Promising Equity v. Issuing Equity
An underlying theme of a number of SHL posts has been the common misunderstanding among young, first-time founders around what startup/vc lawyers in fact do. As I wrote in Legal Technical Debt, a mindset has emerged from certain startup circles suggesting that virtually anything legal that startups do at early-stage, from forming their company to raising seed financing, can be automated with software.
That confused mindset leads founders to (i) assume that all lawyers are just luddites over-charging startups for effectively filling in forms, and (ii) results in founders accruing an enormous amount of compounding ‘legal technical debt’ from badly drafted documents, mis-matched contracts, missed legal steps, etc. For companies that fail fast, the debt never comes due. And yes, there is a clear correlation, from my experience, between founders who arrogantly think lawyers are worthless and those that never build anything of significance. Dumb people believe and do dumb things.
For those founders that do end up building a real business, however, the 10x cleanup cost of legal technical debt (relative to what it would’ve cost to do it correctly from the start) is often brutally painful. There are a lot of very interesting new tools out there being built to streamline and optimize how tech/vc lawyers work, and you should certainly look for lawyers who are using them. But if you think for a second that you’re going to build a real tech company without needing serious lawyers who can safely manage significant legal complexity, you are, without question, deluding yourself.
A significant source of “automation confusion” arises from founders not understanding the difference between promising equity and actually issuing equity. I’ve noticed this from how many of our own (very early stage) clients will randomly e-mail us a set of contracts executed over a period of several months with a short message like: “we went ahead and *issued* some equity on our own. just FYI.” This blog post will save me from having to write the same e-mail 30 times in the future.
I can promise someone equity in 5 seconds, and 1 sentence.
“I promise to issue you 10,000 shares.”
See, it’s not hard. Promising equity is exactly as easy, and as automatable, as it sounds. Anyone who automates a contract for promising equity, which usually means filling in numbers into a static template, doesn’t deserve the slightest bit of praise for innovation. It’s been do-able for decades.
Sure, people still make mistakes in promising equity all the time. They calculate the number of shares incorrectly, or they get the vesting schedule wrong (or don’t offer one at all), or they simply grabbed the wrong form to begin with. But the point is that, perhaps with a little guidance from educational materials and a boilerplate form, promising someone equity is do-able as a DIY project.
The problem, of course, is that promising equity is 2% of the much more complicated process needed to actually issue equity. To correctly accomplish the issuance of equity from your company and into the hands of the intended recipient, a web of highly contextual legal analysis needs to occur. Just a short (non-exhaustive) example:
- What kind of entity are you? That influences the type of equity you can issue.
- Stock? Option?
- If Stock, at what price?
- If Option, at what price? To an employee, or a contractor?
- Vesting schedule? 83(b)? Acceleration?
- Was the price set correctly to avoid tax consequences?
- Enough authorized shares?
- Correct class of equity?
- Is it being issued under an equity plan?
- Was the plan adopted correctly?
- Are there enough shares in the plan?
- Is the recipient eligible to receive the equity under securities laws and tax rules?
- Any state-specific rules/filings to comply with?
- Any contractual approvals needed?
- Any cap table adjustments needed, like anti-dilution?
- Approved by Board?
- Anyone else that needs to be notified about the Board action?
- Any spouses we need to worry about for community property purposes?
I could go on, but you get the idea.
Want to try automating that? Good luck to you. Medical care will be fully automated before complex legal work is. Why? Because there’s far less variability in biology than there is between the legal structures of companies. You simply cannot automate (not in a commercially viable way, at least) in an environment where every use case has a totally different starting point, context, and history, in an infinite number of combinations. Even less so where high-stakes errors are cemented in ways (via contract execution and enforceability) that do not allow for quick and easy bug fixes. That is precisely the world in which serious VC lawyers operate.
Believe me, I empathize deeply with the disdain for lawyers held by many entrepreneurs, and share some of it myself. As someone who manages recruiting for our firm, I constantly find myself fighting a sense that the legal field is a magnet for people who think that perfecting their punctuation matters more than learning to actually advise clients on the what, why, and how of startup law.
But there are lawyers in the market who know how to get things done efficiently and correctly. I hire those lawyers. You can either (i) pay them now, (ii) pay them 10x later, or (iii) assume your company will fail before the debt comes due.
Originally published at Silicon Hills Lawyer.