It’s common for business owners, especially ones that are operating on a budget, to offer equity in exchange for a number of services/goods including for legal work, to accountants, vendors, IT people, among others. However, equity in a company is a business’s greatest asset. Continuously dishing out equity to everyone for what you think will help grow the business can actually leave the founder with very little equity. So, before dishing out equity, let’s explore what needs to be considered before doing this and how to save issuing equity.
What to Consider Before Issuing Equity
If your company was formed properly, it should have formation paperwork dictating who has what percentage of equity, that person’s/entity’s capital contribution, and guidelines when admitting a new member to the company. If your company is a Limited Liability Company (LLC) you should look at your operating agreement to determine who has equity in the company, what percentage, and how much they contributed to the company to get that equity. You can then perform some simple math to determine the value of the company at the time of formation. This will also provide you with information of where the equity will have to get pulled/transferred from when granting equity to a new member.
If you have an LLC your next step is to review your buy-sell agreement (this document may be incorporated into the operating agreement) to determine what was agreed upon relating to limitations when transferring/selling equity in the company. It’s important that you follow the buy-sell and operating agreement to a T, or potential issues such as invalidating the transfer/sale or a breach of contract claim can arise. Neither of these consequences is what you want when you are looking to sell equity for cash or give equity to someone to perform services for your company. So, make sure you review all the incorporating paperwork before making any moves.
To perform the equity distribution you need to have all the below information:
- Information regarding who owns the equity
- What percentage each person owns
- Value of the company at inception
- Current value of the company
- Limitations regarding the transfer/sale of equity
Now, you just need the terms upon which you and the new, equity partner agree to.
So, hypothetically you do all of this work, the equity is granted, but it’s not working out with the person or their value isn’t there. If you did not condition the equity grant on any performance, then you may have to go through the process of voting that equity partner out and going through the entire process again. NO ONE WANTS THAT.
Do I have Other Options?
What is the alternative? One alternative that’s often appealing to new or young companies is a phantom stock plan which is an agreement between employees and the company where the employee will receive portions of distribution and profits.
Phantom stock plans are usually tied to a vesting scheduling and certain conditions that the employee must meet to be entitled to the plan. Some examples of conditions are hours worked, continued employment, sales goals, just to name a few. Phantom stock plans do not come with voting rights or other privileges as common stockholders may enjoy. So, why use a phantom stock plan? It provides the employees with an incentive to perform their job the best they can, give them a sense of ownership, pride to be with the company, and feel appreciated and supported by the company. On the business owner’s side, it saves them from issuing equity in a company, bring new, voting members into the fold, and having to admit new members through the complicated process detailed above.
Phantom stock plans are complicated plans to establish and numerous laws must be considered and abided by when establishing such plans. Thus, when establishing a phantom stock plan it is best to consult with your business lawyer or find a qualified attorney to do so.
This e-bulletin was prepared by Eric J. Proos, Esq., of The Law Office of Eric J. Proos, PC, email@example.com .