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Taking equity in a company can be a great way to grow your investment portfolio, though it is also risky and if you take equity in lieu of cash payment it means you're not getting money now. In these situations there are several things to think about (pro's/con's) and several creative ways to protect yourself.
When you're offered equity in a lieu of payment for a project it can be rather enticing to accept. What if you're offered equity (stocks) in an existing (successful) company? What if it's a start-up company instead? How about a small local business? What then?
You might be thinking that getting equity in a start-up is great, especially if it's a funded start-up. If the company is already well sized and successful and offering you equity for your work, that sounds even better, right?! And that local restaurant you visit has offered you a piece of their pie if you help then, sounds great to help out a local business … of course it does.
Though I pose this question to you:
When will you actually get that money?
The downside of an equity deal (in-lieu of payment)
Start-ups and local businesses will generally not be cash rich, so it's understandable that they'd want to limit their cash exposure. Though the trouble isn't for them, it's for you.
- What if the business goes under?
- Equity isn't money, it's only worth something when you cash out.
- The majority of the time, your equity will be in the form of shares without voting rights.
- You're most likely getting a small equity share … very very small.
- Equity ‘income' is still taxable income in the eyes of the IRS.
- The equity may be worth very little, even after it get's funded.
Equity in an existing business (in-lieu of payment)
Let's say the business is already formed, has clients, has a profit and is doing well enough to be in the growth stage. This already means they have money … so why are they not willing to part with it?
For an existing business to offer equity in-lieu of payment is a rather strange proposition. If you ask they why equity instead of cash, they might say:
Money is tight right now, so we have a very tight budget and we can't afford your services via regular payment forms. That's why we're offering you equity instead.
Sounds rather innocent right? It's understandable that a company that is investing a lot in it's growth doesn't have too much extra money to spend on other things.
Though that logic is flawed. If they are spending a lot of growth or at least actually growing that means they really do have that money but choose not to spend it on you. What does that say about what they think of your value to them?
I'd start asking a lot of questions about my stock rights, amount, cash value of stock and how fast you could get the stocks, and pretty much every other financial document the company has. I'd be rather weary of accepting a stock-only project because it'd be a very big risk on my part without me having any real control of the company's direction and leadership.
You can start by asking the question in the questions section below.
Equity in a local business (in-lieu of payment)
Most local businesses aren't very high profit. For that reason, most cannot even offer that because it would reduce their already low profits. For the sake of arguments, let's say you're approached by a local (active non-startup) local business and they offer you equity in their business in-lieu of paying you directly for your work.
First obvious question is: Why equity and not cash? The following questions would be similar to the questions in the corporate section above. What are the current finances, what's the %, how much would they be worth when I sold them, when can I sell? ect ect…
Generally, it's again a bad idea as you'd be hard pressed to ever get that money. If they don't have money now to pay you at all, what are they chances you'd be able to cash you easily?
Equity in a start-up business (in-lieu of payment)
The most difficult question of all: “Should I accept equity in a start-up company instead of getting cash?” Well, it depends. This really depends on the team, the market and what the company is selling. It also of course depends on what they ask of you and what you're willing to do.
Start-ups are a very unique beast. In a start-up, you usually have long(er) hours, more responsibilities and lots of expenses to cover even without having any profit (yet). The other issue is that IF the company isn't profitable yet, or even getting any sales yet, how will they cover expenses for the project … especially your expenses.
I'm not trying to scare you away from getting stock in a start-up. It can be a very invigorating, extraordinary and learning experience as well as being extremely rewarding. One example is Mark Zukerburg and Facebook. Facebook was a start-up at one point.
VC firms are a great example of happily taking equity. Of course, the ‘resource' they offer is their money (and network). Though on the other side: Dan Kennedy had this to say about accepting equity (not verbatim):
I've had many people offer me equity in their start-up instead of paying me my usual fee. I've turned down at least 200 offers. Though I've taken them up on it twice. Right now, I'm wishing I turned down 202 offers.
The problem with equity is two fold:
1) You're not getting money now.
2) How & when will you get your money?
To make sure that we do get paid, eventually, we need to make sure we can control the situation as much as possible. I'm not saying that we want to be at a management level of a company, I'm just saying we want to control our side of the this deal and in one way or other make sure we'll get paid. This is done by having a very well written agreement.
Things to consider when accepting an equity offer (in-lieu of payment)
Here are some things you should be asking yourself, and your prospect/client before accepting an equity only offer:
- What percentage of the company will I own?
- How much will be shares me worth as soon as I get them?
- What's the prediction for the value in the next 1, 2, 3, 4, 5 .. ect years?
- How soon can I sell my stocks? (vesting)
- What are the requirements for me to sell?
- What happens if you sell the company?
- Do I have any voting rights in the company or are these restricted stocks?
- What are my options if I don't like where this company is heading in the future?
- What is the specific scope and timeframe of my work on this project/company?
- What are my legal liabilities?
- Are you currently funded by an investor/VC? If so, how much did they put it? How much stock did they get?
- What if you or one of the other managing partners wants to leave the company and cash out? What level are my stocks on the pecking order (ie: who get's paid first)?
- What if I want to sell early?
- What if I don't want to sell at all when you sell the company?
- How do I know / how can I trust that this company will grow enough & fast enough so that I can cash out?
There are more question, but that's just to get you started on thinking on how to protect yourself.
Here are some ideas to help you protect yourself if you decide to move forward.
Protecting yourself in equity deals:
- Set a date at which you can freely cash you at a specific cash value.
- Set a valuation amount for the company, at which they will have to buy you out (eg. When the company hits a $10 million valuation (or greater), they'll have to buy your shares for fair market value and you'll get your cash).
- If they company is being bought out, or merging, you have to be the first one to get cashed out of the company.
- If any of the executives are cashing out, they have to cash you out before they can cash out themselves.
- If the company is going under, they HAVE to sell assets in order to pay off your equity at X-minimum value first.
- Payouts at set intervals.
Though, the best option would be to negotiate pay plus equity:
- Cash payment + equity for performance bonuses
- Salary + stock options (or gift) as an employee
- Lower cash payment for voting shares or majority ownership
Some things to consider that would help equity by itself be ok:
- the client pays for any and all expenses related to your work with them
- your work scope, responsibilities and time requirement + your costs are very well laid out and set.
Extra reading material: