The decision to share equity might be the most important ones entrepreneurs ever make.
It’s understandable that small business owners want to keep as much equity as possible. After all they are the ones who took the big risks. Many left promising careers, pledged [and possibly still are pledging] personal assets as collateral for bank loans, held their paycheck until there was enough money to cover them, and on and on. But tough times call for tough decisions and the decision to share equity might have been the most important ones we ever made.
Good talent is hard to find and even harder to keep. Your competitors will be on the prowl and regularly contacting your top talent. It’s especially difficult to keep your key employees when your business experiences a slowdown. When cash is tight you may not have the ability to reward employees with pay increases and if it’s really tight you might need to go the opposite direction with pay decreases. During one particularly tough period, we exhausted our usual options (reducing owner’s compensation, holding checks, etc.) so we needed to do something drastic. We didn’t want to have a layoff because we could see the light at the end of the tunnel and knew we would need the staff. So we implemented an Employee Stock Option Plan (ESOP). We recapitalized the business and put approximately 15% of the shares into the ESOP. We distributed 10% immediately to current employees based on tenure and job title and used the balance to have available for new hires. The plan included a 4-year vesting schedule but there was an accelerator clause for a change in control of the business. It’s probably fair to say that although the employees enjoyed the feeling of having an ownership interest most did not totally understand the concept of a stock option. [Some would later put children through college with the proceeds].
Investors (Preferred Stock vs. Convertible Notes)
In today’s world of abundant tech startups, seed financing is a standard part of the startup process. Our startup was bootstrapped by a small amount of owner investment and a lot of sweat equity. But some businesses like ours need capital further down the line to take advantage of a new business opportunity that can’t be funded from current cash flow. The transition of our company from a bricks and mortar business to a software-as-a-service model was going to take some outside investment. Traditional bank financing was not an option. We turned down a preferred stock investment from a specialty VC fund primarily because we would lose control of some key decision making (e.g., like when we would be able to sell the business). We opted for a convertible notes offering and spent a couple months making presentations to various private investors. We ended up raising $250,000 offering a generous 6% coupon rate and 20% discount when the note was converted to common stock in conjunction with the sale of the business.
In the final analysis, the founders owned approximately 80% of the stock and the remaining 20% was split among employees and new investors. Looking at this purely from the founders perspective, by giving up 20% of the company we realized a 300% increase in the actual cash value of our ownership stake. Although you can debate individual terms of these deals, it’s hard not to conclude that the ESOP and Convertible Notes Offering had a lot to do with helping a struggling company become a market leader and increase total shareholder value exponentially.
And the day you walk around and hand out checks to your employees will be one you remember for a very long time.
This article was originally published on LinkedIn.