By: Noam Wasserman for Inc.com

Dead equity — equity held by employees and founders no longer working at the company — is a large and growing problem.

Facebook’s IPO minted many millionaires and even billionaires.  One who attracted much attention is David Choe, the graffiti artist hired to paint the company’s first headquarters.  Choe opted to forgo a cash payment “in the thousands” for the equity equivalent at the time. Thanks to that one decision, he owns nearly four million shares of stock, worth in excess of $100 million. Choe’s equity is a headline-grabbing example of “dead equity”: equity owned by people who are no longer actively working for the startup.

Every share of dead equity could have been redeployed as incentive for a current or future contributor to grow the value of the startup.  Instead, the dead equity languishes on the cap table, weighing down the startup and making it harder to attract and motivate the people who could impact its growth.

Facebook’s situation is far from unique, even among recent tech IPOs. Mark Pincus of social gaming company Zynga recently confronted a similar problem when he tried to reclaim equity that he felt he had over-allocated to some early hires.

Imagine how much tougher a dead-equity dilemma becomes when co-founders, who tend to hold large equity stakes, are involved. Facebook co-founder Eduardo Saverin was able to hold onto a significant chunk of equity after his forced exit from the company; that equity is now worth billions. Other prominent examples of drop-out co-founders who held significant amounts of dead equity include those at car-sharing company Zipcar and at tech startup govWorks.com (made famous in the movie “Startup.com”).

A Significant – and Growing – Problem

Dead equity has always been a significant issue for startups. Founders and hires have always quit, after all, and their companies don’t always have a way to reclaim their equity. However, our CompStudy data show that the problem has been growing in recent years.

We analyzed the dead-equity data from a total of 733 tech startups: 257 from our 2008 survey and 476 from the 2011 survey.  We took the percentage of equity held by former employees and founders and multiplied it by the startup’s valuation during its most-recent round of financing.  The graph below compares the value of dead equity in 2008 and 2011.

On average, the value of dead equity in these technology startups tripled between 2008 and 2011, from $480,000 to more than $1.5 million.  As shown above, the dead-equity problem increased across the full spectrum of company sizes, but is now a significant problem even for the youngest of startups, which saw the biggest increase in dead equity.

About three-quarters of this change in the value of dead equity is due to an increase in the percentage of dead equity; the rest is due to changes in company valuations.

Anticipating and Avoiding the Dead-Equity Pitfalls

Startups that anticipate dead-equity problems can structure their early equity allocations to increase the chances of protecting themselves.  Within the founding team, the majority of startups split the equity without taking into consideration the unexpected bumps in the road ahead. They fail to include vesting terms (i.e., the progressive earning of equity stakes by remaining involved in the startup or by achieving predetermined milestones), buyback provisions, or other dynamic elements that would help them reclaim the equity stakes of drop-out founders.  (For more about this, see Eric Ries’ blog post and excerpt from The Founder’s Dilemmas.) 

It is more common that startups include vesting terms for their non-founding hires.  However, those vesting periods often underestimate the time horizon over which key hires should be adding value to the startup.  Startups overwhelmingly use “4 years of vesting” as a rule of thumb; as shown in Figure 8.8 of The Founder’s Dilemmas, 77% of non-founding senior executives have 4 years of vesting.  This is true regardless of whether they were hired during downturns in the business cycle (when it will take longer to lead the startup to an exit), the startup’s industry segment, its stage of development, and many other factors.

Vesting can serve both as handcuffs that encourage important contributors to remain at the startup, and as a way to preserve equity when those contributors leave. However, blindly applying the four-year rule, when a longer horizon is needed, weakens both the handcuffs and the ability to recover and redeploy equity. When a fully-vested person leaves prematurely, the startup will have added dead equity to its cap table instead of being able to dedicate the equity to a value-creating employee.

Startups need to evaluate their specific situations and craft appropriate vesting periods by asking (among other things):

• How long will it be until we will realistically exit? How does our timeframe change as market conditions change?
• Over what horizon will each key contributor be needed?
• Given our business challenges, what are the best approaches for minimizing dead-equity problems?  For instance, are there specific business milestones we can tie to vesting?

Founders, board members, and senior executives should try to anticipate these dead-equity problems and avoid the often-costly pitfalls caused by them. Ignore this growing problem at your peril.

Original post can be found here.