The Equity Trap

About once a week or so, someone asks me about a situation something like this:

"I formed an LLC a couple of years ago with my best friend, to start a business building widgets. The business is doing well, but now we don’t get along anymore and I want to buy him out. Can you help me?"

           My first question: “Is he willing to sell?”

About 2/3 of the time, the answer is either “no”, “I don’t think so”, or “we’re not speaking anymore so I don’t know.” Assuming one of those answers,

           My second question: “Do you have an agreement where he is forced to sell to you?”

90% of the time I get a blank stare at this point. It’s 100% if the person formed the LLC without a lawyer to begin with and either did it themselves or used one of the on-line “services”.

If you sell someone your car, can you come back in a year and take it back?  Can you make them sell it back to you? Of course not.

The problem here, and the trap, is that equity (ownership of a company) is property. Once someone has it, it is theirs and you cannot force them to sell it back, or take it away (absent valid agreements that say you can). If you sell someone your car, can you come back in a year and take it back?  Can you make them sell it back to you? Of course not. For a variety of reasons, people tend not to think of equity as property in this sense. 

While there are very many things we could discuss about this topic, I offer 2 points: 

One – be very careful about giving away equity. In the beginning of a company’s life, the owner(s) are enthusiastic and confident that they have built the better mousetrap. The future is bright and all is well. I love that enthusiasm and it is one of the reasons I do what I do. These entrepreneurs are exciting to be around and their willingness to risk it all to build a company is impressive. However, one side effect of this initial enthusiasm can be the desire to gather a team. Money may be short, so they want to get the team together through offering equity. Or they may want the thrill of telling someone, “I’m giving you 5% of my company”. Whatever the reason, my counsel is to resist it. In some circumstances it will be appropriate to bring in equity partners, but in the vast majority of cases I see, it is a mistake. For capital raising, it can be better than taking on debt for sure. For the other reasons, make sure someone is worthy before they get the keys to the kingdom. Make sure you know them well. Make sure they share your passion, enthusiasm, and most importantly, willingness to risk it all to build something.

Two – get good agreements. Through well drafted agreements, you can (a) make sure that equity is sold back if the person no longer works for the company, (b) control if and how equity can be sold to third parties, (c) decide what happens to the equity if the owner dies, divorces, or goes bankrupt, and (d) include the ability to force a sale of the equity if you want to “break up”. If you are selling equity to raise capital, good agreements are even more critical. For more information on these types of agreements, see my article "A Prenup for Your Business?".

Internal fights between owners can kill an otherwise flourishing business. Avoid them, and the equity trap, by having well thought out agreements in place, and using your trusted business lawyer for advice and counsel.

If you have questions on this, or any other business law issue, please contact me at [email protected]. www.SolidCounsel.com