, and Buffett, there are hundreds of disillusioned, disappointed, and failed entrepreneurs who were not able to ride their dream to success.
Entrepreneurs, don’t be left behind. Acknowledge what you don’t know. Learn it, whenever and wherever you can. Get world-class colleagues and advisors. Surround yourself with talent and experience in the form of a great board of directors.
Persist and lead your team.
Note: The information provided in this article does not, and is not intended to, constitute legal or tax advice; instead, all information, content, and materials available below are for general informational purposes only. Information in this article may not constitute the most up-to-date legal, tax, or other information. Readers should contact their attorney or CPA to obtain advice with respect to any particular matter. The views expressed here are those of the author writing in his individual capacity only.
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About the author:
Dennis Cagan, a noted high-tech entrepreneur, executive, and board director, has founded or co-founded more than a dozen companies and served as CEO of both public and private companies. The venture capitalist, private investor, author, and consultant, is a long-time board member of some 67 corporate fiduciary boards. In his Shadow CEO® role, he steps in side-by-side with a CEO to help them navigate circumstances and situations on a day-to-day basis.
A version of this column was previously published in Cagan’s “A Primer on Early-Stage Company Equity.”
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