For some entrepreneurs, selling equity in your business can feel a bit like selling part of your soul. Other cash-strapped business owners eager to grow will take funding at almost any cost.
Very simply put, equity deals involve giving away a percentage ownership of your business in return for funding, resources or skills. How these deals are structured can take a variety of different forms, but the basic principle is the same: equity is given away in order to gain the things that will help take the business forward to the next growth level. Because most entrepreneurial businesses are almost perpetually cash-strapped, they either can’t afford to buy in the skills and resources needed, or they can’t access the funding required to grow. In many instances, the only thing they possess is the equity in the business and this is used as a means of exchange for what they need but cannot access through other means.
It’s a common misconception that equity deals only involve business funding. While funding is what most entrepreneurs lack, resources and skills are equally common reasons for giving away a share of the business. For example, this might involve taking on a partner who brings to the table certain skills that the owner does not possess but which are needed to take the business forward. Alternatively, one might give away equity in return for resources such as equipment or contacts. Someone who can open doors to the right deals can be of immense value to a business and many entrepreneurs choose to give away equity to a person who brings such benefits to the table.
Equity changes through the business life-cycle
Pavlo Phitides, CEO of business incubation company, Aurik, explains that there are two key funding options: debt funding and equity funding. “You need assets to secure debt funding and you need to be able to pay back the loan as well as the interest on a monthly basis. Equity funding on the other hand means you don’t need to dedicate a certain amount of money every month – at a time when money is most needed in the business – to service interest and repayments”. Of course, many entrepreneurial businesses simply can’t access debt funding, so equity funding is the only option available to them, unless they are able to raise capital on their own.
Before you sell equity…
“Giving away equity is akin to giving away your future wealth. Entrepreneurs often don’t realise this. They are so desperate for the money now, that they don’t properly explore all alternative options,” says Phitides. Before you rush into an equity deal, you need to make sure you’ve asked yourself some important questions, he says.
Most important of all is to determine whether the skills, resources or funding you think you need is really critical to the future of the business. Many successful businesses manage without funding, particularly in the early stages – ask yourself if it’s not possible for you to do the same.
If you’re looking for a certain skills set but can’t afford to pay a salary for the right person, it might be worth exploring the possibility of paying a once-off fee to get what you need. In other words, you might choose to bite the bullet and pay a marketer to put together a marketing plan for you, rather than taking on a partner with marketing expertise and giving them equity in return. Serial entrepreneur and investor, Vinny Lingham says, “I generally don’t recommend giving away equity for once-off transactions. If someone does a referral for you but there is no long-term relationship, equity shouldn’t be given away – rather pay cash if possible, or give a payable note for a future date with interest.”
How selling equity will change your business
Make no mistake, an equity deal has immediate and long-term consequences. “Once the deal is done, your business is seldom the same,” says entrepreneur Howard Blake, chairman of Blake & Associates. “Entrepreneurs thrive on their independence and own leadership style in achieving their objectives. They find it challenging and stifling being confronted by the endless compliance and governance requirements of outside shareholders. Innocence lost is never regained, in a sense,” he adds.
Bear in mind that investors will want to see structures and systems put in place, and will expect regular detailed reports on the business’s activities. If you don’t have the stomach for this – and many entrepreneurs don’t – then you don’t have the stomach for such an equity deal. Phitides adds an interesting point. “Often, the reason that entrepreneurs aren’t meeting their goals is because they can’t work within the parameters of the investors. Frustrated or stifled, they lose enthusiasm and passion and deliver a lack-lustre performance where once they excelled.”
Whether you exchange equity for an active partner in the business, or a ‘silent’ shareholder, the fact remains that you give away a degree of autonomy when you give away equity. You will, to some extent, be answerable to others for the decisions you make. “Your funder will want things rolled out and achieved as forecast in the business plan you presented and as agreed when you struck the deal. But I have never seen a business achieve its forecasted plan – ever – and this can leave entrepreneurs in an impossible position,” says Phitides. Depending on the deal, investors may become punitive. “The deal may allow them to increase their equity share because you have failed to deliver what was required and agreed, so you find yourself incrementally losing more and more ownership” he explains.
