Determining the amount of equity founders and employees get is a daunting task. It can be further complicated by mistakes that may cost you equity when negotiating a venture capital deal, an exit or if a founder leaves the company.
Here are five mistakes you can avoid that will preserve your hard-earned equity.
1. Lack of proper documentation
Early stage investors want certainty in the equity ownership structure of their investment. Lack of proper documentation is probably the biggest trigger of a lawsuit – and costly settlement. The problem isn’t when companies go bankrupt, it’s when they are successful. Anybody who has an email, letter or recollection of a conversation about shares they were promised will come knocking if they think they can get a quick payout.
Spend a few grand on legal fees and set up a cap table, stock record and stock option plan:
A Cap Table
This is a listing of who owns what shares and stock options.
Maintain an updated cap table every time an equity transaction is made.
As you grow you can automate cap table management using software such as Carta
This lists all share certificates that have been issued.
Make sure the certificates actually have been issued and keep copies of them if they are paper-based, PDFs if they are electronic.
Stock Option Plan
At company founding, set aside some equity for a stock option pool. Don’t make it too large as the entire amount is considered part of your fully diluted shares- even if you don’t issue all the options. A good starting point is 10% of the total number of shares outstanding.
Make sure you get proper board authorizations and follow your attorney’s instructions for making stock option grants.
Keep copies of the grants!
2. Unintelligible financial reporting
Private companies financial reporting systems often fail to keep up with the growth of the company. This can lead to inconsistent or incorrect financial data, which a savvy investor can exploit to get more equity.
Prior to the fundraising process, educate yourself on the due diligence process. Use a checklist to set up a data room. If you have difficulty getting all that information together, it may be time to hire an external resource to help you out.
3. Raising money after running out of cash
Investors gain tremendous leverage when they know their cash is going to save your company from going under. Avoid a down round by not putting yourself in this position in the first place. Create a weekly cash flow projection of at least 12 weeks to give you advance notice for when funds may get tight. Update it a couple times a month.
4. Failure to track founder capital contributions
Document every dime you put into your business. Do not commingle funds, such as putting business expenses on your personal credit card. If you put cash into the business, classify it as either a capital contribution or a loan. If investors can’t easily determine how much the founder has put into the business they will discount the amount and negotiate a higher percentage ownership for themselves.
Keep in mind that if you put founders loans on your books and hope to raise outside capital, you should treat the loan as a convertible note. Many investors expect founders to convert notes to equity (at the investors valuation) to keep their cash in the business.
5. Negotiating valuation over terms
A term sheet has arrived and that valuation you worked hard for has materialized. The problem is that it came at a big cost of liquidation preferences. When that payout comes, the preferred stock your investors hold may enjoy a guaranteed rate of return before you and your other investors see anything. Terms matter, and shrewd attorneys can help you balance the trade-offs between valuation and terms.
Rob Ripp is Founder and President of Fintelligent, an Entrepreneur’s Financial Department. See his other blog posts about finance and accounting for business owners.