by Mike Moyer
Sometimes you’ll see the pass-the-hat scene in movies where the employees and friends come to the aid of their fearless leader who has fallen on hard times. But this isn’t really how it happens outside of Bedford Falls. Sometimes it just ain’t a wonderful life.
This is one of those cases where the leadership of the organization will have to take the hit. They will have to cover the company’s debt and their payments will be treated as cash.
If leadership is not willing or able to cover the debt they may have to close the business. When you close the business you would sell whatever assets you have, pay off the debt and distribute what is left to Grunts based on their slice of the pie (more on this in a minizzle.)
Less Cool
After giving it the old college try, the founders may decide that they were wrong about the market and it’s not going to be the cakewalk they envisioned to change the world in the manner they had originally planned.
Maybe they couldn’t get the product to work. Maybe they underestimated the competition. Maybe their spouses wanted them to find a real job. Maybe they just decided the idea wasn’t that great after all.
Maybe it was just too hard…
The world seems to be designed in a way that success is never as easy as we hope. Getting there takes not only the right vision, but also the right level of perseverance that some people just don’t have.
Passing the Pie to Other Grunts
When it’s time to depart, the founders of the company could decide to pass the pie off to fellow Grunts. In this the case they can resign, just like any other Grunt. They will be treated like any other resignation without cause and leadership will pass to the next largest shareholder (or whatever the herd decides).
If none of the other Grunts wants to carry on you may have to sell what you can and shut down the company.
Shutting Down
If the company’s debt exceeds any cash they were able to generate through the sale of assets the company will still owe the creditors. If you anticipated taking on the debt you should have set up a legal structure, such as an LLC, to protect the herd’s personal possessions. It is likely that the creditors will come after you directly, but you might be okay if you structured the company legally. If you did not set up a corporate structure the creditors will come after whoever they can. I’m not recommending that you try to avoid your debts. Usually debt is owed by individuals within the herd. They are ultimately responsible for paying it off.
When it is time to close the doors the assets in the business should be sold and debts repaid. If there is any cash leftover it should be distributed in the following order:
Grunts that put in cash or cash equivalents should be paid back in an amount equal to their contribution. This payback will not diminish their equity holding, however (if it matters).
2. If there is not enough cash to cover the cash contributions then payments in proportion to the cash contributions should be made. So, divide an individual Grunt’s cash contributions and divide by the total cash contributions and give them that percent of the leftover cash.
3. If there is any cash left over it should be distributed to all the Grunts according to their percent of equity.
The goal is to make everyone as whole again as possible. Legal creditors (including personal credit cards) always get first rights to the cash. Anyone who put in cash took larger risks and care should be taken to preserve their cash. Grunts, as Grunts, knew getting into this thing that they might not get paid so anything is better than nothing in a going-out-of-business situation.
Chapter Ten:
Legalize It!
The first rule of business, especially entrepreneurship, is to work with people you can trust. A Grunt Fund is the foundation of a trusting relationship. If your first instinct is to protect yourself against your fellow Grunts, you have probably chosen the wrong herd.
A Grunt Fund documents fair treatment and provides a starting point for a group of like-minded people with a common vision to start a company without a lot of hassle. However, even if you engage a Grunt Fund-friendly attorney to help you set up some basic contracts, it is quite possible that you can join a Grunt Fund and still get burned.
If you want to avoid getting burned, you will probably be disappointed as an entrepreneur. You can’t cover your butt from all possible risk.
Without a Net
Hiring lawyers and accountants to set up your company agreements and legal structures isn’t free. Most of the good lawyers I know provide deep discounts for startups as long as they are doing basic things. Still, I’d rather see entrepreneurs spend their money on marketing and sales. Aside from setting up some basic liability protection (more below), try to avoid spending money on too much legal stuff until you are confident that your company has legs.
In the very early days of a new company your focus should be on proof of concept and nothing else. Spend your time and money finding out if there are people in the world that are interested in buying your product or service.
In some cases, moving forward without legal protection is your only option. Going without a net is riskier, but then again, you may not fall and everything will turn out okay.
With a Net
If you discover there are people out there who want to spend money on your product you may be on to something. It’s now time to mitigate the possibility of getting burned by setting up some basic legal structures to help organize and protect your company. Keep in mind, however, that to most lawyers and accountants a Grunt Fund will be a fairly novel concept. Most are used to doing it the traditional way so it’s probably a good idea to either hire a Grunt Fund-friendly lawyer or make sure the lawyer you hire is up to speed with the concepts in this book.
