Let’s review what equity is
When you established your company, you most likely issued some sort of stocks to your co-founders and other stakeholders. In its core, the equity you offered to your team is a promise of a future payment. The notion is that the stock will be worth much more in the future and it will have a cash value that can be redeemed. When a stakeholder wants to get out or you have realized that someone in your team is not delivering as promised, then it means you need to trade the terms of the initial agreement with new terms that work for both parties.
The payout process
Once the decision has been made by you or the stakeholder in your company, to go through the buyout process, you will need to make sure it is fair to both parties. You don’t want to hurt your fragile startup by cash depriving it, nor you want to make your (ex) stakeholders feel that they have not been compensated for the effort and time they have put helping you out with implementing your vision.
Converting stocks to cash at any given time is not an easy process and sometimes can become very expensive. The reason is that there are too many variables that play a factor to determine the current value of the startup stock. That is why the best time to do the buyout is probably just after a company valuation has been performed by a third party – for funding or other reasons. You need to rely on a number defined by a trusted institution, so you and your stakeholders are clear about the value you are discussing and share the fairness of the process.
There are few approaches that are worth reviewing and approaching in such cases.
Stock to cash over time
One of the first and simplest approaches involves creating a mutually agreeable payment plan to transition equity into cash over a set time frame. This method essentially involves maintaining your company’s cash flow while also diligently following through on the agreed stakeholder payment. Usually, this could follow a payment plan distributed over 1-5 years, factoring in the current stock price and the benefit of not having the shareholders remove the entire cash amount all at once. This step-by-step buyout procedure, typically undertaken after a thorough third-party valuation, highlights the necessity of ensuring fair compensation for stakeholders’ equity share. Simultaneously, managing cash flow to avoid a cash shortage scenario in the startup is also vital. These considerations significantly influence how much of the buyout amount is dispensed in periodic payments throughout an agreed plan. For burgeoning businesses, finding the right equilibrium during this transitional stage – delicately shifting from shares to liquid assets – could be crucial in preserving the company’s financial health and stakeholder benefits.
Growth aligned payout
This approach can be viewed as a developed format of the ‘transition of stocks into cash over time’ strategy. In this condition, all parties agree to a remuneration scheme that relies heavily on the annual performance of the business. This strategy is fair to the company and could sometimes even lean in favor of the departing party, considering the predicted year on year growth of the startup. However, this arrangement does come with its own set of risks, mainly due to the fact that a startup by nature is a high-risk investment, and there is a chance its value might decrease over time. Nevertheless, this method seems to distribute equity to all concerned, as the payout is more in line with the real-time value of assets.
The actual growth may be agreed upon and negotiated, possibly based on net gains, total sales, or any other outlined KPIs that both parties find reasonable to determine the buyout value.
Immediate payout
The situation can get more complicated if the exiting party wishes an outright cash payment without delay for any reason. They may foresee a decline in the startup’s value in the future, or certain circumstances force them to opt for a quick payout.
In such a situation, as a founder, you might have an upper hand in negotiating the terms and could aim for a discounted price. Here, the need for cash on hand trumps the value of the company. The necessity for an instant cash agreement heightens this need.
Depending on the urgency of the cash need, you might have the opportunity to negotiate on discounts. A startup investment is generally seen as a long-term engagement, transforming it to a short-term deal certainly incurs a cost.
Conclusion
Maintaining healthy relationships with stakeholders is crucial for a startup founder. Your “people skills” will facilitate smoother dealings with stakeholders who wish for an exit and cash out their investments. However, this journey isn’t always smooth and could prove costly, especially if your startup has significant value. In the early stages, before steady income or funding, the process might be simpler as your startup may not hold much value. But, as soon as you secure funding and your startup is given a monetary value, things may become harder to handle. In this situation, a CEO’s skills, coupled with building good relationships and soft skills, becomes priceless. Always keep stakeholders updated, satisfied, and well-informed about current valuations. Maintain clear KPIs to give a transparent view of your business trends. Always remember, building a successful business entails more than just introducing a product or service in the market.
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