August 31, 2021

A Missed Opportunity to Solve a Big Equity Problem

When the Wrong Lessons are Learned

(Only takes 9 minutes to read.)

A Missed Opportunity to Solve a Big Equity Problem
Photo by Pixabay from Pexels

A lawyer recently posted a feel good social media tale about honesty in business—trading likes for valuable insight.

This was really too bad, because—based on the facts described—in this case the lawyer (who will remain anonymous1) was probably the hero, and the client was probably the villain, but that’s not a good marketing strategy for a law firm. Nor is it helpful for entrepreneurs and future clients who could have learned how to navigate a complex situation.

The story goes like this: MegaCorp offered an entrepreneur a significant amount of money for his business, at which point the entrepreneur realized that he forgot to grant equity to his employees. The entrepreneur, you see, was just so busy running the business that he never got around to it.

Not surprisingly, the entrepreneur felt bad about this oversight. “The employees are the ones who made the company successful,” he told his lawyer. It turns out there’s a straightforward fix for the situation (you can read Steve Wozniak’s solution at the end of this interview); however, according to the lawyer’s story:

…while [the entrepreneur] could have given up a significant portion of his own share, it hurts to have put in all the blood, sweat, and tears and walk away with so much less than you’d hoped for.

Cue the sad violins!

Photo by Alex Blăjan on Unsplash

Never fear, though—the lawyer took an “honest and direct” approach and told MegaCorp that the employees had no equity. “Might MegaCorp sweeten their offer so that the employees could get something?”

“Of course we can,” says the magnanimous MegaCorp, “it’s the right thing to do.”

The social media takeaway: People—even MegaCorps—do the right thing if you are direct and honest with them.

The story concluded with this line:

There can always be heart in business.
Photo by Ann H from Pexels

Nice sentiment. Warm and fuzzy. Great for clicks! Great for likes! Great for happy comments while doom scrolling cat videos!2

It’s also probably not quite true and a massive missed opportunity for a useful and substantive discussion about navigating a difficult situation.

Now, it’s entirely possible that the events themselves happened exactly as written—a best case scenario. This implies a certain level of naiveté on the part of the entrepreneur, lawyer, accountants, boards of directors, and MegaCorp—but it’s possible. The problem is that best case scenarios are terrible for learning, except in the most initial stages. Best case scenarios presented as success stories are dangerously misleading because of survivorship bias—no one hears about the people who did things the exact same way and failed.

What might a more complete version of this story have looked like? Let’s go through some of the issues.

1.) The entrepreneur “forgot” to issue equity.

Photo by krakenimages on Unsplash

“Forgetting” and “being too busy” to issue equity cannot be what happened except in the most absent-minded of cases (which raises real questions on the entrepreneur’s ability to run the company.) “Forgetting” also raises serious questions about the professional advice that the company’s accountants and lawyers—including quite possibly the one telling this story—provided to the entrepreneur, as well as the oversight by the company’s board of directors.

The reality is that the entrepreneur chose to not issue equity—which is a reasonable choice! There are plenty of ways to compensate and incentivize employees, and equity in many cases may be the wrong answer, especially when accounting for liquidity and tax complications. Given failure rates, the expected liquid value of equity in any startup is zero; the rest is marketing. Even if employees have equity, there are dozens of ways for them to get screwed—in the worst case they can get huge tax bills that they can’t pay for unrealized, illiquid paper gains!

Equity compensation can be complex, depending on how the company is structured, but there are tons of resources covering this topic, such as the very thorough Holloway Guide to Equity Compensation. Excellent alternatives include cash bonuses, profit sharing, synthetic equity, and other benefits.

A “more honest” version: the entrepreneur chose to not issue equity, for whatever reasons, including quite possibly never imagining that an acquisition was possible. Solving that problem is a more interesting story!

2.) The entrepreneur “felt bad” that his employees didn’t have equity in the transaction.

Photo by Sarah Kilian on Unsplash

This is the completely foreseeable downside of choosing to not issue equity; this is the trade off.  Did he feel bad? Possibly. It’s also possible that the entrepreneur took out a second mortgage, maxed out his credit cards, and didn’t take any salary, while the employees were paid at the market rate.

As stated earlier, there’s an easy fix for this: the entrepreneur can structure the transaction so that he gets less and the employees get a piece of the pie.  The technical, tax, and accounting details of that would be an interesting discussion. But the story said:

…while [the entrepreneur] could have given up a significant portion of his own share, it hurts to have put in all the blood, sweat, and tears and walk away with so much less than you’d hoped for.

Wait, wait… “hoped for?” Well that means the entrepreneur did have dreams of selling the company. He had a goal, and once again he chose to not issue equity. The downside of issuing equity to employees is that in the event of sale, the entrepreneur gets less. If the entrepreneur keeps all the equity, he gets more. That’s how it works.

So the entrepreneur felt bad, but not that bad.

3.) The employees took jobs at the company knowing they did not have equity.

