At one time or another, most startup companies work with a consultant or enter a contract with a strategic partner and are presented with a dilemma: should the company offer equity to the consultant or strategic partner in payment for services? For a cash-strapped startup, issuing stock or a warrant instead of paying cash is an easy way to preserve limited cash reserves while still growing the business. For a growing, successful startup, consultants and strategic partners may ask to receive equity instead of cash because they want to share in the company’s upside potential. While equity can be a useful tool in these situations, you should be careful about when and how you use it:
1. It can be a very expensive way to save cash. Don’t be shortsighted in using equity to pay for services. If your company has a low valuation, it can take a lot of equity to pay off a small debt. Is the percentage of the company you are giving up worth the cash savings? I once helped some founders sell their company for over $100 million. Years earlier, in leaner times, they had to repay a small bridge loan and rather than using their limited cash or raising money, they negotiated to give the lender a warrant for 10% of the company’s stock in return for forgiveness of the loan. The warrant ended up being worth 100 times more than the cash they saved.
2. Set boundaries. Avoid open-ended obligations to issue stock. I worked with a company that agreed to issue a fixed number of shares of common stock to a strategic partner for each customer that the partner brought to the company. The arrangement seemed like a low risk proposition to them because each customer was bringing cash into the company and making it more valuable. Less than a year later, the company was looking to raise venture financing and the strategic partner’s stake in the company had ballooned to nearly 20% and was still growing. The company’s new investors could not get comfortable with the arrangement because they had no certainty as to what percentage of the company they would end up owning themselves. This open-ended arrangement jeopardized the financing while the company tried to renegotiate the contract with its partner. Setting a cap on the number of shares that can be issued under an agreement is an easy way to avoid this problem.
3. Is your consultant or partner an accredited investor? Different rules apply when issuing equity to an individual versus an entity (such as an LLC or a corporation). While you may be able to rely on Rule 701 of the Securities Act to issue stock options to individual consultants, that exemption from the registration requirements of the Securities Act is not available when issuing equity to an entity. If you want to issue equity to an entity, it needs to be an accredited investor.
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