Equity to key employees? Look out for legal and tax pitfalls!

Sigma started a new company, he and his father were the initial Directors. He had saved some money in his career and invested some of his savings in the startup.

Equity for advisors

Sigma knew a couple of experts, Pie and Rho, who had a good reputation in the industry. He decided to get them on board as advisors. He spoke to them and they also agreed in principle to associate with Sigma. Sigma then started thinking about the compensation that he could pay to Pi and Rho and other professionals that he wanted to employ. He realized that their normal market terms were quite high. When Sigma factored the market related compensation to his potential team and advisors, he realized that the salary costs equalled to over 70% of the available money.

Sigma wondered what he could do… should he approach angel investors for funding? He talked this over with a friend and thought that he could offer a significant stake in the company to Pie and Rho, so that the available money could be used to fund other expenses. He was unclear about the value of the business and valuation of shares that he could offer. After due thought, he decided that he could offer 8% of the company to these seniors and that the shares could be transferred when the first round of angel investment was raised by his company.

The case

Sigma then met Gyan, the business mentor and spoke to him about his plan. Gyan suggested that Sigma should also check the legal and tax implications involved in notional allocation of shares at one time and subsequent allocation much later. Gyan gave the example of Luminous Technologies, which was also started in a similar manner. An advisor was orally promised 10% of the equity shares with a book value of Rs.10,000 at the time of starting the company. In about 12 months, the company was able to raise Rs.1 crore from angel investors, at a company valuation of Rs.4 crore. The advisor’s 10% share was now worth Rs.40 lakhs. The promoters and advisor were then faced with a problem that they had not anticipated. The shares that had been committed at a book value of Rs.10,000/-were now valued at Rs.40 lakhs by a third party. This meant that the advisor would have a significant tax outflow, without any cash being received by him. Further, there was also a chance that this Rs.40 lakhs could go down in value over time, if the company did not do as well as expected. This was a high risk venture.

Possible learning and solution for Sigma?

Gyan suggested that Sigma could instead consider inviting the advisors to invest in the company at the initial book value. This would not only reduce the cash outflow in the startup, it would also capture the terms and conditions of share allocation to the advisor. Sigma went back to consult with his team of advisors and consultants before taking a view.

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About Anjana Vivek 45 Articles
Anjana Vivek, Advisor, Independent Director, Professor, Author, Mentor

1 Comment

  1. Nice Article. This message should reach the people who are keen on starting on their own. Entrepreneur’s should do their home work before approaching Angel Investors or VC.

    Warm Regards
    Vinay Javagal

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