Many budget-minded business owners, offer equity in exchange for a number of goods and services, including to attorneys for legal work, to accountants for accounting work, to vendors for goods and services, and to IT people for software and hardware development, among others. Yet, equity in a company is a business’s greatest asset. Continuously providing equity to others in the hopes of growing the business can actually leave the founder with very little equity. Here’s what needs to be considered before trading equity.
A properly formed company should have formation paperwork that dictates each owner’s percentage of equity, that person’s/entity’s capital contribution, and guidelines when admitting a new member to the company. If the company is a Limited Liability Company (LLC) the operating agreement should determine who has equity in the company, what percentage, and how much they contributed to the company to get that equity.
If the company is an LLC, next must come a review of any buy-sell agreement to determine what was agreed upon relating to limitations when transferring/selling equity in the company. The steps in the buy-sell and operating agreement must be strictly followed or potential issues such as invalidating the transfer/sale or a breach of contract claim can arise.
To perform the equity distribution requires all of the following 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
Then there needs to be agreement on the terms upon which the new equity partner will become an owner.
Then, let’s assume the equity is granted, but the value the business owner thought the new equity partner would bring is not present. If the equity grant was not conditioned on any performance, then the business owner may have to go through the process of voting that equity partner out and, then go through the entire process again and, in the process may still lose substantial equity in the business.
One alternative that often appeals 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, etc. Phantom stock plans do not come with voting rights or other privileges as common stockholders may enjoy. However, they do provide employees with an incentive to perform their job the best they can, give them a sense of ownership, and feelings of appreciation and support by the company. On the business owner’s side, phantom stock plans protect the business owner’s equity in and control of the company.
Phantom stock plans are complicated to establish. They require compliance with numerous laws when establishing such plans. Thus, it is best to consult with your business lawyer or find a qualified attorney to do so.
The information presented is not intended to be, and does not constitute, “legal advice.” Because each situation varies, and only brief summary information is provided here, you should not use this information as a basis for action unless you have independently verified with your own counsel that it applies to your particular situation.
