Dead Equity on Your Cap Table is a Toxic Cancer
Coming up with the idea for a new startup is a lot of fun. These are the happy days. Nothing has been built, no time or money has been expended, and no inconvenient customers have popped the bubble of hope and expectation. Sadly, this is also when most founders eagerly decide how to split the equity and that first handshake often stands the test of time.
As any founder knows, or soon finds out, building a business is a marathon not a sprint. Not everyone has the perseverance or the toolbox to go the distance. Sometimes co-founders drop off along the way, sometimes they never even get out of the blocks but “a deal is a deal”. The Remainers continue the struggle, while the Exiteers drift off to double dip somewhere else. Make no mistake, while the Exiteers quietly celebrate their luck in getting something for nothing, the Remainers find themselves quietly seething every time they look at their cap table. Equity held by people who are not actively working in the business or have not made any kind of cash or hard asset investment is Dead Equity. Dead equity is the devil. Business operators hate it, investors hate it, in fact everyone hates it except the people who hold it and they tend not to let it go.
There should only be two ways for anyone to acquire equity in any business. You either do the work or you buy it with cold hard cash. Not for advice, not for ideas, not for your rolodex. If you think you have ideas or advice or the rolodex, then buy some fucking equity and use everything in your power to make it worth more.
Mike Moyer, an entrepreneur out of Chicago recognised this issue plaguing startups everywhere and went so far as to write a book on the subject called Slicing Pie. It lays out a radical new framework for equity allocation and he has pretty much thought of everything. In short, Mike’s framework revolves around allocating equity for hours worked and pricing those hours according to the opportunity cost of each contributor. it does require a certain amount of process and discipline to implement, not terrible traits for founding teams to possess. Admittedly there will also be arguments around pricing the opportunity cost of each contributors hours or how many hours were reasonably required to get certain things done. Mike does address all these issues but at the end of the day, those kinds of arguments are much less destructive than an unfair allocation of equity.
Even if you decide not to follow Mike’s Slicing Pie framework, at least wait for as long as possible before you allocate equity. You’ll then be able to get a feel for who is adding real value and who is freeloading. You’ll need to get the timing right on when to formalize the split. You need to have it buttoned down before you are open for business or before you raise capital from outside investors. Don’t leave it too late. You don’t want the initial founder equity grants to be deemed a receipt of value and therefore taxable. Your accountant, tax adviser or 409A valuation expert can advise you on the timing.
One thing to ask your advisor about is how to effectively use an LLC for the whole founder allocation. LLC’s are much more flexible than Corporations. Agreements can be created within an LLC about how the proceeds of various assets are distributed among the members upon a liquidity event. Even if your investors require a Corporation (like most venture capital funds) you could still use an LLC to hold all the founders’ shares and the members agreement within the LLC could lay out how the ultimate exit event gets split.
Finally, if you find yourself in a company with dead equity on the cap table, get rid of it! If the freeloaders won’t budge, shut the company down and start again. If you’re an investor, make it a condition of investment that the dead equity gets removed. If the founders don’t budge then save your money and don’t invest. Dead equity allocations are a toxic cancer and nothing good ever comes of it.