Dynamic Equity Design: Reserved Pools, Vesting, and Prearranged Exits

#EquityDesign #SetMilestones #ReserveAnEquityPool #EstablishAPivotalMinority Why do startups so easily become embroiled in disputes over interests or legal disputes? A major reason is that equity design and the distribution of benefits become inappropriate and cannot be adjusted promptly. Startups generally undergo dramatic changes that can unbalance their original equity structures and benefit-sharing mechanisms. If the business model changes, for example, the importance of different resources changes too. A shift from an asset-heavy to an asset-light business reduces the importance of capital and increases that of people. A shift from B2B to B2C reduces the contribution of a team member whose resource is relationships with business customers. The founding team’s individual capabilities may also change. Consider Haidilao: Zhang Yong and his wife, and Shi Yonghong and his wife, originally held 50% each as couples. Over time, Zhang’s management and leadership capabilities became increasingly prominent, and he ran the company. The original equal split began to look unreasonable. Cofounder Shi recognized this and agreed to transfer some shares. The two avoided falling out and ultimately built Haidilao into the business it became. Consider also the dispute between Chinese influencer Li Ziqi and her company. Initially, she was one of many influencers under Weinian, so taking a share of earnings without company equity was appropriate. But as she became a leading influencer and Weinian’s valuation soared because of her personal brand, the original arrangement might no longer have been appropriate. This is the common startup dilemma: early on, when the business model, individual contributions, and how well people work together are all uncertain, the team must nevertheless establish an equity structure and benefit-sharing mechanism. Otherwise, the company cannot get started. Later, changes in the business model, the importance of resources, and individual contributions require adjustments. Yet the founding team cannot agree: everyone believes their contribution and achievements are greatest. They hold each other in check, and often end up in court. People with Shi Yonghong’s wisdom are, after all, uncommon. How can a founding team avoid this trap? In Dedao’s 公司治理30講 (30 Lectures on Corporate Governance, descriptive title), Liu Songbo says teams should anticipate such changes from the outset and leave room for later adjustments in their equity design. First, reserve an equity pool. Rather than dividing all the equity immediately, set some aside. Suppose A, B, and C start a business: A holds 40%, while B and C each hold 15%. The remaining 30% can temporarily be held by the three founders as nominees in proportion to their holdings. When an adjustment is needed, the reserved shares can be allocated without making shareholders surrender shares they already possess, greatly reducing conflict. Second, use equity vesting. Suppose the team member responsible for development promises three new products. Give that person 5% equity for each completed product, reaching 15% only when all three are finished, rather than granting 15% at the outset. Similarly, for a team member who promises to bring in important resources, set a schedule and link equity allocations to the resources actually delivered. That avoids regretting an equity grant later. Third, prearrange an exit mechanism. At the company’s establishment, specify when the equity of a shareholder contributing little should be recovered, at what price, and how it should be reallocated. Of course, agreeing on this is difficult—rather like writing a divorce agreement when getting married. Another approach is to bring in a third party to help coordinate the exit mechanism. Professor Ning Xiangdong once designed a governance structure for a small company whose two shareholders each held 50%. He required them to give up 0.5% each to a relatively impartial person both trusted. That person would hold 1%, becoming the pivotal minority. Why design it this way? Ning thought the two shareholders were quite likely to fall out and separate eventually. An independent third party could then mediate fairly, giving the weaker side reasonable property rights and an exit route without allowing the company to fall apart. In short, startups can use reserved equity pools, vesting, prearranged exits, and other mechanisms to adjust equity and benefit sharing promptly as the company changes. As Xu Xiaoping puts it: “Do not pursue shared interests through brotherhood; build brotherhood through shared interests.” #得到頭條 (Dedao Headlines)