Working Out Equity and Ownership Issues

Startups’ focus on developing a new idea may put long-term planning in their blind spot

by RaeAnne Marsh

Ownership-equity-issues“One of the most important things for startups to know is how precious their equity is; the ownership in their company is,” says Peter Wand, a partner with the law firm Lewis Roca Rothgerber, noting that in some incubators and almost all accelerators there is an aspect of investment in exchange for a share in the company.

All incubators and accelerators operate differently, and their terms may vary, points out Steven Reed, an attorney with the law firm Jennings, Strouss & Salmon, observing, “If it’s a young company or brand new idea, [the entrepreneur] probably hasn’t given thought to how the business is structured or what kind of future shares to give in it.”

Because there are different ways somebody could own a piece of the company, the parties need to understand what the incubator or accelerator is going to be receiving and try to tie down the details. Reed cites Tallwave as an example of an accelerator that has “been doing this a while and has a good idea of what they need to be telling companies and how this should be structured to provide the clarity that’s necessary.” Others may not be so clear, asking simply for a certain percentage of the company — but the question arises as to what that means five years down the road when the company wants to raise money and value may be diluted by additional equity. Says Wand, “Be very certain the agreement you’re entering into is right for you and provides the appropriate valuation of your company.”

Most startups will pay employees and consultants in the form of equity because current cash is not available, Wand observes. Therefore, an entrepreneur needs to be very careful about the amount of equity he or she sells to an incubator, accelerator or investor. The different types of equity need to be considered as well to be sure the agreement with the incubator investor or accelerator investor doesn’t tie the entrepreneur’s hands with respect to issuing equity to future employees and consultants. “We don’t often see it, but it’s important for startups to be able to run the company as they see fit and not have to look to investors for permission,” Wand says.

The equity options to weigh are restricted stock, stock options and restricted stock units. Restricted stock are shares of a company that are not fully vested, and will vest over time in their ability to be sold over the open market. There is generally no income tax effect, but the possible downside is it makes the recipients shareholders with access to all company information and also cedes some control away from the founder(s). Stock options are the right to purchase stock for a given price at some point in the future. The employee or consultant does not have to purchase the stock at the time but can exercise the option if the company becomes successful. This option allows the entrepreneur to restrict access to the company’s books and records. Restricted stock options are similar to restricted stock but upon the stock’s vesting, the company could give the holder stock or cash. This enables the entrepreneur to control how many shareholders the company has. “If the entrepreneurs are not sure they want that employee or consultant to be with the company for the long term, this allows them to maintain the flexibility to cash that person out at any time,” Wand explains.

Intellectual property is another concern about which startups — and companies in general — need to be careful. While acknowledging that he is unaware of any incubator or accelerator making any claim separately from an equity stake, Reed says, “If patents, trademarks or copyright is appropriate, steps should be taken to protect it.” If something is jointly created, such as in a co-working space, parties that helped create it might assert a claim, so Reed suggests parties have a standard agreement making clear where ownership of the intellectual property resides. From a practical standpoint, Reed says doesn’t see that issue coming up and also rarely sees litigation between an incubator or accelerator and the business founder. “Where the real action is, more frequently, is between founders.” Too often, they get together and get going on an idea but don’t formalize what the agreement is between parties — such as percentage and what role each plays. “Companies always fall apart and are in litigation because no formal arrangements were agreed upon,” he says, referring to Facebook as a prominent example. To avoid having to spend time, energy and money down the road, Reed suggests the business arrangements be formalized through an operating agreement. “Hash out the details through the organizational documents of the entities.”

Steven Reed is an associate with Jennings, Strouss & Salmon’s Corporate, Securities and Finance group. He focuses on advising businesses and investors in a broad range of transactions and relationships, including mergers and acquisitions, securities offerings, real estate and general corporate matters.

Peter Wand, a partner with Lewis Roca Rothgerber, serves as co-chair of the firm’s Executive Compensation and Employee Benefits practice. He counsels employers on the design and management of qualified and non-qualified retirement plans and executive compensation programs, including equity-based incentive compensation programs such as stock options, stock appreciation rights, phantom stock and restricted stock.

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