Posted on May 01, 2012 by | 0 Comments
By Dug Campbell
Working with entrepreneurs in the early stages of a business can be addictive. Enthusiasm is infectious and it’s rare to meet a founder who isn’t the first cheerleader for a new venture. But it’s also important that founders don’t overlook a few fundamentals in those early days whilst focusing on future aspirations.
One area to be crystal clear on is exactly who your shareholders are and what rights they have going forwards. An obvious statement perhaps but it’s not uncommon for a founder to mention in passing that a third party has been promised shares as payment for services. There may be no paperwork yet but nevertheless the agreement exists in principle.
Being able to effectively negotiate terms is an essential part of an entrepreneur’s skillset and convincing anyone to accept anything other than cash in return for valuable work falls firmly in that category. Retaining 100% ownership of your business will count for little if it fails to get off the launch pad because you simply didn’t have the necessary time or knowledge to deal with critical tasks. Of course, this ties in nicely with Jean-Baptiste Say’s definition of an entrepreneur as being “one who undertakes an enterprise...acting as an intermediatory between capital and labour”.
Here’s a list of key areas that you should look out for if you promise to make payment in shares.
- Bear in mind that valuing the shares of a pre-revenue startup can be notoriously difficult. Will the supplier agree with your valuation?
- Remember that the new shareholder will have the right to take part in all shareholder votes from here on. Remember puppies and festive holidays? Big numbers (25% and 50%) will have an obvious impact but remember that even one share voted the wrong way can be critical if you want to sell the company (see below).
- What if the new shareholder wants to transfer its shares in the future? Make sure that existing shareholders have the first option to buy.
D. Future share issues
- Will the new shareholder have the right to take part in any future issue of shares? You need to check yourArticles of Association. While this right may restrict them to paying for an exact number of shares which prevents their ownership from being diluted, check if other shareholders have the power to waive these pre-emption rights.
E. Sale of the company
- Your Articles should contain ‘drag-along’ rights which means that a minority shareholder can be forced to sell his shares if the majority want to sell the business.
F. Dividend rights
- A new shareholder who holds the same class of shares will have the same rights to receive dividends as other shareholders. In practice, a high-growth startup is unlikely to be overly concerned initially when distributable profits may seem a long way off.
G. Alternatives to equity
- If equity doesn’t suit, have you considered options? Signing a contract which gives the supplier the right to receive shares on a future date or event (such as an exit) may help you to avoid many of the issues above which would otherwise apply if the shares had been issued on Day One. However, there are tax issues: broadly-speaking, a supplier may receive a tax bill on the shares well in advance of the time that it is able to sell the shares to get the cash to pay the charge. Other possibilities with varying degrees of attractiveness to a supplier can include royalty and profit-sharing arrangements.
Everyone has bills to pay and it can be difficult to find a supplier who is willing to set aside the ‘cash is king’ mentality that is necessary for success for as long as it takes to gamble on the promise of a startup that’s often at its most vulnerable stage of development. However, provided you’re aware of the issues, it could be an option worth considering to get the company through those early days. And for anyone worrying that it’s just a case of “jam tomorrow”, I suspect that a quick conversation with David Choe might change your mind.