What is “Dead Equity” and Why Do We Care?
I had a conversation with a friend who is also an entrepreneur recently, and we ended up getting down in the weeds about an issue that directly affects me, but that I don’t give much thought to on a daily basis. I can’t get too much into his situation, but I’ve heard of similar situations and decided to look into it further.
The issue concerns early employees who leave the company in between rounds of investment. Early on in a company, especially when considering taking on outside investment, the founders (or early team) will decide to issue shares to themselves, reflecting their various contributions to the company thus far. These amounts can vary based on individual efforts, but because the early team are the only people with equity, they end up holding substantial pieces of the company (unless they also set aside an option pool, which is a great idea but can also hurt you later). When those early team members leave the company, they take their equity with them. The graffiti artist who did Facebook’s early mural is a great example. He ended up with four million shares of the company in return for what was, at the time, “thousands of dollars” of work. This is a non-issue if the company buys them out, or shares are not fully vested. However, when a former employee holds a substantial piece of the company and isn’t involved in day-to-day operations, their holdings are are considered “Dead Equity.”
So why do we care? Does this matter? The employee obviously made a significant contribution when the company was still in a fragile, early stage, and deserves to be compensated accordingly. However, investors can view this dead equity as an unpredictable variable. They don’t know how the non-participating (dead equity) shareholder will behave once they invest in the company. Investors are split on this issue. The best solution seems to be a simple drag-along provision.
According to Dave Neal, Managing Director of the Startup Factory, “If you are considering investment, an event that puts a value on the company either has occurred or is about to occur. This changes the psychology of the non-participating shareholders. What was once a shareholding with an indeterminate or seemingly negligible value now has a numerical value attached to the shares that a non-participating founders own.” What Dave is essentially saying is that investors are hesitant in this situation, because they don’t know how that shareholder will act when told what their shares are worth. A savvy founder will address this issue beforehand.
This situation has no blanket one-fits-all resolution, but good attorneys navigate buyouts and sticky situations like this on a regular basis. According to Neal, this issue can be dealt with when the company is formed, if all shareholders agree to have some portion of their shares “re-vest” when they leave. It’s also mitigated by a well-formed option pool. As a company, the goal is to avoid unnecessary dilution while bringing in new capital to grow the business. An investor is going to dilute all the founders, not just one holder of common. An option pool can help with this because the investor can award the other (still active) employees shares from the pool. However, dilution is somewhat inevitable if a company receives several rounds of venture capital.
There’s a similar problem with early angel investors. Angel investors are early believers in the company, and deserve to be compensated for hopping in at the riskiest time. However, they may have bought in cheap, and later investors don’t like to think others are getting a “free ride” if the company does well. If a venture fund is adamant about being the company’s only outside investor, they will pay a premium to buy out an early angel. If the company takes on several more rounds, everyone will be diluted. If the company doesn’t continue to raise or the initial investor is the only one willing to continue to fund the company, the angel will receive the benefits of capital he didn’t contribute.
This bold, optimistic thinking is a necessary trait in both entrepreneurs and venture capitalists. What’s the saying? Success has a thousand fathers and failure is an orphan. If investors are so excited about a company’s prospects that they are actively trying to pour in capital, the future is bright. Nobody passed on Facebook because the muralist owned a bunch of shares. Of course, this isn’t necessarily the case, but people with a low tolerance for risk don’t get into entrepreneurship.
The bottom line is that when you’re forming your company, you should think about the possibility that people will leave, and be prepared. If you are not prepared, you should hire a good attorney, and be prepared to compensate the employee for their contributions. In the real world simple, straightforward conversations are usually the best solution. The alternative to let a venture capital firm figure it out when (or if) you ever raise money again, which could cost you.
