I’ve spoken with many entrepreneurs and one thing that keeps them up at night is the mistake that costs him or her equity. We’ve come across quite a few of these with our clients. Fortunately, with a little knowledge and foresight, you can avoid making them. Knowing what those mistakes are and how to fix them could be the difference between burnout and payout.
1. Lack of proper documentation
Lack of 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 (remember Paul Ceglia who claimed he owned 84% of Facebook?) 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.
An email or letter isn’t sufficient. Spend a few grand on legal fees and set up these things:
- A stock record of 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.
- A written stock option plan.
- At the founding, set aside 10% of your equity for stock options. If you go to raise capital, this will count against your shares outstanding, so don’t put aside more than 10%. You can always raise it later.
- Make sure you get proper board authorizations and follow your attorney’s instructions for making stock option grants.
- Keep copies of the grants!
- Set some standards for who should get how many shares. For example, a non-founder CEO of an established, funded startup may get 5% – 10% of outstanding shares.
- A cap table.
- This is a listing of who owns what shares and stock options.
- It should be updated every time an equity transaction is made.
- As you grow you can automate this using services such as Carta (formerly eShares)
2. 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 cash flow projection of 6 – 12 weeks to give you advance notice for when funds may get tight.
3. 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. It gets messy and nobody ever spends the time separating the two. Write checks to the business and classify them on your books as either capital contributions (preferred) or loans. 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, more often than not the investor will want that loan converted to equity. Loans make your balance sheet weaker as they are a liability to be repaid. Investors want to see a healthy amount of founder capital invested in the business so they know you are committed. It also helps you as the cash committed counts against the valuation of the company and your percentage ownership stake.
4. 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, your investors may enjoy a guaranteed rate of return before you and your angel investors see anything. Terms matter, and shrewd attorneys can help you balance the tradeoffs between valuation and terms.
5. Unintelligible financial reporting
Investors will not invest in your business if they can’t understand it. The language they speak is written in financial statements. If your financials are hard to understand, poorly prepared or are riven with errors investors will use that as leverage to get more equity. Make sure you can pass due diligence by having a seasoned expert review your systems prior to raising funds to ensure the information produced by your accounting can withstand scrutiny. Better yet, implement sound financial systems from the start. You’ll get the information you need to grow the business, make due diligence easier, and impress investors who have seen too many shoddy financial systems in their deals.