We are a consulting company that builds web and mobile apps for our clients. We have been asked if we accept some portion of compensation in equity. We do actually want to for some of our clients, but I don't know the best types of arrangements. We are an s-corp, so would it be through the company or through the team individually? Is convertible debt the best structure? How do we decide how to proceed and what are the pitfalls?
This is an important question. Professional working with start-ups are often asked to take equity in lue of market-based compensation.
I think that for those of us who work with start-ups this is one of the most challenging stages in the relationship development with a new or prospective client. Being a service vendor is very different from being a creditor or investor. The roles and responsibilities are different. The power dynamics are also different. All of this must be taken into consideration when evaluating the opportunity to secure vendor business while also gaining a debtor/investment.
I have found that "un-bundling" the two decisions and evaluating them independently of each other is a critical step in doing the right thing for me, for my company, and for our client.
The first question is are we the right vendor? These are some of the questions you will be asking yourself:
The second quesition is -- do we want to be an investor? When the compensation put at risk is in the form of equity or a note -- you are being asked if you would like to be an investor in the start-up. these are some of the questions that you will want to ask yourself:
and the most important:
Most likely you have answered the first question; Yes. And you have determined the amount of compensation you need to receive in order to deliver a quality product. And the amount of money that you could put at risk. In my company that amount we need is what covers our cost of goods and overhead. The amount we can put at risk is the compensation that would be received by the principals.
Most likely you will answer the second question with "maybe". Maybe you would be an investor. There are often a bunch of "ifs" that go with that. If they did this. Or if they did that. Write these out because they will form the foundation of your negotiation. If your answer to the question of whether you would investor your own money is a resounding no -- then you should not be putting any of your company's compensation at risk. If it is "yes, if I had it." Then it might make sense.
Negotiating the Terms
I recommend that you treat the negotiating of the agreement in two parts which copy the unbudnling -- first get agreement on the scope of service and how much it is worth to the client for them to pay you. Agree upon the amount. And then you put forth the portion of that you are willing to put at risk. Now you are discussing making an investment of that amount in the business. From that perspective you can not take under consideration what you want and need to feel confident about the investment.
Here are option you may want to take under advisement:
The structure of the investment
There are lots of good reasons that can be discussed on whether to make your investment as debt, convertable debt or equity. Regardless the ownership of the position is in the name of your company.
I personally prefer convertable debt because I do not want the legal obligations and responsibilities of equity until I know more about the people and the company. Usually they have incorporated in a state that gives very little rights to a minority shareholder. there is nothing I would hate more than to have my compensation tied up in a minority position of a company that I have no influence over.
Other people like debt because it shows up on the books, and that may even have a payment structure or schedule. They correctly assume that if another round of capital comes in there will be a debt to equity swap and that will be done in accordance with the terms of the negotiated options.
Keep in Mind
Whenever our team is negotating the structure of the investment portion this is what we keep in mind:
The company will be successful -- or it wont.
If it is -- you will recover your investment and benefit from the upside. You will have earned a client for life for believing in them early on. Whether you maximized your investment opportunity and got as much equity as you possible could have is for VC motivated by greed to argue about. You took a risk and were rewarded.
If it is not -- then you will lose your investment. If you walk away from it at the right time with honor and integrity you will have earned a referral source for life for believing in them early on and sticking with them until then end.
Balance your portfolio. You need to get paid. Your business needs revenue. Your mortgage company doesn't take equity. The local food store doesn't accept options. Every start-up looks and sounds great-- but you know the truth of how hard it is and what the failure rate is. Even with fabulous software designed and built by you. So don't put your company at risk by carrying a disproportionate risky debt or equity portfolio. A good investor tries to make sure they are converting on at least 30% of their high risk portfolio. You should strive to do the same with your "compensation at risk portfolio"
The equity should be in the name of the company. That way, there is no debate about who owns the stock. You will need to check to see if S-Corp's can own other corporations -- I don't recall off hand.
I have seen this type of deal done a bunch of ways -- it really depends on how much cash flow you need and the amount of risk you want to take on.
Convertible dept is a good structure for the company because it does not dilute right away and they can retire it before a funding round. If you really want equity in the company, then you need to have the option as to how you want to get paid -- either cash, all equity or a balance.
Personally, I like the deal where the consulting company gets a modest fee and the rest is made up with equity or convertible debt. The reason this is a nice balance is because the consulting company gets show cash in and the startup gets more of their attention.
If it's a pure equity deal, then the motivation is not as strong. The startup can take the "it's free attitude" and not really put the effort in while the consulting company puts it lower on the priority list.
Check with a lawyer in your area on any fine points in terms of taking equity and the tax implications -- their may be some but I'm not sure (I was always on the "here's some stock, can you help me side").
I will add my 2 cents here as my company does this actively now, and its a good thought exercise for me.
We have invested in around 8 companies over the years, each one has taken differnt forms, but personally I like to get a direct ownership / shareholding of between 8 and 25% depending on the stage they are at and the amount we are contributing.
Problems we have encountered.
Second time around I either do or should do:
Hope this helps.