Not Only Luck.
An essay by John Melonakos

A Naïve Mistake and Its Fix

When we jumped into AccelerEyes 6 years ago, none of us founders had seen anything other than engineering school. Our work experience amounted to a few summer internships. We were ripe for a making naïve mistakes.

We understood our naïvety at the time, and we looked for trusted advisors on all the important issues. However, as we would later learn, advisors are not all created equally, and we followed some bad advice.

The first big mistake was to trust the business advice of our lawyer. I think this is a common problem many early startups face. Lawyers are some of the first professional people that get involved in a young business, often helping to organize the business’ founding documents. Through that process of setting up our original operating agreement, our lawyer (who was working for free initially because we had won his services in a business plan competition) became unduly esteemed in our eyes. On his counsel, we would end up with a terrible agreement with a part-time MBA-student volunteer that would later have to be undone.

The Story

As self-admitted naïve engineering students, we thought we logically needed some “MBA-ish-ness” on our team. We had a great relationship with one of Georgia Tech’s MBA students. We thought he would be a great fit for getting our company off the ground.

He was an awesome guy – great to be around, accomplished on many levels, hard-working, smart, and much more. He had no previous experience in our market, no networked connections in our space, and no fundraising knowledge. He had no intention of sticking with our startup long-term, was very distracted by his MBA studies and personal sporting ambitions, and had a full-time job lined up with a big company upon graduation.

He was required by some of his course work to help on our business anyway, and he was also an equal member with us on the business plan competition teams where he personally won several thousand dollars like the rest of us. We wanted to motivate him to work more than was required by the schooling and competitions, but we did not have any money to pay him. So we came up with an “equity” arrangement whereby he would work for free for the company as often as he was able (which turned out to be meagerly part-time work beyond the other school/competition requirements) in return for a percentage ownership in the business.

At the time, we had no unit sharing mechanism in place, so we did a one-off legal agreement. We discuss the agreement with our lawyer who claimed to “know startup stuff” and got his “this is a standard agreement” signoff on it. Here are the terms of that agreement:

In the event that at any time following the date of this Letter Agreement, the Company closes on a transaction in which the Company (or its members) sells all of or substantially all of the Company’s assets or limited liability company units to an unaffiliated third party (a “Company Sale”), you shall receive an amount equal to the net amount of, and in the same form as (including, but not limited to cash, stock and/or promissory notes), the consideration you would have received had you owned (a) 2.75% of the limited liability company units of the Company immediately prior to the effective time of such Company Sale if the Company Sale yields less than or equal to $12.5 million; (b) 2.50% if the Company Sale yields more than $12.5 million, but less than or equal to $17.5 million; (c) 2.375% if the Company Sale yields more than $17.5 million, but less than or equal to $20 million; and (d) $475,000 if the Company Sale yields more than $20 million.

I remember the naïve feeling that those terms were fair because:  1) they represented what we felt was just a “few percent” of the company, 2) they had a max payout cap of $475,000, and 3) they would not take money out of the business unless there was a “company sale.”

Later, I would come to understand that there were several big problems with the agreement:

  • A “few percent” of equity is a HUGE amount to give someone, let alone someone that is not committed substantially to the business for the indefinite future
  • A “few percent” of equity is a HUGE amount to give someone that is only working part-time, even if they are going unpaid
  • Straight-up percentage agreements are disastrous to follow-on investors who want to see that everyone is diluted evenly as the company takes on investor money
  • “MBA-ish-ness” is actually not that valuable for a startup

Two years after signing that agreement, Sig Mosley pushed hard on us to get rid of this structure before he was to invest in our “Friends and Family” round. With Sig’s push, we approached this early volunteer with the offer to cash out his agreement. We calculated what his pay rate would have been had we been able to pay him a generous summer internship wage. He pushed back, but we negotiated back and forth and ended up at a buyout amount. It stung, but was necessary to clean our equity slate and make Sig and other investors feel at ease with respect to their investment in our startup.

We learned a lot from this and other similar naïve mistakes early in our startup. Luckily, we’ve been able to mend those mistakes and move forward. One of the best parts about working for a startup is getting to participate in the raw opportunity to error and repair on the most fundamental aspects of business, iteratively and ongoingly.

What naïve mistakes have you made in your startup? How have you corrected those mistakes?

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From the conversation

Comments preserved from the original post.

Jay McDaniel

I see this issue on occasion when a company wants to create an equity incentive or simply cannot afford to pay the going wage. The owners ask me to draw the papers and I then try to convince them of the error they are likely about to make.

The problem is that once you grant equity to anyone, the only way to get it back is to buy it back — unless you have thought through the possibility of failure. I usually tell clients that if you want to give employees or anyone else an equity incentive, create a separate class of interest with a stated value. They can take earnings from the success of the business, but if they need to be bought out, the number is nominal.

For example, you can have an employee class of LLC interests where the stated value on withdrawal is equal to $1 per percentage point of the class. The right to profits allocated to the class may be dealt with separately. Another important detail that is often overlooked is that you need to make sure that the interest has a qualification that the holder must be employed by the company. (Of course, none of this works if you are an S Corp. which is limited to a single class of equity.)

All in all, equity should be for the real owners — that is the people who risk their capital, sign the guarantees and take real responsibility for the overall success of the business.

melonakos

In reply to an earlier comment

Great points! The big tradeoff at the time was lack of money to pay lawyers to setup the class of interests properly (the crappy agreement we signed was much cheaper). In hind sight, the agreement we signed was a mistake. But the alternatives weren’t easy either. All part of the struggle to start a bootstrapped business.