Photo by Sebastian Herrmann on Unsplash

If the entrepreneur promised the employees equity and never issued it before the transaction, then we have a really interesting legal liability discussion. But that doesn’t seem to be what happened. The employees knew that they didn’t have equity, and therefore they knew—or should have known—the risk that the entrepreneur would make money on the sale and they wouldn’t get anything. If they didn’t know this, then the fault once again is on the entrepreneur. If he misled them on this point, then the employees received a very expensive education on startup equity. It’s not the first time this has happened; in fact, it’s more common than not, but this outcome doesn’t make a good press story. Reputable companies playing the venture capital game now have financial advisors meet with employees early to prevent such misunderstandings.

4.) The employees were key to the entrepreneur’s success.

Photo by Markus Winkler on Unsplash

This part is undoubtedly true, and it’s a critical point later…

5.) The lawyer’s strategy was “to be honest and direct” with MegaCorp and tell them that the employees didn’t have any equity.

Photo by Ruthson Zimmerman on Unsplash

This is a lie. As part of the transaction, MegaCorp had to see the capitalization table for the company as part of due diligence. MegaCorp knew exactly who owned every piece of the entrepreneur’s company.

The more likely situation was: the lawyer called MegaCorp and explained (or hinted) that since the employees had no equity in the transaction, key personnel might walk out the door if they didn’t get any extra compensation. MegaCorp presumably had no interest in buying the company without the people who knew how to run it. In many industries, the people are the reason for the acquisition!

Result: MegaCorp raised the price and/or almost certainly offered some sort of retention package for key employees.  It had nothing to do with the lawyer being honest and direct. MegaCorp had the cap table. Maybe the employees were going to walk, maybe they weren’t—the lawyer just had to put some doubt in the minds at MegaCorp.

This is actually a pretty smart strategy on the part of the lawyer—it just isn’t warm and fuzzy and isn’t the type of thing that gets likes on social media.  Lawyers, however, aren’t paid to be warm and fuzzy. They are paid to act in the best interest of their clients.

Let’s be honest here about the lawyer being “honest and direct” — it was a tactic, and it worked.  Good on the lawyer! That’s what lawyers are paid to do!

Alternatively… maybe it wasn’t the lawyer at all. Maybe MegaCorp agreed because their initial offer was far less than they were actually willing to pay. They expectedthe entrepreneur to negotiate! If he hadn’t, they would have thought he was a chump! So raising the price under the guise of being nice to the employees they needed to retain was a no brainer. In fact, they probably had planned and budgeted some sort of package to retain key employees, especially if the MegaCorp team had any experience with acquisitions.

By the way, even if the employees did have equity, the terms of the transaction could have been negotiated in many different ways that would result in them getting zero. Everything is subject to negotiation, and there are dozens of ways for employees to get screwed.

6.) We don’t know what happened after the transaction.

Photo by Bophomet Zhang on Unsplash

Just because a deal is signed, that doesn’t mean there is a happy ending. MegaCorp could have realized that if the entrepreneur was too slipshod to take care of the equity in his company, then he probably wasn’t someone they wanted—and maybe they dumped him before he received everything he thought he would get. Perhaps MegaCorp was a disastrously run company, and the employees all quit. Perhaps the employees were laid off prior to getting the retention bonuses. Perhaps MegaCorp signed the deal, and then refused to pay the cash, knowing that the entrepreneur couldn’t afford to sue them.  All of these things can and do happen! Entrepreneurs and their lawyers should plan on them and not depend on the “heart” in business.

We also don’t know how the transaction was structured—details such as an asset sale versus a stock sale greatly change the tax situation and how much money flows into which pockets. The headline price may or may not correlate to the bottom line—and if the entrepreneur in this case overlooked the equity compensation details, there’s a good bet he didn’t understand the taxes either.

So what’s the honest version of this story about honesty?

Photo by August de Richelieu from Pexels

“Our [possibly clueless?] client didn’t issue equity to employees, and we used that to get a [possibly?] better deal in the transaction.”

It’s a great PR story for a law firm—unless they had been the counsel at the beginning and flubbed the equity compensation package at formation—but terrible for clicks!

Just one more thing

There is yet one more possibility, which is fun to think about even if it’s unlikely to be what actually happened.

What if the entrepreneur was in fact just crazy like a fox?

Photo by Pixabay

Suppose the entrepreneur knew exactly what he was doing. He knew that by not issuing equity, the acquiring company would probably have to offer higher additional incentives to the employees, especially the valuable ones. By not issuing equity, he created artificial leverage. He could always claim it was an “accidental oversight” when in fact it was a Colombo strategy. Maybe even the lawyer believed it…

The entrepreneur gets to appear beneficent, and any concessions he receives from the acquiring company appear to be a win that gives him credit. In reality, however, he takes far less dilution than if he had issued equity to early employees.

This strategy solves another problem too: what if the entrepreneur wasn’t sure the early employees would work out? He could have had underperforming or problem employees end up on the cap table forever, causing additional paperwork and complications. The entrepreneur would end up diluted—perhaps significantly—by people who were “early” but actually didn’t contribute.

Instead, by not issuing equity to anyone else, the entrepreneur ensured that only the ones who were key and contributed were around for the acquisition. Plus, he could tell the acquiring company exactly which of the employees were critical and how much of an incentive it would take to make them stay. If the acquisition wasn’t “fair” in his opinion, he could always step in and offer some of his own equity as a concession. But, it’s just that—an optional concession, versus guaranteed dilution.

A strategy perhaps worthy of Keyser Soze, but definitely not social media.

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