“One of the worst and most damaging mistakes is that they don’t formalise the agreement, setting out clearly the expectations, deliverables and consequences. Phitides says that most entrepreneurs don’t formalise their contracts because they lack money for a lawyer. “Things are agreed verbally but are hardly ever written down, and it leads to endless problems and conflict,” he says.
Another common mistake is for entrepreneurs to take on partners for the wrong reasons. Just because you like and trust someone doesn’t make them an ideal business partner. “When you’re starting out I suggest you find one partner to start the business with. One of you should have technical or product skills and the other should be business or marketing focused, for example,” says Lingham. It’s comforting to go into business with a partner who is similar to you, but what’s actually needed is someone who has complementary, but different, strengths and skills. “If you both enjoy sales and marketing, the operational and financial side of the business will get neglected,” says Phitides.
“Being too generous or too greedy is another pitfall,” says Lingham. While you might believe that your business will be valued at R1 billion in five years’ time, remember that this is only a projection. Any investor who does an equity deal is taking a risk, so bear this in mind when you find yourself becoming greedy. On the other hand, don’t undervalue your business to the extent that you give away so much and find yourself five years down the line owning only 6% of something really valuable that you’ve put your heart and soul into building.
How to value the business
One of the most difficult aspects of doing an equity deal is how to value the business, not only on paper but in your own mind. After all, you need to have a sense of what the business is worth to know what your top and bottom end will be for any equity deal. Lingham discusses how to weigh the decision: “If you bring on a partner or investor, you need to determine if the equity you are giving them will deliver a greater return on your existing equity than not having them will do.
Let’s assume you have a business that is worth R1 million and that you own 100%. You give 50% to an investor who puts R1 million into the business. So you now have 50% of the business, but it’s now worth R2 million. In theory this puts you back in the same position, of ‘owning’ a share worth R1 million. But, if you are able to use the cash to double the value of the business to R4 million then your 50% is worth R2 million and you’re ahead. The question to always ask yourself is, ’By taking on this partner, can I grow the business so that my new percentage of the grown business will be worth more than I have now?’”
What makes for a good equity partner?
Phitides provides insight into what to look for in an equity partner:
- An ongoing contribution in one or, ideally, all of the following: business funding, skills, resources and relationships.
- Someone who buys into and supports your vision. While you will be answerable to them to some extent, their involvement shouldn’t quell or interfere with your passion. It is this, after all, that drives the entrepreneur’s tenacity and allows them to stick with it when the going gets tough.
- Patience. Nothing ever goes according to plan and it may well take longer than expected for an investor to see returns from an entrepreneurial enterprise.
What You Should Include In The Partnership Agreement
How to create a formal written partnership agreement.
When taking on a business partner, it is critical to have a formal, written partnership agreement. While this is not a legal requirement, it does provide a framework for the partnership in terms of everyone’s obligations, settling conflicts, disagreements and other issues that could occur. The agreement is needed for the wellbeing of the business.
Create your written partnership agreement with the assumption that anything that can go wrong with your partnership will. Friction between partners over things such as money, power or ego frequently undoes business relationships.
Your partnership agreement should prepare you for all possible “what-if” situations, and set methods for resolving them.
You can save money by drafting your own version of the key parts of your agreement, then taking it to your firm’s attorney to be reviewed, clarified, modified and finalised. It is important to have an attorney review the contract.
These are some of the key areas you should include in your written partnership agreement:
1Partnership Agreement Basics
- What is the name of the partnership?
- What is the purpose of the partnership?
- What is the duration of the partnership?
2Responsibilities, performance and remuneration
- What is each partner’s role?
- What are each partner’s responsibilities within the company, and what level of performance is expected?
- Are partners expected to make a full-time commitment to the venture, or are business activities permitted?
- What will be the income of each partner, and how will profits or losses be distributed?
- What will each partner be contributing to the partnership in terms of cash, assets, loans, investments, and/or labor?
- If a partner loans the company money, what will be the terms or repayment?
- Will the business partners be expected to make additional contributions to the partnership, and if so, how will that be handled?
