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Due Diligence Comes Before Joining a Startup

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This week a friend of mine was offered a chance to work for an exciting startup in the consumer packaged goods industry (think food and beverages).  He wanted to know what he should ask before accepting the offer, which was a below-market salary in exchange for equity ownership in the company.  Oftentimes this equity ownership comes in the form of stock options.  I’ll write about that later.  In this case, he was being asked to join a Limited Liability Company (LLC).

So here’s some of the advice I shared with him:

  • As an LLC, there is no stock, there are only units.  Properly structured LLC’s have an operating agreement explaining how the units behave, so you might ask to see that.
  • LLC’s may be have classes of units, and their distribution may be arbitrary (i.e., unfair) so you need to read the operating agreement to learn whether or how you can be diluted or underprivileged.
  • Having experienced a motivation misalignment before, I would try to find out whether the folks running the company are motivated more by wealth or more by control.  I’m wealth-motivated, so whatever produces the greatest long-term value is what I want to do.  In the past I’ve worked for control motivated folks, and we often disagreed about what to do.
  • Business owners acting in their own best interest should only use ownership as a form of currency when the ownership is being over-valued by the employee or deal partner.  Options and units can be great examples of this.  Give out an “eye-popping” amount to employees (“Oh, that sounds like a lot!”) and hope they don’t realize what it’s actually worth.  Be wary.  Specifically, for an LLC you want to see that operating agreement to know how many units there are, how many you’ll get, and how new units will be created.
  • I’d ask to see financial statements.  If the company is a going-concern with a history of profitability, your units are absolutely taxable, and the valuation could be performed by an expert or by me or someone else.  Regardless of who values the company, the IRS always retains the right to disagree.
  • If they are a going-concern with a history of profitability, or else if the founders have done this successfully before, I’d be highly inclined to find a way to take the ownership.  You can live very comfortably on a corporate salary, but you can be “set for life” if you hit it big with a young company that you purchased with your labor when it was worth very little.
  • If they’re a loosey-goosey operation, they may flinch at showing you their underwear drawer:  they may not have an operating agreement or financials.  If that’s the case, I’d be highly inclined to take all or most of the compensation in cash at market rates, rather than equity.  Remember that most startups fail, and if it’s not your baby, you need to make a living from it.

So that’s some food for thought beyond the global picture, which is “what is the business, does it make sense to me, etc.”  Keep an eye out for your own interests, and you’ll make a good decision.

For further reading, I suggest

  • Noam Wasserman’s “The Founder’s Dilemmas”

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