JP Mangalindan
Why startup founders are swapping equity with other founders

Cash strapped and leaning on their entrepreneurial friends for advice and support, equity swaps are a supportive way to bet on mutual success

Photo: Ana Maria Serrano/Getty Images

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When Jack Abraham was 19-years-old, he and Wharton School classmates Nat Turner and Zach Weinberg rented out a residential loft space they turned into an office in Northern Liberties, a gritty industrial neighborhood in Philadelphia perched on the edge of the Delaware River. In the midst of gentrification, the area then was still dominated by ramshackle tenements with shattered windows and manufacturing plants with signs missing all the letters to spell out the company’s name. Late in the evening, it wasn’t unusual to hear gunfire — moments that terrified Abraham, a student who hailed from the cozy town of McLean, Virginia, and arrived at Wharton with ambitions of becoming another great tech entrepreneur.

Despite the shifty neighborhood, Abraham, Turner and Weinberg made the best of it, living and working in their makeshift office: a stark space with concrete floors, no air-conditioning, and no internet access. (The solution: running an ethernet cable across the street to a nearby church.) Abraham’s most promising idea was a shopping engine that searched local store shelves on-the-fly to find the best prices and availability for different kinds of products; Turner and Weinberg bet on Invite Media, a platform that helped ad-buyers more easily bid on display ad space and make their display ad campaigns more efficient.

The trio wanted to support one another in their ventures but were cash-strapped. In Milo’s earliest days, for instance, when Abraham worked six or seven days a week, he slept on a narrow airbed and owned 100 black t-shirts from Walmart, largely because the entrepreneur hated doing laundry.

“I didn’t have any money at all,” recalls Abraham, who paid himself an annual salary of $34,000 initially and lived on packets of ramen noodles.

So Abraham, Turner and Weinberg tried a different tack. Why not each give one another up to 5% in equity from their startups in exchange for services rendered, such as advice and guidance? In 2007, Turner and Weinberg granted Abraham 5% in equity in Invite Media, while Abraham gave Turner and Weinberg 2.5% equity in Milo.

“It was a great way to align interests and to root for each other,” explains Abraham. “There was certainly a little bit of a diversification element, which is always attractive. But we believed in each other, and it seemed like a smart thing to do.”

The financial payoff came several years later. In 2010, nearly three years after Abraham, Turner and Weinberg swapped equity in one another’s fledgling startups, DoubleClick, a subsidiary of Google, purchased Invite Media for $81 million. Six month later, eBay purchased Milo for $75 million.

Abraham won’t disclose exactly how much that particular stock swap earned him in 2010, other than to say that there was a mere $100,000 difference between his windfall from Invite Media’s acquisition and Turner and Weinberg’s cut from Milo’s purchase. However, in a now-deleted Quora post from last September, the 33-year-old entrepreneur and startup investor pointed out he was well on his way to becoming a billionaire by his mid-to-late 30s — Abraham is 33 — driven in part by Abraham’s first stock swap in 2007 and his subsequent investments in companies such as Pinterest, Flatiron Health, Postmates and Uber.

In the fast-paced, unpredictable world of startups, where fledgling ventures crash and burn by the hundreds, if not thousands, every year, what Abraham, Turner and Weinberg did as struggling founders isn’t standard practice, but it is commonplace enough that Silicon Valley attorneys regularly field requests from founders looking for ways to share paper riches with their founder friends in exchange for support. Finding a legal route for “founder equity swaps,” as they’re called, is tricky, but the younger the startup, the easier stock swaps can be made.

“You get a lot of founders who are just kind of friends, who would like to have some exposure to other friends’ companies,” explains Raymond Thornson, managing director at the international tax firm Andersen, which has a large San Francisco office. “In some ways, they view it as a sort of diversification of their holdings. If they’re able to swap out, they’re able to diversify their holdings, but they think, you know, maybe their friends’ company has some upside to it. Now, finding a method that’s agreeable to everyone, well, that’s the challenge and doing something that’s relatively straightforward? That’s also a challenge.”

