We occasionally come across companies where one of the original co-founders has left the business. Founders may struggle with remaining positive in those hard early years where sales cycles are long and enter the famous ‘trough of disillusionment’.
Others might not be at financial liberty to continue investing their time in a high-risk startup while their bills mount, or they may fall ill.
There are a host of other reasons why someone may want to leave an early-stage company. People change, and expectations do not always live up to reality. Nobody said that starting a company is risk-free. In fact, it’s quite the opposite.
Either way, what a remaining co-founder wants to avoid is the situation in which a co-founder departs but insists on keeping all their equity. This is known as “dead equity” i.e. equity owned by people no longer actively involved in building the business.
The term can also apply to those grasping ‘accelerators’ who may demand a disproportionately large share of your company in return for some advice or for opening doors, without realising the problems that this may cause down the line.
In fact, the term can pretty much apply to anyone who takes a large stake in an early-stage company without continuing to contribute value in one way or the other.
A many-headed hydra
Equity can be used to acquire talent and capital. If you have a lot of equity that can’t be used for these purposes, then it’s effectively dead. And dead equity is a many-headed hydra.
For starters it’s a future financing risk – investors want founders and employees actively working on the business to maintain as much ownership as possible in order to keep them incentivised.
This is because ownership becomes diluted with each funding round. Therefore, if the management team are left with single-digit ownership while the company still requires investment, they may decide that the reward is not worth the risk and stress, and throw in the towel, leaving the company rudderless.
Owners of dead equity tend to contribute very little. Investors don’t want to take the financial risk only for a person on the cap table who contributes nothing to benefit. And this is before we even discuss how the other people in the company will feel when the owner of the dead equity continues to benefit from the hard work of the remaining team.
What’s more, nobody knows which obstacles a shareholder may put up to future funding rounds, especially if they have voting power.
These are just some of the reasons why institutional investors will generally want dead equity to be reduced before they invest.
I should add that the issue of dead equity is generally less of an issue when raising money from angel investors or corporate investors as these investors tend not to stress as much about the subject and don’t always understand the ramifications.
Avoiding dead equity
The best thing to do is avoid dead equity rearing its ugly head in the first place. Here are a few considerations you may wish to bear in mind with regard to ownership as you build out your company:
Agree on vesting schedules. A vesting schedule will allow you to take back at least some of the shares if a founder leaves within a certain period of time. Four-year vesting with a one-year cliff (e. no equity is given until at least a year has passed) has been the norm for a long time, but with companies taking longer to exit, you may wish to consider increasing the vesting period to six or seven years. Agree for a percentage of a leaver’s dead equity to re-vest when they leave the company in order that this can be used to incentivise new and existing staff; you may need to replace a senior member of the team, and this will be a lot easier if you can offer a slug of equity. In general, try to incentivise staff with options over shares; aside from being more advantageous from a tax standpoint, options will generally stop vesting when an employee leaves the company.
Put a buy-sell agreement in place. Setting out what happens if one founder leaves is essential for ensuring a smooth transition of ownership in extreme circumstances, such as disability or death. These policies can be funded through life insurance policies where the policy’s proceeds are used to buy out the departing owner’s share in the event of death. In this way, the transaction can be financially feasible without disrupting the business’ cash flow.
Avoid paying with equity. Try and avoid giving shares in your business in return for services. It’s not uncommon when cash is tight for founders to pay early bills with company shares. A good rule to follow is that if you can pay for services in cash, do! If equity is the only way (for example in the case where you are simply unable to raise cash to pay providers), then give options that will vest only in certain circumstances. Tempting as it may be, try not to give away too much equity to advisors (and certainly no greater than single digits); try and ensure that you retain the biggest chunk of equity as long as you can, as anyone outside the founding team with a disproportionate share of the equity is a warning sign to institutional investors.
Model it out. Model out any equity issuance in advance to see how it will affect future funding rounds and your own stake in the business.
Mitigating dead equity on your cap table
You may be in a position where the deal has been done and it’s too late to take any of the steps above. In this case, all is not lost:
Negotiate. As the old adage goes, it’s better to own a small part of something big than a big part of nothing. Of course, this is not always an easy conversation, not least when you have vastly differing views on the value of the company. People can certainly be difficult, but also have a great capacity to surprise. If you don’t ask, you don’t get.
Offer compensation. You can offer to compensate founders or employees for their contribution in return for them returning all or part of their shares, but beware of the tax implications and get professional advice. You may be able to facilitate a secondary sale, even if it’s not for the return they expect;
Get third-party input. If you are unable to agree, consider asking a third party whom you both trust to hear the case. These questions can be emotive and often all it requires is a cool head to find a solution that was there from the very beginning.
Chris Lascelles is an investment manager at Triple Point Ventures.
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