- Withdrawal of partners/admission of new partners
- What guidelines should be followed if one partner wants to leave the partnership?
- Will partners be allowed to sell their interests in the business to outsiders?
- On what grounds can a partner be expelled from the partnership (misconduct, non-performance of duties)?
- How will new partners be admitted to the partnership?
- What guidelines should be followed if one partner wants to retire or leave the business partnership?
- What happens if a partner is incapacitated or dies?
- Will the partnership take out “key man” life insurance to ensure the surviving partner is able to buy the deceased partner’s shares from his/her heirs?
- Will partners who leave have to sign a non-compete agreement?
- What methods will be used to settle disputes that can’t be otherwise resolved?
- What procedures should be used in the event of a tie vote between partners on crucial partnership decisions?
- Will you use mediation or binding arbitration?
- If disputes can’t be resolved, is there a mechanism in place for dissolving the business partnership?
- What banking arrangements will be made for the partnership?
- Which partners will have check signing privileges?
- Who will be authorised to draw on the partnership’s accounts?
- How will the books be kept?
7Method for dissolving the partnership
- When can the partnership be dissolved?
- What happens to the partnership if the partners decide they can’t work together?
- What methods will be used to determine the value of the business in the event of a sale, dissolution, death, disability or withdrawal of a partner?
- FreeLegalDocs: www.freelegaldocs.co.za
- LegalWise: http://www.legalwise.co.za/index.php/downloads/free-contracts.html
Do You Speak Start-up?
The start-up dictionary for every budding entrepreneur.
Venture capital in South Africa is starting to take hold. With a host of venture funds, section 12J companies, incubators and start-up clubs being launched, start-ups are becoming more popular and investors are encouraged to consider these new opportunities.
Chris Ball, an investment analyst at AlphaWealth and a co-founder of Fincheck.co.za, a financial comparison fintech start-up, explains the colloquial jargon of venture investors and start-up entrepreneurs.
Chris wrote this ‘dictionary’ initially to educate AlphaWealth’s high net worth clients about the start up world so that they could consider becoming investors.
An angel investor is generally someone who provides seed capital to a start-up in its infancy. In South Africa, there are a few well known angel investors. However, most entrepreneur’s first funds are generally received from family and friends who believe in the idea.
B2B, B2C, P2P
Business to business – This describes a business that is targeting another business with its product or services. This type of service is also known as enterprise technology. Salesforce would be a great example of this technology.
Business to consumer – describes a start-up that sells directly to consumer.
Peer to peer – is a platform concept, where the technology matches buyers and sellers. One of the earlier peer to peer technologies was Ebay. Today, the peer to peer platform has evolved to incorporate finance institutions such as Lendico.
This is a concept where founders pool their own capital resources to get the start up as far as possible before looking for external funding.
The term comes from “pulling oneself up by one’s bootstraps”. This mindset links directly into the lean start up methodology.
Related: 6 Tips For Bootstrapping
Both technology and business models can be disruptive and is defined when a start-up disrupts the current market place by displacing old businesses and winning market share. Outsurance and Uber have disrupted the insurance and personal transport businesses.
This is someone who starts a business or venture, assuming all potential risk and reward for his or herself.
This is the start of a venture where a founding team have enough to illustrate the concept but are yet to execute the initial steps of their plan.
Lean start-up methodology
The lean start-up methodology, is a business thesis that was founded by Eric Reis. The business methodology is based on the practice of testing multiple small iterations in an effort to find the product, design or user experience or even business model that is best adopted by the end consumer.
Read more on the Lean start-up methodology here.
An organisation that helps develop early stage companies. Generally this help is offered in exchange for equity. The Israeli start-up ecosystem has some of the best incubators where they offer workspace, networks and guidance.
‘Go big or go home’ – this is the impossible idea that a team wants to accomplish. The term was originally coined when John F Kennedy challenged American scientists to get a human to the moon.
A company that changes its business direction as a result of a dead end or the ability to use their technology in a more significant way. Instagram was originally a location check in service before pivoting to become a photo sharing application.
Pre-money and post-money
Post-money = Pre-money valuation + new funding.
