“Dead equity” refers to company stock owned by individuals and entities no longer contributing to the company. In general, there are two types of dead equity seen on emerging company cap tables:
- Departed founders/employees. A co-founder or early employee leaves a company or no longer significantly contributes to the company’s success but still owns a significant amount of stock.
- HODL investors. An early-stage investor(s) negotiates a disproportionate ownership stake, then contributes very little to the company. This can happen when early SAFE or convertible note holders get unreasonably deep discounts or valuation caps.
Both scenarios can frustrate a maturing company’s contributing founders, early employees, and institutional VC funds.
Why do we care about dead equity?
There are two main reasons to be concerned about dead equity:
- Fairness. It can be very frustrating for a founder to spend years building up their company’s value but earn proportionally the same amount as a co-founder who left early and did not contribute through the exit event.
- Moral hazard. An inadequately incentivized management team may be a big risk factor to investors who view the leadership as uncommitted to the company’s success. Encouraging stockholders to stay around and enjoy the fruits of their labor is the best way to align incentives among all the stockholders.
How can a company avoid dead equity from the start?
Dead equity is not always avoidable, but there are many things a company can do to minimize the amount of dead equity on its capitalization table:
- Use vesting schedules. We recommend standard vesting schedules for all founders and employees, avoiding acceleration clauses. It may be worthwhile to accelerate vesting upon a change of control to reward founders and key employees who can achieve an early exit. But, to avoid dead equity, we do not recommend having acceleration provisions if the founder or key employee is terminated (for any reason). Not only is this type of acceleration rare; it usually results in the acceleration occurring—even in the case of termination for “cause”—to avoid a protracted dispute or litigation.
- Think about your founder equity split carefully. Most founders do not settle on a 50/50 equity split. There should be a “lead” founder who is getting more than the other(s). Speak to your attorney about what is “market” in these situations. In general, founders should split equity based on initial contributions (time, money, intellectual property, assets, etc.), how likely they are to give full attention to the company, their network/contacts for raising capital and onboarding advisors, pay equity, skills, experience, etc.
- Choose your co-founders carefully. One of the biggest missteps a founder can make is to loop in their buddy to help with their new idea. Often, relationships turn, or the “buddy” is not as passionate or driven about the business, resulting in stress and sour grapes in their working relationship. Founders should trust the skills and commitment of those they pick to join them on their adventure. When setting equity splits, we don’t recommend accounting for friendship in the decision process.
- Be strategic about which early employees get stock vs. option grants. It can be tempting for an early-stage company to issue restricted stock to all of its early employees. However, founders should carefully decide if this is the best approach for their company. Shares entitle holders to voting power and all the legal rights of stock immediately after the shares are issued, but stock options don’t have these rights until they are vested and exercised. There are many cases when early employees exit a company and don’t want to put in their cash to exercise the options. Those shares return to the company’s stock pool and never become dead equity (or dilute the founders). In addition, a company could negotiate a settlement or severance agreement to make a small cash payout to the employee instead of exercising options. While a company could also arrange the repurchase of vested shares, the repurchase price is usually more costly than the cash payment for the settlement.
- Pay close attention to the status of your service provider relationships. It is common for companies to realize that they have granted too much equity to their service providers. This often occurs when the service provider has ceased or reduced their work for the company. Equity is valuable and should match the individual’s efforts and contributions; and if an individual is not pulling their weight, a company should consider adjusting the terms of their equity award. While the company cannot unilaterally change a vesting schedule or cancel options, most stock plans have a provision that allows the administrator to “stop” or “toll” vesting if there has been a significant change in the service relationship. In some circumstances, a company decides to end the relationship. In that case, it is crucial to clearly communicate the decision to the individual in writing and comply with all contractual and legal requirements to terminate a service provider. This minimizes the ability of the service provider to claim they were never terminated (and vest more shares than they earned). This situation is most common with advisors.
How do we get rid of dead equity?
The best course of action is to tidy up the capitalization table. Here are some common questions about how to do this:
- Can the company just buy back the stock? Absent a vested share repurchase right, the company can buy back the stock if the dead equity holder is open to selling their shares. Ultimately, it depends on the price, the amount of stock repurchased, and whether the company can pay that price. Also, an essential factor is whether this redemption will blow the company’s qualified small business stock status (assuming they qualify for such tax incentive). In many situations, repurchasing the stock is not a viable option for a company.
- Can a third-party investor, the remaining founder, or a new founder buy out the individual’s stock? Again, it depends on the willingness of the selling stockholder to agree on the terms of the sale. Secondary sales are sometimes offered during later-stage preferred stock financing rounds, and early investors—or those with dead equity—may be given the option to “cash out” at the preferred stock price. When engaging in secondary sales, it’s essential to consider the various legal and tax complexities involved. For example, accredited investor status may be necessary, and the IRS may view the sale as compensatory to the seller. Secondary sales may also require compliance with the tender offer rules. To navigate these complexities, it’s recommended that companies seek experienced counsel.
- Can we put a voting agreement or proxy in place? Individuals may relinquish their voting rights, but this usually requires some form of compensation. Ensuring that the founder’s company stock is subject to the same limitations as other shares of common stock is crucial. Investors may impose certain restrictions on common stockholders, such as limiting their ability to appoint board members or amend the charter. Although these provisions can shift voting power away from holders of inactive equity, they can also adversely affect the remaining founders. If an investor proposes the addition of “dead weight” management provisions, careful consideration should be given.
- Can the company just restructure and assign the IP to another company? Not without the cooperation of the dead equity holders. It’s important to note that directors have a fiduciary duty to all their stockholders, regardless of their type of equity. Directors can be held liable for breaching their fiduciary duty by causing harm to stockholders for personal gain without obtaining the consent of the affected stockholders. Before making any plans to restructure, it’s recommended to consult with legal counsel to avoid any potential liabilities.
- Can we issue new equity to the contributing management team? Generally speaking, “true-up” grants are the most effective method for restoring balance to the cap table and motivating current employees. It may be necessary to obtain approval from investors, particularly if the option pool needs to be expanded to accommodate these new grants. To avoid any potential legal repercussions, the team should be cautious of their fiduciary responsibilities and seek advice from a lawyer.
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