Dead equity can seriously impact your start-up’s future growth and investment prospects.
- Investors may hesitate or lower valuations if dead equity takes up a large portion of a cap table.
- Active team members will feel frustrated and demotivated if an inactive shareholder holds a significant stake.
- Dead equity reduces the ownership pool available to incentivise key contributors.
To keep your business on track, we’ll explain what dead equity is, why it’s a problem, and how to manage it effectively from the start.
What is dead equity?
Dead equity occurs when a founder or team member keeps equity in the company despite no longer contributing to its growth. This often happens when a co-founder leaves or a team member’s role ends before fulfilling their expected contribution.
Early-stage companies usually divide shares among a small group of founders and key employees. At this stage, each stake represents a significant percentage of ownership. However, many start-ups fail to plan for what happens if one of these individuals leaves.
Some founders ignore the dead equity issue, assuming they can address it later. No one likes to think they could be the one to leave (or be forced out) and lose their shares.
If shareholder agreements don’t cover these situations, there’s no automatic process to reclaim shares from a departing shareholder. As a result, they keep their full stake, even if they no longer contribute to the business.
Why dead equity is a problem
Dead equity creates major challenges for growing start-ups.
Fundraising becomes difficult
Investors don’t just look at how equity is distributed—they care who holds it. If inactive shareholders own a large portion, it raises red flags:
- Lower valuations: Investors reduce valuations when a company’s cap table includes dead equity, affecting their post-investment stake.
- Less flexibility in funding rounds: Dead equity makes it harder to negotiate future investments.
- Limited equity for investors and new hires: A cluttered cap table discourages key stakeholders.
- Decision-making uncertainty: Inactive shareholders may retain voting rights and blocking powers.
Investors also worry about how dead equity holders will act when their shares gain real value. A disengaged founder may reappear if a major funding round or exit looms.
Team morale drops
Nothing demotivates a team faster than knowing a non-contributor owns a large stake while they continue to work hard. Founders and employees expect rewards for actual effort—not just for being there at the start.
If a former founder still holds meaningful equity, the remaining team may feel undervalued or frustrated.
Future investments will dilute all shareholders, but active team members won’t appreciate being diluted at the same rate as someone who no longer contributes.
Less equity for growth & talent
While cash is tight, start-ups rely on equity to incentivise team members and attract new talent. Dead equity limits this by reducing available shares for:
- New hires who actively grow the company.
- Advisors or board members who offer strategic value.
- Performance-based incentives to retain top talent.
A well-structured option pool can help, but founders must plan carefully. Investors may demand further dilution to increase the option pool, affecting active shareholders.
How to manage dead equity
You can avoid dead equity problems by taking proactive steps early.
Apply founder vesting
When setting up shareholder agreements, include a vesting schedule for all founders and contributors. In UK companies, this is typically outlined in the Shareholders’ Agreement and Articles of Association.
Founder vesting is a legal concept that describes how founders of a company earn ownership of their shares over time
Vesting ensures founders earn their shares over time. A common structure involves vesting over 3-5 years, often with a 12-month cliff.
Vesting ensures founders earn their shares over time. A common structure involves vesting over 3-5 years, often with a 12-month cliff.: Shares vest gradually (e.g., 1/48th per month over 48 months). A cliff delays vesting—if a founder leaves before 12 months, they get nothing.
Introduce Reverse Vesting
After raising a Series A round, consider reverse vesting. This process reclassifies some already-vested shares as unvested, requiring them to re-vest over time.
If vesting wasn’t included earlier, new investors may demand it as a funding condition.
Use buyback provisions
Start-ups should include buyback clauses in shareholder agreements. These clauses allow the company to repurchase shares from departing founders, keeping equity with active contributors.
If the company can’t legally repurchase shares, an alternative is to convert unvested shares into non-voting deferred shares with no economic rights.
Implement Good & Bad Leaver clauses
Vesting mechanisms often treat leavers differently based on the circumstances.
- Bad leaver: If a founder leaves for misconduct or without fulfilling their obligations, they may lose all unvested shares and forfeit some vested ones. The company can repurchase vested shares at nil value or convert them into deferred shares.
- Good leaver: If a founder exits for a valid reason, their vested shares may be repurchased at fair market value. Any shares not bought back remain theirs.
- Founders must align leaver provisions with decision-making rules in the Shareholders’ Agreement and Articles of Association. If investors lack direct control, they need a way to trigger leaver clauses to avoid dead equity issues.
In summary
Dead equity might seem like a problem for the future, but failing to address it early hurts a start-up’s growth, funding potential, and team motivation. As founders;
- You can prevent dead equity by using vesting schedules, buyback provisions, and clear legal safeguards.
- Remember, Investors prefer cap tables where equity remains with active contributors.
- Your team members deserve fair equity allocation—dead equity causes frustration if left unchecked.
By taking these steps, you can protect your start-up’s future and maintain a strong, motivated team.