Valuing a start-up has become a bit of an art, but more and more funds are starting to adopt a common methodology as the industry matures. In essence, the pre-money value is the monetary value of the company before a new investment is made.
Proof of concept
After the idea comes the execution. One of the first hurdles entrepreneurs need to clear is the proof of concept. This is a point where the start-up proves that the business model is feasible.
Software as a service. These businesses are hosted in the cloud and the software can be rented out as a service.
Seed, A Round, B Round…
Start-ups raise capital in several tranches because raising it all at once would dilute the founder’s share before they have even had a chance to build the business. The seed round is done to prove proof of concept. The A round is raised once proof of concept has taken place. There can be several rounds before an exit or IPO is achieved. Some of these companies have grown so large through several rounds of investment that they are termed a unicorn business.
Understanding Your Responsibility As An Employer
Now that you have your own employees, here is what you should know about your new responsibilities.
Hiring employees requires more work from you as the employer than simply placing a job ad, hiring the right person and training them on their role.
You need to be aware of the Labour Law requirements in terms of the various funds and other stipulated registrations. The law does not differentiate between different size organisations, and therefore it is imperative that SME’s fully understand the implications of all aspects of Labour legislation.
Related: 5 Factors That Make a Great Boss
Employers may only deduct money from a worker’s salary if the worker agrees or if they are required to do so. The provisions for deductions do not apply to workers who work less than 24 hours a month.
Employers may not deduct money from a worker’s pay unless –
- the worker agrees in writing to the deduction of a debt, or
- the deduction is made in terms of a collective agreement, law (e.g. UIF contributions), court order or arbitration award.
Deductions for damage or loss caused by the worker may only be made if –
- the employer has followed a fair procedure and given the worker a chance to show why the deduction should not be made,
- the worker agrees in writing, and
- the total deduction is not more than 25% of the worker’s net pay.
Employers must pay deductions and employer contributions to benefit funds (pension, provident, retirement, medical aid, etc.) to the fund within 7 days.
What is UIF
UIF stands for Unemployment Insurance Fund and you need to register for it, whether or not you employ staff. It applies to all employers and workers (except those working less than 24 hours a month), learners, public servants, foreigners working on contract, workers who get a monthly State (old age) pension and workers who only earn commission. The fund makes short-term provision for individuals who become unemployed, or are unable to work because of illness, maternity or adoption leave. It also provides financial relief to the dependants of deceased contributors.
As an employer it is your responsibility to register with UIF and make the monthly payments. These include a 1% payment from you (based on your employees’ individual salaries).
Each individual employee needs to make a further 1% payment, but it is your duty to deduct this amount from their salary and pay it to UIF, together with your contribution, on a monthly basis to SARS if you are registered for PAYE or directly to the UIF if you are not.
You can register your business by completing a UF8 form and each new employee needs to be registered using a UI-19 form. These can be obtained from the Department of Labour.
What is COIDA
COIDA stands for the Compensation for Occupational Injuries and Diseases Act and being registered for it works in your favour. It is based on a no-fault system which means employees are entitled to compensation regardless of who caused the injury or illness.
But it also exempts you from liability for injuries or diseases contracted by your employees in the course of their work. In other words, employees can’t claim damages from you in those events. Instead, COIDA allows them to claim compensation for total or permanent disablement and death as well as reasonable medical expenses arising out of injury for two years.
You are required to pay the employee 75% of their normal salary for three months during the time that they are injured or ill but the fund pays you back this entire amount and covers all the relevant medical expenses.
If you are not registered, however, you are not indemnified. Getting registered involves submitting a WAs2 form, together with a copy of the registration certificate from the Registrar of Companies, or your ID document, if you are a sole proprietor. Every year before 31 March you will need to submit a statement of earnings paid to your employees. You will also be required to pay an assessment tariff, which is fixed according to your class of industry.
If an employee gets injured during the course of their work or falls ill as a result of their work, they can claim from the Worker’s Compensation fund. Dependants of employees can claim if a family member dies from an accident or disease. Employees wishing to claim will need to be furnished with one of the WG30, WAs2 or WAc1(E) forms, which they need to submit to the Compensation Commissioner for compensation.
How Does Maternity Leave Work?
The law protects women against unfair discrimination arising from any form of prejudice. An employer may not ask a candidate who applies for a job if she is pregnant, nor if she is planning to start a family at any stage.
If you do, she could argue that you are discriminating against her. Equally, she is in no way obliged to disclose her pregnancy when applying for a position. The bottom line is that it has nothing to do with the candidate’s ability to meet the requirements of the position. And nothing stops her from resigning once she has returned to work after taking maternity leave. She has rights regardless.
The Basic Conditions of Employment Act stipulates that an employee is entitled to four months unpaid maternity leave. All that is required is a notification by the employee that she is pregnant, accompanied by a doctor’s certificate. This leave should start four weeks before the expected date of birth, or when a doctor or midwife certifies that leave is necessary for the health of the mother or child. An employee must notify her employer in writing of the date on which she wants to start maternity leave. She may not work for six weeks after delivery, unless she is declared fit to do so.
An employee who has a miscarriage during the last three months of pregnancy or who bears a stillborn child is also entitled to six weeks maternity leave, whether or not she has started maternity leave at the time. Companies in South Africa are not obliged by law to provide paid maternity leave. A female employee who works for a company that does not offer maternity benefits can claim from the Maternity Benefit Fund if she has been contributing to the Unemployment Insurance Fund (UIF).
An employer who pays maternity leave does have some rights, however. Paid maternity leave is a benefit, and the company is within its rights to conclude a contract with the employee stating that if she does not return to work for at least one year following her confinement, she will be obliged to return the salary she earned during her maternity leave.
South Africa has no paternity leave provisions in place, but workers who have been employed at a company for longer than four months may take three days’ paid family responsibility leave during each year of employment.
Family Responsibility Leave
Workers may take up to three days of paid leave a year to attend to certain family responsibilities. The provisions for family responsibility leave do not apply to workers who work less than:
- Four months for their employer
- Four days a week for one employer
- 24 hours a month.
Family responsibility leave expires at the end of the annual cycle. Employees may take family responsibility leave:
- when their child is born
- when their child is sick
- in the event of the death of a:
- spouse or life partner
- parent or adoptive parent
- child or adopted child
Employers may require reasonable proof of the birth, illness or death for which a worker requests leave.
Related: What Young People Want From Work
The amount of overtime a worker may work is limited. Workers must get 1,5 times their normal hourly pay or paid time off in exchange for overtime. Alternatively, a worker may agree to receive paid time off or a combination of pay and time off.
The section of the Basic Conditions of Employment Act that regulate working hours does not apply to:
- workers in senior management
- sales staff who travel and regulate their own working hours
- workers who work less than 24 hours in a month
- workers who earn more than R115 572 per year
- workers engaged in emergency work are excluded from certain provisions.
Workers may not work:
- overtime, unless by agreement
- more than 10 hours’ overtime a week (collective agreement may increase this to 15 hours per week for up to two months a year)
- more than 12 hours on any day.
Employee Pay Slips
Each time workers are paid, employers must give them a pay slip containing certain details. Employers must give workers the following information in writing when they are paid:
- Employer’s name and address
- Worker’s name and occupation
- Period for which payment is made
- Total salary or wages
- Any deductions
- The actual amount paid
- If relevant to the calculation of pay:
- Employee’s pay and overtime rates
- Number of ordinary and overtime hours worked
- Number of hours worked on a Sunday or public holiday
The total number of ordinary and overtime hours worked in the period of averaging, if a collective agreement to average working time has been concluded
Workers must get paid time off for public holidays, but if they agree to work, they must be paid double their normal daily wage. The provisions for public holidays do not apply to –
- senior management
- sales staff who travel
- workers who work less than 24 hours a month
Workers must get paid time off for any public holiday that falls on a working day. Working on a public holiday is by agreement only. A public holiday can be exchanged with another day by agreement. A public holiday cannot be counted as annual leave.
