How to Take Stock

If you're thinking about taking equity instead of cash as payment for services, here's a checklist of things to consider.

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Business 101

Robyn Sachs's $28-million advertising and public-relations company, RMR & Associates, in Rockville, Md., began receiving equity from some clients in exchange for services two years ago. One of those clients, the Netplex Group Inc., issued RMR 16,000 options at an exercise price of $3 a share. Sachs was all aglow: the potential for gain was huge. In March, when Netplex's stock price reached $19 a share, it looked as if Sachs had hit it big. But by May, Netplex had crashed to $3 a share. What had seemed to Sachs like a chance for colossal appreciation turned out to be just another casualty in the bursting Internet bubble.

A services-for-equity transaction can be a chance to make a killing if one's customers are acquired or go public, and such deals show solidarity with customers through shared financial interests. But as Sachs discovered, playing the equity game is risky and complex. And the volatility of the stock market is only one of the reasons. These deals are as much art as science, and each is negotiated on its own merits. Still, dependent as the transactions are on the particular situation of your company and your attitude as owner, some of the important issues to consider are universal.

Tax consequences
RMR's Sachs made the mistake of putting the equity deals on the books of a C corporation, which meant she could have faced double taxation down the road. When C corporations are sold or liquidated, there can be a tax on appreciated assets levied not only on the corporation but also on the individuals who are corporate shareholders.

When Sachs found out about the possibility of double taxation, she set up Silicon Beltway LLC, a sister company of RMR, through which all equity transactions are now handled. Under the LLC, no corporate- level taxes apply upon liquidation. "The key is not to trap gains in a C corporation," says Steve Wiltse, partner at accounting firm Argy, Wiltse & Robinson PC, in McLean, Va. "You want some flexibility by doing the deals in a pass-through entity like an S corporation or an LLC."

Due diligence
How do you determine whether to take a chance on a customer by accepting stock or stock options as part of your fee? The same way you'd judge any potential investment. "The fact that you're exchanging services for the stock doesn't mean you should look at it any differently," says Elizabeth Horwitz, partner at law firm Cors & Bassett in Cincinnati.

One due-diligence method is sharing the start-up's business plan with your professional confidants. "Most new ventures have nondisclosure agreements that they'll get you to sign, but these typically allow the signer to share the business plan with a CPA, attorney, or investment adviser," says Linda Gill, managing director of the Cincinnati office of SS&G Financial Services. Second opinions, she adds, can keep you from succumbing to a start-up's evangelism. "It's infectious sometimes -- that emotional charge that entrepreneurs have. It's easy to get in over your head, overcommit, and say, 'I'm on board with you.' "

You also want to stay clear of start-ups whose managers you don't get along with. That's because taking equity for services often means a commitment rather than a one-job stand. Which is why Sandra Gassman, CEO of MarketingFuel Inc., in New York City, pays careful attention to "the relationship side" of things. "It's still a business decision, but the relationship is really important, since you'll know them a lot longer than one project," she says.

How much? How often?
In Gassman's first stock-for-services deal, MarketingFuel took only 25% of its fee in cash, 75% in equity. "At that particular moment in our cash-flow cycle, we were comfortable doing it," she says. Sachs, by contrast, would feel edgy forfeiting that much cash. As a rule, RMR takes at most 30% of its fee in equity. Moreover, Sachs limits RMR's equity participation to three customers, and $150,000 in fees, a year. Compare that with the strategy of Scott Jamar, CEO of VisionStart Inc., a start-up consulting firm in Lafayette, Calif. Jamar takes up to 50% of his fees in equity and aims to take equity in all his clients. "It's a core component of what we do," he says.

The different approaches of those three CEOs reveal a marked trait of equity pacts: their individuality. Pacts vary widely not only from company to company but also from deal to deal. One factor has to be a priority: "Cash flow has to come first," says SS&G's Gill. She suggests devising a formula for equity deals. One solid method is always taking enough cash to cover a project's out-of-pocket costs. "You still come out even on a cash basis if what you take in stock is equivalent to your profit margin," she says.

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