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are agreements, usually contained in written contracts, that increase an investor’s percentage of ownership upon the occurrence of a specified event, such as the failure of the firm to reach a sales level on a given date. By increasing the investor’s share of the company, equity penalties decrease the share of other investors, including management. Be wary of equity penalties. They include any arrangement that results in management’s stock ownership percentage decreasing if the company fails to achieve its goals. Equity penalties can be in the form of investor options, specialized antidilution protections for outside investors, or restrictions that prevent management shares from vesting. Equity penalties are often legitimately included in venture fundings. They are used to allocate risk among the parties. Sometimes, however, equity penalties sneak into a deal late in negotiations as a "sweetener" for the investor. The first hint that an investor wants this type of "sweetener" often comes when the investor suggests to management that if the company does not meet the projections in its business plan, then his investment will not be a good one. To get the funding, management probably made a good sales pitch to the investor. In the course of its many discussions, management probably reassured the investor several times that the company’s projections were reasonable and attainable. Now the investor suggests that if the company does not meet its projections, his return on investment will not be high enough to justify his investment. The fair thing to do, he says, would be to increase his equity percentage if the company fails to meets its projections. At this point, most entrepreneurs get heartburn. They have spent a lot of time with the investor and have become accustomed to thinking of the deal as done. If they refuse this "reasonable" request, they might lose their funding. The temptation to concede is great. But is the request reasonable? Should management concede the investor’s request? Usually not. Most investors know how difficult it is to accurately project results and do not really expect management to concede this issue. After all, the value of management’s investment also diminishes if company projections are not met. And one reason the investor is getting so much equity for his money in the first place is because of the risky nature of the investment. When an investor insists on equity penalties and management has neither the time nor inclination to look for other investors, it should nonetheless try to get the investor to require "extra" equity only if the company does not attain 70% or 80% of projected results. Management should also try to work in a time cushion. If the projections show the company reaching a certain result on January 1, for example, management should try to get until April 1 to reach 80% of the projections. Finally, management can suggest that if it makes sense for the investor’s percentage to increase if the company fails to make its projections, that it also makes sense for his percentage to decrease if the company exceeds them. Investors will often concede the fairness of this proposal and console themselves with their original offer for a fixed percentage of the company. See: Benchmarks, Business Plan, Earnouts, Earnups, Negotiation, Projections, Take Away Provisions, Vesting Schedules. |