Employee Sick Leave
Workers may take the number of days they would normally work in a six-week period for sick leave on full pay in a three-year period. Employers may insist on proof of illness before paying a worker for sick leave. The provisions for sick leave do not apply to:
- workers who work less than 24 hours a month
- workers who receive compensation for an occupational injury or disease
- leave over and above that provided for by the Act.
During the first 6 months of employment, workers are only entitled to one day of paid sick leave for every 26 days worked. An employer may require a medical certificate before paying workers who are absent for more than two consecutive days, or who are often absent (more than twice in an eight-week period).
Staff Working Hours
Basic Conditions of Employment laws set maximum working hours and minimum rest and break periods for workers. The section of the Act that regulate working hours does not apply to:
- workers in senior management
- sales staff who travel and regulate their own working hours
- workers who work less than 24 hours in a month
- workers who earn more than R115 572 per year
- workers engaged in emergency work are excluded from certain provisions.
The maximum ordinary hours per day for someone who works one to five days per week is nine, the maximum amount of hours per week is 45. For those who work more than five day per week should work a maximum of eight hours per day and 45 hours per week. Workers may agree, in writing, to work up to 12 hours a day without getting overtime pay. However, these workers may not work more than:
- 45 ordinary hours a week
- 10 hours’ overtime a week
- five days a week
Workers must have a meal break of 60 minutes after five hours’ work. A written agreement may:
- reduce meal intervals to 30 minutes
- eliminate meal intervals for workers who work less than 6 hours a day
Workers must have a rest period of 12 hours each day; and 36 consecutive hours each week (must include Sunday, unless otherwise agreed).
Workers working between 18h00 and 06h00 must:
- get an allowance, or
- work reduced hours, and
- have transport available to them.
Skills Development Levies
Employers must pay 1% of their workers’ pay to the skills development levy. The money goes to Sector Education and Training Authorities (SETAs) and the Skills Development Fund to pay for training. The Skills Development Levies Act applies to all employers except–
- the public service;
- religious or charity organisations;
- public entities that get more than 80% of their money from Parliament; and
- whose total pay to all its workers is less than R 250 000 per year; and
- who do not have to register according to the Income Tax Act
Employers who are required to pay the skills development levy must register with the South African Revenue Services (SARS). Employers must pay 1% of all their workers’ pay to the skills development levy every month. Employers must pay the levy to the South African Revenue Services (SARS) by the seventh day of each month. Employers who do not pay will have to pay interest on the money they owe and may also have to pay a penalty.
What is PAYE
All employers are required to deduct Employees’ Tax from their salaries. The amounts deducted must be paid by the employer to SARS on a monthly basis. The process of deducting or withholding tax from remuneration as it is earned by an employee is referred to as Pay-As-You-Earn (PAYE).
Employers are required to:
- Deduct the correct amount of tax from employees’ remuneration.
- Pay this amount to SARS monthly, ensuring SARS receives a Monthly Employer Declaration (EMP201).
- Reconcile these deductions and payments with the completion of the interim and annual Employer Reconciliation Declarations. During the reconciliation periods, employers are required to submit an Employer Reconciliation Declaration (EMP501) confirming or correcting the PAYE, SDL and UIF declarations per EMP201s submitted, the payments made and the tax values of the Employee Tax Certificates [IRP5/IT3(a)].
- Issue tax certificates to employees
- An employer must issue an employee with an IRP5/IT3(a) where remuneration is paid or has become payable and from which Employees’ Tax was deducted. The IRP5/IT3(a) discloses the total employment remuneration earned for the year of assessment and the total deductions. IRP5/IT3(a) certificates must be issued to employees during the annual Employers tax season.
Seek professional advice
There is a lot to keep track of once you become and employer. It is advisable to call in an expert. You can use the services of a suitable experienced and qualified HR consultant who can help to set up the principles and processes of the above, and then work on an ad hoc basis only as and when needed reducing the cost of a full-time HR manager.
- The Department of Labour: www.labour.gov.za
- SARS: www.sars.gov.za
- uFiling: www.ufiling.co.za
- Commission for Conciliation, Mediation and Arbitration (CCMA): www.ccma.org.za
- The South African Labour Guide: www.labourguide.co.za
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