Over his 20-plus decades of experience in tax practice, Thornson says that a number of startup founders have come to him seeking advice for a legal way to transfer equity to other startup founders.

The younger the startup, the easier it is to swap equity, simply because there are less employees at the company and less people to answer to should a founder suddenly decide over several cocktails at Charmaine’s — a swanky rooftop bar in San Francisco Civic Center neighborhood — that an equity swap with their buddy would be mutually beneficial.

When companies are just getting started, it’s easier to give stock, simply because of the low dollar amount of the stock on paper. Because of that initial low dollar amount, founders don’t end up having to pay taxes, essentially. Yes, the other founder is receiving something, and the government could characterize that as income. But in the case of Abraham, Turner’s and Weinberg’s swap, the three wrote one another a check for $5 — a pittance by frothy Silicon Valley standards. The tax is negligible.

There’s also another option. Each founder can issue the other founder an option to buy their shares at the current price of the stock. The reason why options are used to heavily in Silicon Valley is that when you grant them to employees, they don’t technically have any value on paper. If you exercise them, because they’re simply priced at the value today, which is why almost every company in Silicon Valley when they’re doing stock-based compensation gives option grants to employees. Technically, the option doesn’t have economic value, and consequently, there’s no tax in that transfer. So when both founders basically give each each other options to buy their shares, then you could do this stock swap. For like the majority of founders who may be thinking about this, giving options may be idea, because if you transfer options around and their exercise price is fair market value, then technically, you’re not transferring value around. Therefore, they don’t have to pay taxes.

Such was the case with Aaron Swartz, a serial entrepreneur who in 2010, swapped shares with his friend, entrepreneur Bhavin Parikh. Swartz at the time was in the early stages of growing his startup, Modify Watches, a company that specialized in making and selling customizable timepieces.

Parikh’s startup education startup Magoosh, was also in its infancy. For over a year, Swartz and Parikh traded bits and bobs of advice over coffees, beers and phone calls. Swartz offered Parikh guidance on how to establish cultural elements like company values and how to approach hiring employees across different teams across the country. Likewise, Parikh advised Swartz on challenges, such as content marketing and search engine optimization. After more than a year of back-and-forth discussions, Swartz and Parikh gave each other .25% shares in one another’s companies — shares awarded from their own personal pool of company shares.

“Parikh was the number one person I was talking to about strategy, how we should raise [ capital], and what’s the right way to negotiate or negotiate that,” explains Swartz of the move.

In Swartz and Parikh’s situation, the exchange was fairly simple. The two single founders swapped equity in Modify Watches and Magoosh, respectively, from their own personal pool of equity as founders. (The situation becomes much more complicated and ethically problematic, if startup founders gift equity to other founders from another, separate pool of their company’s equity, meant for incoming employees.) Swartz and Parikh’s equity began vesting after two years and then thereafter on a monthly basis.

The third option founder equity swap option is the most difficult. While founders are technically able to trade equity once a startup is publicly traded, it’s a much more complicated and convoluted affair that involves establishing an exchange fund, in which a person’s stock is allowed to diversify into a basket of stock, and because publicly-traded shares are put into what is effectively structured as a partnership, that stock isn’t taxable.

After Facebook went public in May 2000, for instance, several exchange funds popped up to allow Facebook shareholders who wanted to diversify but not pay taxes, contribute their shares. But the overall complex structure around an exchange fund has put off at least several founders who have approached Anderson about the possibility over the years.

“I think founders, you know, get together with their buddies, and they talk to each other, and they’re like, ‘Oh, yeah, that’d be a cool thing,” says Anderson. “But then when it actually kind of comes down to doing it, they’re put off by the potential legal challenges. They realize jumping through those hoops makes for a really complicated process, and it’s not really worth it to do that.”

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