Equitable distribution

I have had many encounters with the question of how much equity vs. how much pay people should get for working on/in a startup. My basic philosophy was developed after one of my earliest startups, Legal Software Incorporated (LSI). This was a company I started with my uncle and cousin who ran a law firm (Apple and Apple in Pittsburgh, PA). LSI built a Unix-based software/hardware solution for law offices wishing to automate the processing of large volumes of cases. In this particular instance there was a combination of a standard law practice and a collection law practice. Collection law typically has lots of small- and medium-sized cases. I think our system had 25,000 or so cases from one client (a jewelry chain) at one point.

I designed and implemented a system that had user terminals and was designed to make it minimal effort for a trained legal assistant to do the specific repetitive tasks associated with the law practice, including tracking all the dates on every case and making sure the process was properly followed in a timely fashion and with the proper sets of letters and actions associated with every phase of the legal collection process. I eventually created "PayBack", a PC-based software product that automated this for even smaller law offices.

In forming the company, I had never before thought about the question of who should get what for what. Lesson learned. Even my uncle and cousin couldn't come to terms with me on how to do this, and my naivety was a substantial part of why the business never could compete with the one major competitor in the space. That and a total lack of funds... knowledge of how to get funds or the need and use for them, understanding how to succeed in a marketplace, business acumen, a go to market strategy, an intellectual property position, the list goes on and on. What I did have was technical skills and energy to implement a solution for a 25-person law office in my uncle's practice. They got 10 years of hardware-cost-only computing and higher worker output, and I got experience.

Perhaps fortunately, I owned a relatively small share of the equity in the company that failed. Otherwise, I would have lost a fortune when it went out of business. How's that for justification?

My current views

My basic philosophy is that earlier is worth more, more work is worth more, higher risk is worth more, and some work is worth more than other work (strategic, important, rare, etc.). Let's break that down:

Things get complicated

In the simplest case, this is pretty directly calculable, assuming you have the knowledge you need to do the calculations. But things get complicated. One common example of a more complex situation is the holding and operating company model.

In a holding company model, a holding company owns some set of key things to the success of the overall business, and it creates operating companies to operate different facets of the business. Operating companies are generally separated based on projects and their funding or business functions. For example, there might be a research and development company that gets tax credits and government funding, several operating companies that operate in different states under different regulatory schemes, and a holding company that has the common intellectual property and connections to suppliers and customers. In such cases, each new operating company, as created, may have a combination of equity from local investors who fund the project, the holding company that brings intellectual property and connections, an advisory board, a CEO and local executives who run the operating company, initial employees, and so forth.

Determining the equitable distribution of equity is a function of what who brings to each table. For example, if each operating company reasonably needs an advisory board, that board may combine local expertise in the operating environment with expertise from the holding company, to provide the best combination of advice in context for the operating company. If there are 50 operating companies in 50 states, this means 50 advisory boards. The holding company representative who works on all 50 advisory boards will likely be extremely knowledgeable in how to do this function, and the information from each of the operating companies will be very useful to the others as well as the holding company. A CEO, on the other hand, typically has fiduciary duties to the operating company and cannot be the CEO of more than one such entity. For that very reason, they need the advisory board and its local and global content and team members in order to operate efficiently in context. But the decisions must remain local.

Employee equity

Employees getting equity starts to create problems at some point. Generally, anyone performing labor should be compensated for that labor directly. Thus pay becomes the path for compensation for time. As long as this compensation is fair, that is, at reasonable rates for the individual in the role, there is no problem. However, when people work for less than their normal rate and are compensated by equity, this becomes more complex, and some method of calculation should be used to determine fair compensation taking into account delays, risks, rewards, etc.

The problem is that there is only so much equity. 100% of all the ownership. The more you hand out, the less there is left. At some point, you run out or you have to dilute the equity holders in order to get more value in the company. But dilution changes the compensation equation for all of the participants. If you reserve some portion of equity for workers, as you get more workers, the value of their equity per workers goes down until it is almost worthless. And of course that equity is only realizable if you are a public company or if there is a monetization event.

In many cases, worker equity is effectively worthless, and it is often used as leverage to convince them that they are worth more than what they are paid. Thus the average worker gets underpaid and never recovers the difference. Of course you hear about the winners and how it makes the worker part of the team. We are all in this together. In truth, this is rarely the case financially, even if it works psychologically.

As a further complication, there are different sorts of equity that can be present in different sorts of entities. This includes non-dilutive, preferred, founder, and other special sorts as well as common. Each has different rights under different agreements in different jurisdictions, so note particularly when there are operating companies in different jurisdictions, you may need a legal advisor on each just to advise you on the equity issues.

An example

Here are example particulars for a small startup situation:

Each operating company:

The numbers here are not based on anything in particular, but hopefully, this makes sense as a structure.

In summary

Equity is complicated and should be well thought through. Once given you cannot really take it back, and it lasts till the end of the company or its monetization. Think though these issues for yourself, including the issues of what happens over time. Otherwise you may be surprised at how little you end up with and how complicated the legal case gets.

Copyright(c) Fred Cohen, 2017 - All Rights Reserved