A founder came to me recently to sell her business. She had built it over six years and had a buyer at a good price. The buyer wanted 100% of the shares. She owned 92% of them.
The other 8% belonged to a developer who had built the first version of her platform in year one. She could not afford his rate at the time, so she gave him shares instead. He did good work, left after eighteen months, and had not been in touch since. He still held the shares. Nobody had written down what would happen to them if he left, and no one had asked him to sign anything since.
The sale did not fall over. But it took two months longer than it should have, cost her a sizeable chunk of the price in a settlement with him, and most of my fees went to a problem that was created in a ten-minute conversation years earlier.
I see a version of this story often enough that it is worth writing down.
Why equity feels free
When cash is tight, shares look like the obvious answer. You are not writing a cheque. The business is small, so the shares are worth almost nothing on paper. And the person you are paying is often excited to be part of something. Everybody walks away happy.
The trouble is that you are not paying with something you have. You are paying with a slice of everything the business will ever be. If the business fails, you gave away nothing. If it succeeds, that 5% or 10% you handed over for three months of work can end up being the most expensive invoice you ever paid.
That is the first thing to understand. Equity is not a cheaper form of cash. It is a different thing altogether. Cash is a one-off transaction. Equity is a relationship with no end date, and the other person is now in the room for every decision that matters.
Control: a small shareholder is still a shareholder
Founders tend to think of a 5% holder as a passive passenger. In practice, a shareholder in a small company has real rights, and most of them do not depend on how big the holding is.
A shareholder is entitled to notice of meetings and to vote at them. A holder of 5% or more can require the directors to call a meeting. Any shareholder can apply to a court if they think the company is being run in a way that is oppressive or unfair to them, and courts take those applications seriously in small companies where the founder is also the director and the only employee being paid a salary.
Then there are the things that need every shareholder, or a large majority of them, to agree. Changing the constitution. Issuing new shares in a way that dilutes existing holders. Converting the company structure. Bringing in an investor. In a company with no shareholders agreement, the rules that apply are the default ones in the Corporations Act, and they were not written with your business in mind.
None of this means your developer will become difficult. Most do not. The point is that the relationship is now governed by company law whether you planned for that or not. The 50/50 post I wrote last month was about what happens when two people with equal power disagree. Giving away a small stake does not create that problem, but it does create a smaller version of it, and it does so permanently.
Tax: the bill nobody budgeted for
This is the part that most people haven’t thought about, and it’s especially important for the person receiving the shares. Shares issued in return for work are income. The person receiving them is generally taxed on their value at the time they get them, as if they had been paid that amount in cash. The problem is that they were not paid in cash. They have a tax bill and nothing to pay it with, because the shares cannot be sold.
There are concessions for shares issued by genuine early-stage companies, and they can work well. But they come with conditions on the age and size of the company, on how the shares are priced, on how long they are held, and on paperwork that has to be in place at the time. They are not something you can claim retrospectively because it would have been nice. If the arrangement was a handshake and a line in the share register, the concessions are usually off the table.
The founder has a tax problem of a different kind. Wages are deductible. Shares issued out of thin air are not. So the company paid for the work with something that gave it no deduction, and the recipient paid tax on something they could not spend. From the tax office’s point of view, the only party that came out ahead was the tax office.
There is also a valuation question hiding underneath. To work out any of this, someone has to say what the shares were worth on the day. Founders tend to say “nothing” when it suits them and “a lot” when they are raising money. The tax office is not obliged to accept either.
Exit: the holding that holds everything up
Buyers of businesses want clean ownership. Investors want a clean cap table. Both will ask for a list of every shareholder, how they got their shares, and what they signed.
A small holder who left years ago and has not been heard from since is a problem on that list. The buyer wants 100%. Every shareholder has to sign the sale documents. If there is no drag-along clause forcing minority holders to sell when the majority does, the founder has to go and find the developer, explain the deal, and ask nicely. The developer now knows that the deal cannot complete without him. That is a strong negotiating position for someone who has done nothing for five years.
Investors are less dramatic but just as unforgiving. A cap table with three or four people on it who got shares for services, with no vesting and no documents, is a red flag. It tells the investor that the founder gives equity away easily and does not keep records. Some will walk. Most will insist it is cleaned up before they put money in, which means the founder is back to asking nicely, except now with a deadline.
The vendor finance post I wrote in September was about how a sale gets structured when the buyer cannot pay the full price up front. This is the mirror image. It is about what stops a sale from happening at all, and the answer is often a shareholder the founder had forgotten about.
Why it is hard to undo
Founders sometimes assume they can take the shares back if things do not work out. They cannot. Once shares are issued, they belong to the holder. A company cannot simply cancel them because the holder stopped turning up.
The lawful routes out are a buy-back by the company, which has its own rules and usually needs shareholder approval, or a transfer from the holder to the founder, which needs the holder to agree and sign. Both need a price. The holder gets to argue about the price. If there was no agreement at the start setting out what happens when they leave, there is nothing to hold them to.
This is the real difference between cash and equity. If you overpay a contractor in cash, the money is gone and the relationship is over. If you overpay a contractor in shares, the relationship is only beginning.
What to do instead — or at least first
None of this means you should never pay in equity. Sometimes it is the right call. An early hire who will be with you for years, who is taking a real pay cut, and who you want thinking like an owner, is a good candidate. A contractor doing a fixed piece of work and moving on is not.
If you are going to do it, a few things make the difference between a sensible arrangement and the story at the top of this post.
- Ask whether it needs to be shares at all. Deferred cash, a bonus tied to a milestone, a share of revenue for a period, or a loan that converts to shares later can all do the job of “I can’t pay you now” without handing over permanent ownership. Options, where the person earns the right to buy shares later, are often a better fit than shares issued today.
- If it is shares, make them vest. The person earns their holding over time, and if they leave early, the unearned part goes back. This is standard. Nobody reasonable will object to it.
- Write down what happens when they leave. Good leaver, bad leaver, what price, who buys. This is the clause the founder in my opening story did not have.
- Put a drag-along in. If the majority sells, the minority sells with them on the same terms. This is what keeps a 5% holder from sitting on top of your exit.
- Get the tax position looked at before the shares are issued, not after. The concessions are real, but they depend on doing things in the right order.
- Check whether the person is actually an employee. If they are, there is a floor under what you can pay them in cash, and shares do not count towards it.
All of this fits in a short shareholders agreement and an offer letter. It is not expensive. It is a fraction of what the founder at the start of this post paid to untangle a problem that was never written down in the first place.
The short version
Shares are not a cheap way to pay people. They are a permanent transfer of a piece of your business to someone who will then have rights over it, a tax bill they did not expect, and a seat at the table when you come to sell.
If you are about to do this, get in touch before the share register is updated. If you have already done it, it is worth knowing exactly what you gave away and what paperwork sits behind it, because at some point a buyer or an investor is going to ask.
