The New York Times had a terrific story this weekend on a matter I see all the time in my practice: entrepreneurs who hand out equity in their businesses at the startup stage, then years later want to buy those equity-holders out, but lack the resources to do so. The piece opens with the story of Brad Sacks, a food entrepreneur in Akron, Ohio:
BRAD SACKS brought in two family friends who were older and wiser when he started his sauce company, More Than Gourmet, in 1993. They didn’t invest any money, Mr. Sacks said, but for their help, he gave the men half of the company.
Two decades later, the company, in Akron, Ohio, was booming, with lines of demi-glace and cooking stocks that were being used at the Capital Grille and the Hilton Hotel chain and sold at supermarkets like Wegmans. But Mr. Sacks said the two original partners were reaping the benefits of his work even though they were no longer advising the business.
The story goes on to describe how, when Mr. Sacks tried to buy his “partners” out, they (not surprisingly) resisted. And, while a deal was ultimately reached, the negotiations “got ugly,” and then Mr. Sacks had to figure out a way to come up with the cash to actually buy his partners out of what had become a highly successful business.
This situation is common in the world of small business: an entrepreneur believes he lacks something that he needs to get his business up and running – expertise, experience, relationships, financing – and in exchange for obtaining that “something” from someone else, grants that someone equity in his business. After all, money is tight in the early days of a business, and granting equity seems like it doesn’t cost anything. But then the company becomes successful, and starts making money, and then…. well, then it sure does start costing the founder money, because he has to share the profits with those other equity holders.
Now, if the company really could not have gotten off the ground without the assistance of these early backers, then perhaps no one can argue with those supporters reaping the benefits when the company really takes off. But I see quite often that such is not the case. Many times, a company’s founder could have gotten the same “something” from another source (such as a small business loan rather than investment financing), or the granting of equity was not even necessary to achieve that something (such as granting equity to a chef or bar manager who is also earning a salary in exchange for the expertise they bring). Then there is the situation where the equity is granted, but the “something” is never really provided – or is not what the founder expected it to be (such as a head of sales who doesn’t make any sales, or an industry consultant who actually doesn’t know the industry as well as he said he did).
We regularly advise our clients on ways to address these issues before they grant equity in their businesses. And if they do still decide to do so, we prepare their operational or investment documents in a way to ensure that they get what they bargained for and have maximum flexibility in the future when it comes to the management and growth of their business. After all, what helps you get off the ground at the startup stage, should not be an anchor around your neck later.