Written By Dennis Cagan –
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.
The shifting value of equity vs. cash as incentive compensation
From the time a company is founded to the time it’s a multi-million dollar thriving firm (if it’s that fortunate) it goes through alternate cycles of the relative value of cash versus that of equity. Whichever one it has the most of is the least valuable.
Before the startup raises meaningful capital, money is more valuable than equity. When the startup has raised a healthy round of capital, its equity becomes more valuable, since it can now afford to pay cash to its employees, vendors, and other contributors.
This cycle can repeat itself several times over the life of a company.
The company can issue large numbers of shares, as long as they were originally authorized. The number of authorized shares of a corporation is set in the Certificate of Incorporation or Formation. Any change must typically be approved by a majority vote of shareholders. One common mistake is setting the authorized number too low to accommodate future needs including raising capital and incentive equity grants to contributors.
Certainly, one concern of founders and senior executives is dilution—the situation where more shares are sold or granted to investors or employees, and the insiders’ percentage of ownership is diluted or reduced.
One important thing to remember is that no matter if you use equity (shares for a corporation or units for an LLC (limited liability company), the company is still adding equity to the total outstanding amount. Therefore, both create equal dilution on a per-share basis. This emphasizes the importance of understanding, at any given time, which of the two—cash or equity—has more intrinsic value to the collective existing ownership of the enterprise.
Keep in mind, the dilution of management’s ownership is not a one-way downward slide, as many advisors will tell you. Later in this article, we will discuss how management can legitimately increase their ownership percentage in the company without buying more. For the benefit of simplicity, we will specifically reference the details involving corporations—regardless of the state in which they are incorporated. In most cases, these details and approaches can be tailored to apply to LLCs as well.
Why is equity such a good incentive?
It’s well known that most people do not work for money alone. Most tend to seek jobs that offer satisfaction, advancement, and perks.
A job at an early-stage company can be very gratifying. Advancement is very likely, especially when you get in early. As for perks, what sounds better than the prospect of a material cash payment somewhere down the road?
If an individual can afford to work for a reduced salary, or even works for a full market salary, the idea of placing a bet of their time and energy on the future, can be very motivating. It’s a big part of what motivates entrepreneurs themselves.
Others feel similarly, but perhaps to a slightly lesser degree. That said, going back almost to the start of ‘business’, people have worked for a share of the profits. Working for equity is just another variation.
Role of the board of directors
As a long-time professional board member and board consultant, I often suspect that my bias may be to magnify the importance of a board and its authority. However, time and again, we read stories and hear anecdotes from colleagues about situations where a board has made a decision or taken an action that either dramatically increased the value of the company, or alternatively, caused its downfall.
Underestimating a board’s relevance, even in an early-stage company, is a serious mistake that’s frequently made by entrepreneurs and even their experienced advisors.
The foundational documents (which will be covered in Part 4 of this series) of any company will stipulate how all decisions are made on behalf of the enterprise.
In a sole proprietor business, it’s the owner who ultimately makes the decisions. In a corporation, in almost all cases, the foundational documents give that authority to the board of directors (the “board”). In a closely held firm, the board may consist of only the founder/owner, or it may include a co-founder, spouse, or trusted associate—effectively placing ultimate control with the founder(s)/owner(s).
However, best practice for companies pursuing a growth path that they hope will ultimately result in a meaningful liquidity event (such as an IPO or acquisition) involves forming an impressive fiduciary board of directors with independent board members.
Regardless, either one is still officially the board.
Having board members who are experienced in the areas of raising capital, equity distribution, compensation, and more can not only save the company tremendous amounts of money and trouble, but also be a meaningful strategic advantage.