The Practical Guide to Addressing Dead Equity.
Equity is the primary "currency" startups use to motivate founding team members, attract talent and investment and, ultimately, grow. But as startups progress on their entrepreneurial journey, they can run into a common challenge: dead equity. This term refers to the company stock owned by individuals and entities no longer contributing to the company. Such dead equity renders part of the startup’s primary currency unusable, making it harder for the startup to adapt and grow. In this guide, we share advice on preventing and mitigating the impact of dead equity. Let's get started!
DEFINITION
In this guide, dead equity refers to company stock owned by individuals and entities no longer contributing to the startup. Examples may include former founders and employees who left the company, as well as early investors with low engagement or minor contribution to the company. In the following we are using the words "startup" and "company" interchangeably.
WHY DEAD EQUITY MATTERS
There are many reasons why good management of equity is critical for a startup's success:
- Attracting and Retaining Talent: equity is frequently used in startups as a key element of compensation, especially in the early stages when cash is not readily available. If a significant portion of equity is tied up as dead equity, it limits what startups can offer to new hires, or use as incentives for existing team members. This can make it harder to attract and retain the talent needed to grow.
- Raising Capital: investors look closely at a startup's cap table before deciding to invest. A cap table cluttered with dead equity can be a red flag, suggesting potential conflicts or indicating that the startup may not have been managed efficiently in the past. It can also reduce the amount of equity available to offer to new investors, potentially making your startup less attractive for investment.
- Aligning Shareholder Interests: equity is a tool for aligning the interests of the company's stakeholders with its success. When equity is held by individuals no longer contributing to the company, it can lead to misalignment between the company's active contributors and its shareholders. This misalignment can create conflicts and distract from the company's growth objectives.
- Maintaining Flexibility and Adaptability: startups need to be agile, able to pivot and adapt as they grow and as market conditions change. A cap table weighed down by dead equity can limit a company's flexibility, making it harder to make strategic decisions such as acquisitions, mergers, or significant business model shifts.
- Safeguarding Company Morale and Culture: knowing that a portion of the company's success will benefit individuals who are no longer contributing can be demotivating for current team members. It is important for morale and company culture that employees feel their hard work will be rewarded and that everyone who holds equity is contributing to the company's success.
PREEMPTING DEAD EQUITY
To avoid the pitfalls of dead equity, it is important to invest time and effort from the outset in aligning the objectives of the founding team, and jointly putting appropriate legal frameworks and agreements in place, to ensure that equity remains with individuals who are actively contributing to the company's success and can be reallocated if necessary to support the company's growth and objectives. Good agreements make good friends indeed.
Here are some key preemptive steps:
- Specific Founders' Agreement Clauses: one of the first documents every startup should put in place, the Founders' Agreement outlines the roles, responsibilities, and ownership stakes of each founder. It is critical it also includes clauses and provisions for what happens to a founder's equity if they leave the company. Common mechanisms include a buyback clause and/or a vesting schedule.
- Vesting Schedules: implementing vesting schedules for all cases where equity is granted to an individual is a crucial strategy. Vesting means that instead of receiving their entire equity grant upfront, an employee or a founder earns their shares progressively over time or as they achieve certain milestones. This ensures that equity is given to and held by individuals who are continuously contributing to the company.
- Buyback Rights: adding buyback rights (or share purchase rights) clauses in your agreements allows the company to repurchase shares from an individual if they leave the company or no longer contribute. The corresponding terms, including the buyback price or the process for setting a buyback price, should be clearly defined in the relevant contracts.
- Clawback Provisions: similar to buyback rights, clawback provisions allow a company to reclaim equity under certain conditions, such as when an employee leaves before their shares have fully vested (see also Vesting Schedules) or if they violate non-compete or confidentiality agreements.
- Right of First Refusal (ROFR): ROFR gives the company the right to buy any shares that a departing employee or early investor intends to sell to a third party, allowing the company to control who owns its equity.
- Drag-Along Rights: these rights enable a majority shareholder to force minority shareholders to join in the sale of a company. While this might seem harsh, it is a practical measure to ensure that a few minority holders can't block a sale that's in the best interest of the majority of shareholders and the company itself. It is good practice to combine Drag-Along Rights with a Tag-Along clause, that gives minority shareholders the right to sell their stake in the company by joining a majority shareholder selling its stake.
