Guest post by Eric Engelmann, General Partner at Cedar Rapids-based ISA Ventures. This story was originally published on Substack.
Your cap table tells a story about your business: it contains the people and organizations who’ve invested in the company during each chapter of your company’s history. As a founder, you need to manage that cap table story carefully, or the plot might go in directions you didn’t intend. One example of this is founders who unintentionally get themselves into trouble by having “dead equity” on their cap table.
What is dead equity?
Dead equity happens when significant amounts of company stock has been granted to an individual that is no longer actively working to advance the company toward an exit. Every share of stock held by that person is worth the same as a share of stock held by someone who is still working very hard every day to build the company’s value.
There are two common situations we see that typically create this dead equity:
- when a co-founder leaves the company to pursue other interests, or a co-founder significantly reduces their time contribution to the company to pursue other interests (e.g. takes a full-time job but moonlights for the startup)
- when an early stage investor takes a disproportionate ownership stake in the business but contributes little to the company thereafter.
In both cases, there is usually no ill-will or bad intent. While the relationship between the parties might be fine, the problem rears its ugly head later when the dead equity becomes apparent.
Why is dead equity a problem?
Dead equity can cripple a company in many subtle ways:
- It reduces the amount of stock for the remaining founder(s), which can misalign their incentives with investors or reduce their appetite for sticking it out and seeing the company through to exit. Over time, the founders’ stock is diluted when raising capital from investors, and potentially reduces their incentive.
- It reduces the amount of stock you can sell to investors, starving the business of oxygen later when you need that capital to grow. For some businesses, this mistake doesn’t become apparent until it’s too late, and the dead equity becomes a poison pill.
- It can make it impossible to attract or compensate key employees later. Stock options are one of the most important ways you can compensate key employees for joining your company and taking on the risk of doing so. Whatever stock is held in dead equity isn’t available to you to put into an Employee Stock Option Pool to compensate key hires to join your team as you grow. That makes it harder for you to hire the right people – a catastrophic downside.
- It builds resentment. Most co-founders, or founders and investors, are friends. But when one is putting all of their time and energy into the business, while their co-founder chases a different opportunity or their early investor is absent, this can fracture relationships over time. As fellow shareholders, you want to have as strong and collaborative a relationship as possible.
- It can make voting matters harder. Stockholders make key voting decisions during the lifespan of the business. If the relationship is poor, a prior cofounder with significant stock voting power can make votes more challenging – and potentially obstruct business operations.
- It can be fatal for later funding rounds. All of the above are reasons that can be a deal-breaker for later-stage investors: they need you to be fully motivated as a founder with substantial equity; they need you to hire and retain the very best talent; they need governance matters to go smoothly; they need to ensure the company is adequately capitalized and can raise what it needs to raise it the future. Dead equity is contrary to all of those. Professional investors will often pass on deals just because the cap tables are “dirty,” loaded with this kind of dead equity. They see it as significantly added risk atop an already risky venture investment – especially when compared to other investment options that don’t have that headwind to deal with.
How to prevent dead equity in your startup
Dead equity can’t always be prevented, but it can be minimized.
- Set up vesting schedules: when co-founders begin a business together, having strong vesting schedules – in which founders “earn” their stock ownership over time by working hard on the business – is critical. Vesting schedules make it easier for everyone, if situations change – the co-founder who wants to leave can do so cleanly, and it makes it easier for the remaining founders to recapture some or all of the stock to use to grow the business.
- Have a buy-sell agreement: co-founders can write a buy-sell agreement to get the company past a deadlock situation that allows one founder to buy out another founder. This prevents dead equity on your cap table, but of course one founder is forking over cash to another to get them out of the business, which is usually better (and perhaps cheaper) than litigation. Your legal counsel can draft one for you.
- Manage expectations between co-founders: Co-founding a business is an extraordinarily stressful and complicated relationship. Spelling out expectations early on is crucial. Having conversations regularly – and writing them down – about your responsibilities, potential life changing events, or shifting interests is important in managing expectations in a team of co-founders, so there are no surprises.
For founders seeking early investors:
- Sell equity to early-stage investors carefully. Being a founder is lonely, and an investor who puts their faith in you early on can be a huge confidence booster. But you need to be careful to ensure the price for that stock is reasonable and appropriate. Early stage investors are not co-founders; seek experienced counsel before selling stock to an early stage investor. As a rule of thumb, early friends & family investors should be buying low single-digit percentages of the company at most.
- Manage your capitalization table carefully, from the beginning. Sometimes founders grant stock or options without being able to see the fully-diluted impact of those choices. Do not wing-it with this math in a spreadsheet. We recommend using a product like Carta to keep everything organized and clear. It also makes it much easier to model and see the outcome of different decisions you might make in granting equity or options.
Ways to deal with dead equity in your startup
If the dead equity is already in place, you don’t have many options. Everyone entered an agreement in good faith, and it is often difficult to change it. You should seek the advice of your legal and accounting/tax counsel on all of these options.
- Request to reallocate the stock. If everyone involved is on good terms, perhaps you can convince them to work with your counsel to re-allocate the stock in an appropriate fashion between active and passive founders. Perhaps your understanding at the time you granted the stock to yourselves was that you would each work for the company and earn your stock, but didn’t put that into a written agreement at the time. Or, perhaps the value and potential of the business didn’t become clear until after you got started, and you realize you sold stock in the business far too cheaply. The arguments in this post may be able to convince them that such a move is best for the long term success of the company – and their own shares of stock in it. Or, conversely, if they refuse to re-allocate the stock, the dead equity may prevent the stock from being worth as much – or anything at all.
- Buy back the stock. If you granted stock to someone, but you want it back, you can always negotiate a price to buy it back from them. Be aware that there are almost certainly tax implications here.
- There may be other options depending on your situation that your legal counsel may be able to help with. Be advised that almost all of these options have significant and painful drawbacks.
All-in-all, managing your cap table carefully from the beginning makes this risk much lower. Dead equity is an “unforced error” that is mostly preventable. Avoiding dead equity is a great way to increase the chance that your startup’s story has a very happy ending.