Putting Stock In Your Advisers
For many cash-poor start-ups, offering stock for services in ieu of hard currency is not a new way of doing business. The technique is often used to create a sound -- and relatively cheap -- insurance policy against the defection of top personnel. In the sometimes heated free-agent market for business talent, home-grown stock-option plans can play a key role in helping to convince managers and other employees to stay -- or, indeed, to come aboard in the first place.
But there is a growing trend for smaller companies to use equity to foster a similar sense of commitment on the part of such important service firms as recruiters, attorneys, or accountants, for whom shared financial risk has seemed anathema. These nonroster players are coming to see accepting equity as a major element of their participation in, and long-term commitment to, promising young companies.
Howard S. Klotz, chief executive officer of Contemporary Communications Corp., a video-, data-, and voice-transmission service company in New Rochelle, N.Y., views the question from a founder's perspective: "The question you always ask yourself with someone like a recruiter or an attorney is, 'Does he have the proper incentive to give you the best and most appropriate advice, or are you simply one of 1,600 clients from whom he's collecting a fee?' For him, taking equity means taking a chance, because not all new businesses succeed. But when a recruiter, say, takes equity, you don't doubt his incentive to send along the best possible candidate for the job."
Last June, for example, Klotz hired Haley Associates Inc., a New York City-based executive search firm, to fill several important managerial slots. Haley's standard contract is to take payment of one third of a recruit's first-year compensation (a fee to Haley of $40,000 to $50,000, as a rule). But with Contemporary Communications, as with a majority of its other venture capital-financed clients, the company charged a reduced fee and took stock options to cover the difference. Haley senior vice-president John Carlson described this new strategy as "a willingness to move the piano to the piano bench."
"Historically," he explained, "recruiting firms haven't paid much attention to [equity compensation], because their cash-flow priorities prohibited it. But the venture capital community has helped change the game. They look to entrepreneurs to spend their cash as wisely as possible, and, by the same token, they look to outside advisers who are willing to share in the long-term commitment. Because they've seen so many blow hot and cold on them over the years -- hell, it wasn't so long ago that most venture capitalists were roundly ignored by Wall Street -- they tend to be wary of you if you're just in it for the fee."
Carlson concedes that not every equity arrangement is a fail-safe proposition. In the case of another client, Control Video Corp. of Vienna, Va., the company approached Haley for recruiting help during a period of high momentum: 125,000 of its video game master modules were already on order and management needs were expanding. But not long thereafter, the bottom dropped out of the game console market, and retailers started reneging like mad on existing contracts. Control Video was left with a backlog of about 50,000 units. Forced to retarget marketing plans toward home computer users, Control Video CEO William von Meister admits that Haley's willingness to eschew some hard dollars for equity options was a big factor in his having chosen them in the first place, and helped the company through its cash crunch.
"If a search firm really believes in you," von Meister says, "I have to think they'd want stock warrants. After all, they know the impact their work can have on your company. At General Motors, one new manager coming in doesn't make much difference. It does here, especially if you're a small company in a turn-around mode."
There can be some pitfalls in using equity as compensation, however. Jack Nicholson, a partner at Finnegan & White Inc., a Santa Monica, Calif.-based search firm, believes the technique is becoming more and more accepted as good technology-company executives get harder to find. However, Nicholson offers this practical advice to companies: Make sure there is general agreement among partners that equity compensation is an appropriate ploy. Propose that only some of the fee be paid this way, then be prepared to negotiate the final percentage. Open your books to the recruiter as you would to any potential investor. Don't offer the recruiter a seat on the board. And make no promises about future use of the recruiter's services.
Nicholson says he and his colleagues began "putting our toes in the water on this" about three years ago, but that since then equity compensation has turned into a very deliberate part of their efforts. "It's hard to build equity when you're in a cash business," he notes, "and at a certain level if you're just adding cash on cash, you're getting 50-cent dollars. So there's real opportunity here." Why no seat on the board, though? "A good recruiter doesn't always make a good director," he answers. "Besides, that's the one area where I think you can really get into a conflict of interest. Especially if you hope to do business with [that company] in the future."
Accountants face an even tougher question of conflict. Prohibited by law from signing off on audits of companies in which they have a financial stake, they are limited to serving as financial advisers/consultants for companies that have paid them in stock.
Even then, there can be ethical obstacles. "If we take an equity position with Client A, and he has a large contract with Customer B, what happens if we become Customer B's auditor?" asks Linda Holloway, a partner in the Flint, Mich., accounting firm of Dupuis & Ryden. "That's one problem. As far as risk goes, the biggest one isn't financial, it's the risk of being associated with a failure."
Despite those concerns, Holloway thinks taking equity instead of cash is a likely concession in a marketplace in which capital is scarce and risk plentiful. Nowhere is this truer than in Flint, a city rocked by the auto-industry recession and scrambling to incubate start-up companies.
"Accounting has been a conservative, low-risk industry," she notes, "but we have to respond to changing clients' needs. I feel that CPAs will look more and more to the AICPA [American Institute of Certified Public Accountants] for guidelines on this. We're definitely wrestling with it here."
One point of harmony among the professionals is that equity should not become a precondition for offering services to smaller, younger companies. While it may enhance the relationship, many feel, both financially and psychologically, it should not be considered a panacea. "The biggest mistake we could make," says Haley's Carlson, "[would be] to institutionalize the venture capital arrangement. You have to offer it where appropriate, and recognize that there's a certain masochistic element to it. Sacrificing cash flow often means sacrificing sanity and happiness, too. With most start-ups, organizational and staffing problems are inevitable. And when you come in on an equity basis, you come in all the way."