- Dilution Provisions: these can be structured to incentivize ongoing involvement. For instance, anti-dilution protections might be contingent on active participation in the company, ensuring that those who aren't contributing don't benefit disproportionately from future investments.
By implementing these clauses and provisions into your company's legal framework and agreements from the start, you can create a transparent equity structure, that aligns individual interests and create common commitment towards the startup's growth and success. It is also important to regularly review and update these agreements as your company evolves to ensure they continue to serve your needs at the stage of development of your company.
DEALING WITH DEAD EQUITY CHALLENGES
Despite all preparation and preemptive steps, you may find yourself in the situation where you have to deal with dead equity. It is never too late to take action. Here are some steps startups can take to manage and reduce dead equity:
- Equity Buybacks: the company can offer to buy back equity from inactive shareholders. This can be a straightforward way to reduce dead equity, but it requires available cash and agreement from the shareholders in question. The terms of buybacks should be fair and comply with any pre-existing agreements (See Specific Founder's Agreement Clauses).
- Negotiating with Holders of Dead Equity: In some cases, direct negotiation can lead to a resolution. For example, an inactive shareholder might be willing to return some or all of their shares to the company in exchange for some form of non-equity compensation, or simply to support the company's future growth.
- Legal Remedies: If there are legal grounds to do so, such as breach of contract by the shareholder, the company might pursue legal action to reclaim the equity. Taking this step should be considered carefully, as it can be time-consuming, costly, and potentially damaging to the company's reputation.
- Implementing a Stock Recapture Plan: This involves creating a plan to gradually buy back shares over time, which can be more financially manageable than a one-time buyback. This plan can be part of a broader strategy to reduce dead equity systematically.
- Converting Dead Equity to Non-Voting Shares: In some cases, converting dead equity into non-voting shares can be a solution. This doesn't reduce the amount of dead equity but can mitigate its impact, allowing the company to retain control over its decisions without interference from inactive shareholders.
- Use of Equity Incentive Plans: An equity incentive plan can be designed to include provisions for reclaiming equity under certain conditions, such as the departure of an employee. Implementing or revising such plans can help manage future equity more effectively.
- Use of Option Pool: A stock options pool can be used to reduce the impact of dilution during investment rounds for active employees by awarding them shares from the pool, effectively reducing dead equity.
- Cap Table Restructuring: In more extreme cases, a comprehensive cap table restructuring might be necessary. This can involve a combination of buybacks, conversions, and new equity issuances to realign the company's equity structure with its current and future needs.
With the above options in mind, it is important to understand that addressing dead equity often requires a tailored approach, taking into account the company's specific circumstances, the nature of its dead equity, and the relationships with the holders of that equity. It is essential to approach these situations respectfully, thoughtfully and sensitively, as they can involve difficult conversations and negotiations.
IN SUMMARY
In this guide we shared practical advice on how founders can prevent and mitigate the negative impact of dead equity.
Ideally, startups shall take action at the outset of their entrepreneurial journey to define and adopt appropriate legal frameworks and agreements that can prevent dead equity. When faced with dead equity challenges, startups should take decisive action to address them, to ensure they have the flexibility, resources, and alignment needed to grow and thrive. Finally, managing dead equity shall be viewed as a continuous process, that shall adapt to the startup's development stage.
DISCLAIMER
This article is for informational purposes only and is not legal or financial advice. Neos Chronos strongly encourages you to seek the advice of your own attorney/counsel or financial/tax advisor before undertaking any of the steps described in this article.
CREDITS & REFERENCES
For the avoidance of doubt, Neos Chronos is not affiliated with and has no financial interest in any of the companies mentioned in this article. All names and trademarks mentioned herein are the property of their respective owners. Please observe the Neos Chronos Terms of Use.
- Investopedia: Capitalization (Cap) Table, Share Purchase Rights, Right of First Refusal (ROFR), Drag-Along Rights, Tag-Along Rights
- Startup Percolator: Dealing with Dead Equity
- The Anh Han, Luís Moniz Pereira, Francisco C Santos, Tom Lenaerts: Good agreements make good friends
- Neos Chronos: Equity Dilution Calculator, Template Library
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