What to Talk to Your Lawyer About
To help you get the most out of your GruntFunded company you will want to discuss liability, ownership rights and taxation with your lawyer.
One of the first things you will want to do with your new company is to set up a formal corporate structure. In most cases, you can set up the company yourself using online tools or going directly to the Secretary of State. I like this method because it requires more research which helps you better understand how it all works. However, most startup friendly lawyers will help you set up your company at a very reasonable rate. Grunt Fund-friendly lawyers may even take pie instead of cash.
Limiting Liability
A key feature of any formal business structure is its ability to protect the owner’s personal assets from liabilities incurred by the company. This includes everything from corporate debt to lawsuits. The protection they offer isn’t always bulletproof, but it’s better than nothing. The better you manage and organize the business the more protection it will provide. For the most part this means a clear separation between personal activities and the activities of the company. Avoid turning business trips into vacations and avoid dipping into corporate bank accounts for personal reasons.
When you meet with your lawyer be sure to discuss ways to get the most protection from your legal entity.
Ownership Rights
Setting up a formal corporate structure will also help you manage intellectual property rights and asset ownership. When a Grunt makes a contribution to the company the Grunt relinquishes ownership of that contribution to the company. This is important because you don’t want people taking things out of the company when and if they leave. If you start a pizza shop and your partner contributes a pizza oven in exchange for pie, the company should own the oven. If you don’t have a formal entity set up the guy can bail and take his oven with him. That wouldn’t be very good, raw pizzas aren’t very delicious.
Likewise, if the team writes some great software the company should own the code. You don’t want individuals to take copies with them and build competing firms.
It’s better that the company owns all the stuff and all the intellectual property by default. This is a general rule for all companies, not just those with Grunt Funds.
This is where things get interesting. How you and your company get taxed has everything to do with the type of formal entity you set you. Most people reading this book will be deciding between and Limited Liability Company (LLC) or a Corporation (Inc).
LLCs are Better
LLCs are a good choice for GruntFunded companies because they offer more overall flexibility than corporations.
One of the best features of the LLC is that partners in an LLC can divide up the profits anyway they want. Using a Grunt Fund you could simply distribute profits according to each person’s share of the pie (this assumes that each person receiving profits has at least nominal ownership in the company). This can change whenever you want so as the pie changes so does the payout.
Things get a little more complicated if you decide to liquidate the company or transfer ownership to a buyer or investor. While the founders were sharing profits, each was earning “credit” in his or her capital account which will ultimately determine how the proceeds are distributed. You should be okay as long as you were following the rules. Each person’s capital account should reflect their share of the pie. Talk to your lawyer about what all these things mean – I’m not entirely sure myself.
Corporations are Trickier, But Not Impossible
A corporation is a good choice if you expect that your startup will require significant investment in the short term. Stock in a corporation is more structured and VCs and sophisticated Angel investors often prefer this structure.
Keep in mind that it is fairly easy to convert an LLC to a corporation, but it’s hard to convert a corporation to an LLC. So, starting with an LLC is a good idea.
The problem with corporations (S-corps or C-corps) is that the IRS assumes the “normal” method of dividing up the pie before it’s baked because that’s how it usually happens. If Grunts receive equity after it’s baked (based on their percentage of the pie) the IRS might argue that the stock was essentially compensation that can be taxed as regular income.
To avoid this problem the equity needs to be granted early in the process when the value is clearly zero. This, unfortunately, creates a fixed split.
To solve the problem you will want to issue restricted stock to Grunts that is subject to vesting and buyback provisions that mirror the concepts in this book. Each Grunt will need to file an 83(b) election with the IRS which helps ensure there will be no tax when the stock eventually vests (ask your lawyer about this).
Example:
Clint and Chuck go into business together selling Abraham Lincoln action figures. They form a C-corporation and each take 1,000 shares of restricted stock subject to Grunt Fund-style vesting and buyback provisions. Both of them file 83(b) elections with the IRS.
After the first month, Clint has earned 80% of the pie and Chuck has 20%. Eight of Clint’s shares vest and two of Chuck’s vest, so they now own 80% and 20% respectively.
The following month they hire Parker. They issue 1,000 shares of restricted stock to him subject to the same terms. Parker files an 83(b) election as well.
At the end of the next month, Clint has 70% of the pie, Chuck has 20% and Parker has 10%. The shares vest to bring their vested shares in alignment with the pie: 12 more of Clint’s shares vest, four more of Chuck’s shares vest and three of Parker’s vest. So, at the end of the second month Clint has 20 vested shares, Chuck has six vested shares and Parker has three. Their vested shares equals the pie.
