We were recently reminded of the graffiti artist who created murals at Facebook’s Silicon Valley office and was paid in stocks. In 2012 when Facebook went public, his stock options were worth about $200 million – significantly more than the $60,000 he would have invoiced for the project.
While the exponential rise in value of the stocks is unusual, this situation isn’t uncommon – and for many investors, it serves as an orange-to-red flag.
What is Dead Equity?
Dead equity refers to the situation where individuals who are no longer actively contributing value own a company’s shares.
Common situations where this arises includes:
- Departed founders or early employees who leave the company (either before or after their equity vests fully) and are no longer contributing to the company’s growth.
- Service providers that receive equity as compensation for services rendered but that do not provide continuing services (as discussed above).
Why Does Dead Equity Matter?
Dead equity is problematic because it can lead to reduced motivation and resentment from active contributors and the dilution of value of the shares. In some cases, particularly in the case of departed founders or very early stage employees who are no longer with the company, it can also result in decision making challenges – if the dead equity holders have significant voting power.
While reduced motivation and resentment may seem minor on its face, investors can see this as an orange or even red flag. They want the leadership of the companies they invest in to be motivated, and dead equity may be a big risk factor weighing against investment. Further, it can impact motivation amongst employees, particularly when early employees received significantly more equity compensation than current employees who may view their role as equally impactful on the company’s growth.
Preventing Dead Equity
Dead equity isn’t always avoidable. In fact, a small amount of leakage from formation and mismanaged equity in the early days is to be expected. However, companies should be mindful of the following factors when allocating equity early on to reduce the amount of dead equity:
Carefully negotiate founder equity.
Most founders do not land on a 50/50 split in equity. As a preliminary matter, it is advisable to avoid a true 50/50 split to minimize the risk of founder deadlock in the event of a disagreement early on. Further, it may make sense to leave some early stock avaliable in the event another co-founder is brought on to the team (e.g. a technical co-founder, etc.). Finally, the amount of early equity split amongst founders will vary depending on the unique circumstances, but factors like initial contributions, likely long-term contributions, skills, experience, and even temperament should all be considered. Note that ‘closeness of the friendship’ is not a factor that should be weighed.
In some situations, a buy-sell agreement may be worth considering as it can help to minimize founder deadlock situations. This agreement allows one founder to buy out the other in certain circumstances that range from personal changes to business matters. This is often cheaper than litigating the matter would be.
Vesting schedules incentivize individuals to stay with a company and/or to fulfill specific requirements before the equity is fully acquired. It acts as a retention tool and helps to align founder/employee interests with the company’s success in the longer term. While the most common is 4 years with a 1 year cliff, vesting schedules can be customized to fit the specific needs of the company.
Consider granting stock options over stock to early employees.
Stock options can be used strategically (alongside vesting schedules) to minimize the risk of dead equity. One reason for this is that it requires early employees to put cash into the company to exercise the options, and they may be reluctant to do this if they’re leaving, or they may simply not have the funds available. In this case, the shares return to the company’s stock pool and are typically available for future grants.
Additionally, options will often stop vesting upon termination or departure of an employee. When this happens, the unvested options also return to the pool for future use.
Finally, the company can use a ‘cash for option’ strategy when negotiating settlements or severance. The cash payment is usually less than the repurchase price, so the result is better for the company.
Include ‘stop’ vesting clauses in service provider contracts.
Companies should include clauses that allow them to ‘stop’ vesting if there is a significant change in a service provider relationship – such as if the service provider has stopped working for the company or stopped meeting expectations. There are legal requirements in this situation (such as communicating the decision in writing to the individual), and we recommend laying out the requirements in your contracts and speaking with your legal counsel before utilizing this option.
Reducing Dead Equity
If the ship has already sailed and you have dead equity on your capitalization table, you might consider:
- Opening a dialogue with dead equity holders – you can encourage dead equity holders to continue to contribute value or explore potential win-win opportunities such as a facilitated secondary sale.
- Buying back the stock – assuming the holder is open to it and the company has the cash (note that there are specific legal requirements the Company must meet to be able to do this).
- Having the stockholder relinquish their voting rights – though, again, this will require compensating the holder.
- Issue new shares to active contributors to dilute the dead equity holders – there are risks that come with this approach, however, and experienced legal counsel should be consulted before implementing it.
If you need assistance managing your equity, reach out. Our attorneys would love to work with you.
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