For over 20 years, I have served as investor, adviser, founder or BOD member in more than 50 start-ups. During that time, I have struggled with the practice of lawyer-administered stock option plans and stock certificates as well as the management (perhaps, better, the mismanagement) of capitalization tables. These activities may seem straightforward – but in reality – the current procedures in most start-ups are seriously broken and need overhaul. I believe the time has come for start-ups to handle their equity plans and associated documentation the same way they handle employee and other company benefits, which are often managed with the support of an objective 3rd party.
Every possible configuration of stock plan administration has crossed my screen/desk, and I often witness the shortcomings of these administrative practices at the time of exit, whether by IPO, acquisition, merger, or bankruptcy. I’ve worked with the best lawyers in the world, and each has his or her opinion – but I believe we’re at a tipping point as start-ups blossom, the use of equity compensation accelerates, and capitalization tables become increasingly complex. It’s time for entrepreneurs and early-stage CEOs to change proactively the practice for how they administer the equity in their companies – and I believe (because I’ve done it) that with very little effort, there are significant benefits to be gained. Let me explain.
Committing to your outside professionals for important tasks has benefits, but also risks. Most sophisticated modern start-ups rely on a lawyer to manage their corporate legal work. My favorite selection criteria were expressed last year in this post.
During the hiring process, many companies issue equity packages to employees (stock options or restricted stock, for example). At the appropriate time, the company is obligated to provide the employee with a certificate representing the equity that the employee owns or could receive. For most start-ups, the standard practice is to assign the lawyer (or more specifically, the lawyer’s paralegal) with the task of holding and managing the certificates. The belief is that using a lawyer is the most responsible way to track the certificates so that when you need to collect the certificates quickly – as in the case of an IPO or acquisition – you don’t need to chase down a random ex-employee who may have used the stock certificate as a placemat at the summer BBQ. This belief is outdated and, more importantly, negatively affects the employee in two ways. (This is the very person who is working hard every day to make the equity worth something).
The first problem occurs if/when the company changes lawyers. Here, all certificates held by the lawyers (paid by the company, remember) on behalf of the employee need to be transferred to the new lawyer and the new paralegal. I’ve experienced first-hand the awkward incentives that were produced in this situation. Of course, the new lawyer wants to do a good job – the old lawyer is obligated to ensure successful transfer. However, if we look down the road a few years, say when the company gets acquired and the new lawyer must track down certificates, most of which held in escrow, there just happens to be one missing – and it was before the new lawyer took over the reins. What then happens? Call the old lawyer – who has little/no motivation to help figure out the cert’s location. If the certificate is not found and the underlying shares are now publicly traded, the EMPLOYEE must pay what is essentially an insurance fee to the new transfer agent. This insures that if the lost cert later appears, claims on the equity by someone else do not occur. The fee? …..Oh….wait for it……usually….exceeds $15K !
So here you are: because some inexperienced junior paralegal screwed up certificate administration, the employee who worked hard, did your job, sacrificed as required to make the company successful and produced results, now has to reach into their pocket and pay $15K+ for a bond that should have been completely unnecessary. Not fair in any way, shape or form – but it happens all the time,far more than anyone would admit. And, as in the case with infections in hospitals, no one has an incentive to make the problem their problem.
The second problem is difficult to quantify, but perhaps has greater significance. Employees do not possess tangible proof of their individual equity – other than their executed stock plan documents. To me, this feels wrong. I’m a huge believer that equity ownership is one of the most powerful motivators of personnel in early-stage companies, and it creates tremendous value for you and all your colleagues. To take the item that represents the hopes and dreams of most start-up employees and hide it in some law firm’s file folder really seems like a waste of a vital item possessing symbolic meaning.
Just eliminating certificates to alleviate the logistical challenges is not the answer. A few years ago one of my lawyer friends began talking about having his companies go “uncertificated.” Basically there is no legal reason why companies have to give out these certificates – so, if there is such a huge administrative burden and only downside if certs are lost, why not just completely do away with them? I think that this approach misses the whole point of employee ownership – removing completely such a tangible symbol of hard work and passion negates the proposition of equity growth in mission driven start-ups.
So is there a solution?
I was blown away a few years ago when I met Henry Ward. He started eShares, a service designed to provide effective, secure and reliable electronic stock certificate and stock plan administration for many hundreds of start-ups and now even later-stage/larger companies. Managing certificates electronically, as a 3rd-party administrator, is the company’s sole purpose! I believe so strongly that the right approach is to use a 3rd-party administrator like this, that I made an investment in eShares. I invested because I used the service myself for Tamr and other portfolio companies – and found it so compelling (low effort + huge benefit) that I begged Henry to let me invest.
Consider the result of using eShares when compared to the old process. If you switch lawyers, it’s not a problem – now it’s as easy as removing the old lawyer’s access and allowing the new lawyer to have access. Each employee logs into their account, and if desired, prints a physical copy of their certificate – just a copy – so if they do decide to use it as a placemat for their BBQ, no worries since it’s just a physical artifact. On the other hand – when you go public or sell the company – you’ve got direct access to all of the electronic certificates required to do any transaction and you can efficiently message the stockholders – regardless of their current employment status with the company.
Another benefit of using eShares’ solution is that as the Founder/CEO/CFO of a new company, YOU are in control and have complete visibility of your cap table at all times. Rather than call your lawyer to get a copy of your cap table and wonder if she/he is going to charge you for the two minutes @ $500/hour, instead you just log into your account and you get your accurate and completely up-to-date cap table – managed and controlled by YOU instead of a lawyer. (Interestingly, my experience so far has been that the best lawyers – the ones who try to maximize value instead of fees – embrace the eShares solution, even though on the surface it would seem to go against their interests.)
I also think employees should insist on using electronic certificates – because, unfortunately, sometimes bad actors do take the reins in early-stage companies. I’ve witnessed CEOs and CFOs who have used the inability to track down a certificate as an excuse to “write off” some equity holders at the time of an acquisition. I know – illegal and awful – but there are bad people in the world, and there are many VCs prone to replacing early-stage Founder/CEOs as a normal course of practice. Having your stock managed in a system like eShares produces irrefutable evidence of appropriate ownership and eliminates the potential ambiguity of lost paper certificates.
In short – this is a very simple, low cost method to ensure that the people working hard every day to increase shareholder value are rewarded when their stock is worth some dough at exit. I encourage you, if you are a Founder/CEO, to check out eShares. The minimal effort is worthwhile. And, if you are an employee of an early-stage company/start-up, I strongly recommend that you ask your executive leadership to consider getting set up on eShares or a similar system ASAP.