It doesn’t matter how many shares each person has, it only matters what percent they have vested. Each period you simply vest whatever is necessary to bring everyone in line.
The next month Chuck decides that he no longer wants to be involved. He is leaving without good reason. His shares are subject to a buyback provision that reflects the spirit of the Grunt Fund. His shares are taken back by the company and the remaining founders (Clint and Parker) are the only outstanding shareholders.
The remaining shares reflect the percent ownership for each participant. Both Grunts have a larger share, but they have been left in the lurch by the departing Grunt so they will have to scramble to rebuild their company.
A Grunt Fund-style vesting schedule is considerably more complicated than a traditional vesting schedule. In a traditional program a certain number of shares vests after certain periods of time or certain events. In the GruntFund-style program the contract will have to reflect the terms of the Grunt Fund. It is not an insurmountable legal problem. If your lawyer tries to talk you out of using a Grunt Fund you are dealing with someone who does not fully appreciate the concept. Find someone who does.
I can help connect you with a Grunt Fund-friendly lawyer. I keep tabs on lawyers who have embraced the Grunt Fund concept. Some of them have even started developing some boiler-plate Grunt Fund contracts that I’ll post to my site.
A special thanks to Clint Costa, Esq. who provided the inspiration for this chapter.
Pie A La Mode
Grunt Fund-Friendly Lawyers
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Chapter Eleven:
Making Grunt Funds Work
The essential ingredient in a good pie is fairness. People deserve to be treated fairly no matter what. Greed, which is the desire to have more than you deserve, is the enemy of fairness. Gordon Gekko’s famous line “greed is good,” does not work well in a startup environment.
My parents taught me that life isn’t fair, and that’s true. This book isn’t going to change that. Notice, however, that when you get the short end of the stick you often feel resentment toward those who put you in that situation.
You don’t want those people to be your teammates in your startup company. Those kinds of relationships are difficult to repair.
In order for a startup to succeed you need to create a high level of trust. Leaders need to earn trust and maintain it. Otherwise the company will decay and any success will be dumb luck.
To make the Grunt Fund work you will first need to share the rules with everyone and agree to follow them. That’s where this book can come in handy.
If you disagree with my rules as outlined here that’s fine. Make up your own rules. As long as they are fair and everyone agrees to them in advance you have the foundation of a Grunt Fund.
Perhaps you think that cash shouldn’t get four times its value in pie. No problem. Change it. Just make sure you don’t change the rules in the middle of the game. The rules in this book are based on my own experience. Yours may be different.
Ultimately a Grunt Fund is about you and your fellow Grunts. Create rules that you are comfortable with that will allow you to move forward with a common understanding. A Grunt Fund is kind of its own philosophy. Sometimes you have to think issues through and have discussions about what you feel is right and wrong. Have the discussions and do your thinking before problems arise.
The real danger is not having rules at all or not settling on them in advance. Startups are fast-changing environments, but not everything should change on the fly. If you must change a rule, be sure to get every Grunts input. Do not take changes lightly; bad changes can poison a good herd of Grunts.
How I Can Help
I’m on a mission to make sure that all entrepreneurs get what they deserve from their hard work. My job won’t be done until every startup uses a dynamic equity split program like a Grunt Fund.
When you have questions or concerns about your own Grunt Fund I would be happy to help you figure out what the right “Slicing Pie” decision should be. Just let me know when you run into snags.
If you are part of an incubator, accelerator or other entrepreneurial organization I would be happy to do seminars or webinars for your members. I’m happy to do anything I can do to help startups and spread the word.
How You Can Help
There are lots of entrepreneurs, just like you, who are struggling with how to properly reward their team. If you like this book please rev
iew it on Amazon, email it, tweet it, blog it, or otherwise share it with people in your network. They, and I, will appreciate it!
Also, I occasionally update this book based on feedback from readers. If you have ideas for improving the content in this book please let me know. The legal and retrofit chapters, for example, were written as a direct response to reader comments. I’ve also created “A La Mode” content to help readers with specific problems.
When you use a Grunt Fund you are being fair to your team and to yourself. Remember, fairness is fun! So have fun, I wish you nothing but success beyond your wildest dreams.
Most sincerely,
Mike Moyer
[email protected]
July, 2013
Version 2.3
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Part II:
Grunt Funds in Action