Equity

"Earn your Equity" structure?

Matt Schaar

April 24th, 2013

Hi all,

I'm working with a few people to build out a loosely-defined collective of freelancers/developers.  Our plan is to take on client work while also creating our homegrown types of projects, spinning them off as need be.  Really, our only full-time employee(s) would be those managing our client accounts and overseeing the project managers assigned for each role.

Creating an equity structure around this is a bit tricky -- we want to keep it as egalitarian as possible.  So, we're kicking around the idea of having an equity "pool" from which freelancers are given a share of the company based on the work they undertake.  We're thinking of making it a simple structure, like x hours on a project = y% equity stake.  

Based on what we're projecting, it would take a considerable amount of time before equity is fully distributed, so it gives a handful of freelancers the opportunity to work on some cool stuff and be a partial owner.  

What pitfalls or areas of concern do you seasoned founders see with this approach?  And how do we construct our legal documents to adhere to this type of structure?

Thanks for your help!
Matt

Alex Gourley Founder at Active Theory Inc

April 24th, 2013

As Tom said, a vesting cliff seems wise. 

Do you know how long it will take until the entire pool is vested to people? What do you do then? Dilute the pool? That only works if the value of the company has been growing substantially due to the work of the initial members. You said you're spinning off products, are they actual business ideas that can grow?

If you don't have one of those ideas take off and increase the valuation of your company, you'll be in an impossible spot when the equity pool is fully distributed. 

John Wallace President at Apps Incorporated

April 24th, 2013

We looked to create a structure that gave our folks upside without having to deal with regulatory and tax issues or figuring out how to buy back stock from with disgruntled shareholders. What we decided to do was create a two tier structure. People in our core group who put in the initial equity (cash or sweat) got stock in proportion to their contribution. The second group got phantom stock in proportion to their service to the company. (Phantom stock is a contractual obligation on the part of the company rather than equity.) In our case we decided to compute service per year based on the number of hours they contributed times their hourly rate. For profit taking we created two pools, and shareholders took profit according to their equity from one pool, and phantom shareholders took profit according to their phantom equity from the second pool. That profit taking was after distributions to shareholders to pay for taxes (S-corporation). The nice thing with that structure is that the interests of everyone are aligned to create profit, but it keeps the equity under the control of a small group.

Matthew Cordasco Co-founder and Head of Product

April 24th, 2013

The SEC requirements (409) around stock/ options are so very complicated and burdensome, your scenario seems doubly complicated.  Have you considered something like Stock Appreciation Rights (SAR's) which are much less regulated and allow you more control than stock.

Better stil... you might think about not giving out "ownership" but more of a profit sharing concept.  People work towards a percentage of the pie, which is handed out as cash dividends monthly, quarterly, yearly, etc..  And every month/quarter/year people start from zero again.  This solves several problems including people that work a lot up front and then stop contributing.

Good luck!

M

Tom Huntington

April 24th, 2013

Hi Matt, I can imagine a few challenges you'll need to work through. - Do hours worked really equal quality output? Can someone increase their equity stake by taking longer to complete a job? You might consider output-based milestones that are more in your control. - Who is keeping track of hours? Now that there is equity involved you'll want to police it more carefully. - If you have different level contributors you may want different equity rates per hour. - Option grants should be signed by both the employee and the company. You won't want to paper this continuously so you might consider a quarterly or monthly batch process. Also, option awards should be granted at-the-money (strike price = current stock price) to avoid immediate taxable income (and payroll tax obligations to both the company and the employee) so you'll need a process for asserting the common stock value at the same time that the options are awarded. - You should consider the total amount of equity you think you'll be handing out with this mechanism. You don't want to wake up and find out you're heavily diluted because all the work took longer than planned. In more traditional options programs, full time employees receive a grant which vests over a long period of time (e.g. four years). The vesting schedule often has a one-year cliff (nothing vested until the employee's first anniversary) and then monthly vesting thereafter. This cliff is because a lot of new hires don't work out and leave or get fired after a few months. You want the equity to go to those individuals who are contributing over the long term, not short-timers. If equity is all you have at the moment (no cash), then it's a little bit of a different story. Tom Tom Huntington (781) 535-4818 M tomhuntington@hotmail.com

Matt Schaar

April 24th, 2013

These are all fantastic responses, folks.  Thanks much for the feedback so far!

One thing that's been rolling through my head is, given that we're more of a client services organization, the umbrella structure doesn't really *have* equity -- it's the individual projects, and the IP contained therein, that will equate to value.  So one option in store could be to create individual equity structures for each project as it's incorporated/spun off and leave the core team to deal with that.

Just typing it out sounds complicated. :)

Given that we're starting this as a part-time project for freelancers, the only true equity is (at the moment) sweat.  The company won't have any intrinsic value until project #1, so there's nothing to distribute amongst the team just yet.  Perhaps a profit sharing plan is more effective in this instance, although we'll need to tackle any spin-offs on an ad-hoc basis as they will have some equity component -- and we would likely begin to retain some equity as an incubator of the project in the first place.  

Will Glasson Assistant County Attorney, Multnomah County

April 27th, 2013

Erik -- I haven't read "Slicing Pie," but I'll check it out (thank you for the recommendation!). 

Although I generally support founders' shares vesting, there's a disconnect between the good sense incentive represented by a vesting structure and some of the tax, securities, and corporate governance issues created when most of an entity's shares or interests vest. Again, this is complicated stuff and vesting works better or worse depending on a number of factors -- such as the nature of the business, the number of founders, revenue or market growth, and the capital structure. 

That said, entrepreneurs interested in using a plan where founder vest in should carefully model how that plan will work. The dialogue around modeling the plan is useful by itself, as it can reveal founders' differing commitment levels; but the discussion is critical to understanding the impact on cash, management control, and professional services needed to get the company through that initial stage of development and growth. 

Ideally, a startup structures vesting and compensation to minimize tax and securities issues. By in effect offering stock as compensation, tax and securities issues are often triggered at exactly the time when the company is least able to pay. It also forces the company into valuation issues that are also ill-timed, as valuation is mostly an academic exercise until the product and brand are out there.  

Will Glasson Assistant County Attorney, Multnomah County

April 24th, 2013

Matt -- Pitfalls abound. This creates a host of securities and tax problems. I'd be happy to summarize some of them for you in a call but, bottom line, if you want to structure your business and compensation in this way you need to retain very good and likely expensive legal counsel -- tax, business, and securities. Will. Will Glasson will.glasson@gmail.com (503) 807-1261

Erik Larson

April 25th, 2013

Will G., have you read "Slicing Pie"? It requires a lot of interpersonal trust and acceptance of different risks, but it seems like a pragmatic solution without the weighty legal burden you point out, at least at the beginning of the endeavor when the equity really doesn't have any value. Matt could create profit sharing for the consulting work they do as a partnership (lots of ways to do that, well understood) and maintain a "grunt fund" for any work on the home grown projects that could eventually turn into something worth having ownership of.

I may start a separate thread about "Slicing Pie" since Matt's question is fairly specific to folks who are earning consulting money while also building their own stuff.