Back in 1997, Randy Parker was staring at a blank whiteboard, wondering where he'd find the money to hire the employees and consultants he needed to build his new product. "We had a rough time early on," says Parker, president and chief technology officer of Roving Software Inc., a 50-employee provider of e-marketing solutions to small and midsize businesses, based in Needham, Mass.
To grow his cash-strapped start-up, Parker ended up sharing equity -- not only with employees, but also with consultants and vendors. The advantage? Parker found that equity as compensation helped build loyalty to his company -- even among consultants. "Sometimes consultants are a tougher sell because they frequently like cash up front," Parker says. Nevertheless, he finds that equity is generally "a great tool to use before you can line up enough cash to pay people."
But sharing equity can have pitfalls, too. Parker, for example, often sealed his agreements with a handshake rather than on paper. Before Roving Software could receive its first round of financing from professional investors, in early 1999, he had to put all the stock arrangements in writing. That cost him accounting fees, legal fees, and time because the financing round couldn't close until the arrangements were formalized.
These days, start-up entrepreneurs like Parker do sometimes use equity not only to motivate key employees but also to help pay for consulting and other services. Should you use equity to pay for professional services? "I advise my clients that you offer stock only after you've searched your heart and soul and can't come up with a way to pay with anything else," says Thomas H. Durkin, managing partner with the Boston-based law firm Lucash, Gesmer & Updegrove LLP. Chip Morse, cofounder and partner with Morse, Barnes-Brown & Pendleton P.C., based in Waltham, Mass., agrees. "I happen to think equity is the most precious commodity, so I'm pretty chary to give it out," he says.
Generally, both Durkin and Morse view compensating consultants with equity as a last resort. "The $10,000 or $20,000 you give out in equity could be worth 10 or 20 times that amount in the future," Durkin says. Besides the future potential earnings you're forgoing, you're also diluting your own ownership in the company
Admittedly, there are situations in which equity can secure critical professional services that a start-up might not otherwise be able to afford. "If you have to [ use equity] , you have to decide whether the service provider is really worth it," Morse says. If the consultant is, make sure you take the following points into consideration before you sign an equity-as-payment deal.
- If you have an S corporation, make sure you don't jeopardize your S status. There are some restrictions on the type of investors an S corporation can have. For example, Morse notes that neither C corporations nor venture capital funds structured as partnerships can, by law, be S corporation shareholders. "Many companies start out as S corporations and inadvertently blow election" by the way they grant shares, Durkin says. Consult your lawyer for details.
- As you think about how much equity to offer, have a reasonable valuation in mind that's been determined using professional advice.. If you're offering the consultant stock options, you'll also want to take into consideration what the exercise price is going to be and how long the options will be outstanding.
- Decide the maximum number of shares you'll be granting. "Create an options pool, if nothing more than in your mind, so you have some parameters to work within," Durkin says. Look out over the next 12 or 18 months, estimate the number of shares you'll need to give away to enlist consultants or hire employees, and then come up with a number of shares for the pool. Durkin, who works with many young high-tech companies, says that he sees such start-ups generally putting aside about 20% of their stock into a pool. One note of caution: Be careful how many options you give to outside consultants for one-shot deals because you'll need a lot of options for new employees.
- Determine when the consultant will receive the options. "If you give it to them up front, and they don't finish the work, you don't get [ the options] back," says Morse. He suggests granting the options on day one but making sure they vest only upon satisfactory completion of the project. That way, he says, "Vesting is an encouragement for the project to be completed."
- Don't overlook federal and state securities laws. Any stock grants you issue have to qualify for exemption under state and federal securities laws. These laws apply to private offerings as well as public offerings.
- Consider whether or not you'll be raising financing down the road. "The offering to a consultant may affect your securities compliance in later offerings and will certainly add to further dilution to founders," Durkin says.
- Talk to your lawyer about putting together an agreement. All stock, whether granted to employees or consultants, should be granted pursuant to a written agreement. "What's always nice to get in that agreement are share transfer restrictions," Durkin says, "which prevent the consultants from selling their stock to other people, like your competitors." He also suggests adding a right of first refusal to the agreement and, if granting stock to employees, also adding a buyback option.
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