Share Dilution

Using equity as an incentive and the role of the board »Dallas innovates

The Shadow CEO is an ongoing series of advice for entrepreneurs from serial founder and tech industry veteran Dennis Cagan, who has served on sixty-seven boards of for-profit companies, including ten listed companies.

Many first, second and even third time founders find themselves in difficult situations that could be avoided if they knew more about how corporate governance and stock distribution works in start-ups. .

Whether you want to eventually sell your start-up to a bigger company or navigate your way through an IPO, if you are considering recruiting investors (friends and family, angel investors, venture capitalists, or strategic investors), you need to understand how. protect you. and your management team.

Segments in this ongoing series can not only save you time and energy, but they could also save you or millions of dollars.

The variable value of shares versus cash as incentive compensation

From the time a business is founded until it is a successful multi-million dollar business (if lucky), it goes through alternating cycles of the relative value of cash versus capital. clean. The one he has the most is the least valuable.

Before the startup raises significant capital, money is worth more than equity. When the startup has raised healthy capital, its equity becomes more valuable, as it can now afford to pay cash to its employees, suppliers and other contributors.

This cycle can repeat itself several times over the life of a business.

Authorization of actions

The company can issue a large number of shares, provided they have been initially authorized. The number of authorized shares of a company is set out in the certificate of incorporation or incorporation. Any change must generally be approved by a majority vote of the shareholders. A common mistake is to set the allowable number too low to meet future needs, including fundraising and capital incentive grants to contributors.

Understanding dilution

Certainly one of the concerns of founders and senior executives is dilution, i.e. the situation where more shares are sold or allotted to investors or employees, and the percentage of insider ownership is diluted or reduced.

An important thing to remember is that no matter if you use equity (shares for a corporation or shares for an LLC (limited liability company), the corporation always adds equity to the total amount outstanding. Therefore, both create an equal dilution on one This emphasizes the importance of understanding, at all times, which of the two – cash or equity – has the most intrinsic value in the existing collective ownership of the business.

Keep in mind that the dilution of management ownership is not a one-way decline, as many advisers will tell you. Later in this article, we’ll look at how management can legitimately increase their percentage of ownership in the business without buying more. For the sake of simplicity, we will specifically refer to details about corporations, regardless of the state in which they are incorporated. In most cases, these details and approaches can be adapted to apply to LLCs as well.

Why is fairness such a good incentive?

It is well known that most people don’t just work for money. Most tend to look for jobs that offer satisfaction, advancement and benefits.

A job in a start-up business can be very rewarding. Advancement is very likely, especially when you arrive early. As for the benefits, what looks better than the prospect of a big cash payment somewhere down the road?

If an individual can afford to work for a reduced salary, or even for a full market salary, the idea of ​​betting their time and energy on the future can be very motivating. It’s a big part of what motivates entrepreneurs themselves.

Others feel the same, but perhaps to a slightly lesser degree. Having said that, going back almost to the beginning of “business” people have been working 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 amplify a board’s importance and authority. However, time and time again, we read stories and hear anecdotes from colleagues about situations where a board of directors made a decision or taken an action that significantly increased the value of the company or, conversely, caused his fall.

Underestimating the relevance of a board of directors, even in a start-up business, is a serious mistake frequently made by entrepreneurs and even their experimented advisers.

Basic documents

The foundational documents (which will be covered in Part 4 of this series) of any business will stipulate how all decisions are made on behalf of the business.

In a sole proprietorship, the owner makes the final decisions. In a company, in almost all cases, the founding documents confer this power on the board of directors (the “board”). In a private company, the board of directors may be composed only of the founder / owner, or it may include a co-founder, spouse or trusted partner, effectively placing ultimate control with the founder (s) ( s) / owner (s).

However, best practice for companies pursuing a growth trajectory that they hope will ultimately result in a significant liquidity event (such as an IPO or acquisition) involves forming an impressive fiduciary board with independent members.

Either way, one or the other is still officially the board.

Having board members with experience in raising capital, distributing shares, compensation, etc.

MORE SHADOW CEO

PART 1: Early stage insights for entrepreneurs

PART 2: Do you decide to distribute start-up equity? Here is a founder’s guide

About the Author:
Dennis Cagan, a high-tech entrepreneur, executive and board director, has founded or co-founded more than a dozen companies and has served as CEOs of public and private companies. The venture capitalist, private investor, author and consultant is a long-time board member of some 67 corporate trust boards. In his role as Shadow CEO®, he accompanies a CEO to help them navigate the circumstances and situations on a daily basis.

A version of this column has previously been published in Cagan’s “A Primer on Early-Stage Company Equity”.

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