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.
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."
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.
Cors & Bassett's Horwitz recommends diversifying your equity portfolio the same way you would other holdings. "Look at how angel investors do it," she says. "Most of them say, 'I'm better off investing $10,000 in each of 10 different start-ups than putting $100,000 in one basket.' "
A marked trait of equity deals is their individuality. They vary widely not only from company to company but also from deal to deal. But in any deal, cash flow has to be a priority.
Deciding what percentage of fees you'll take in equity is easy; assigning a cash value to private-company equity is not. In other words, just because you've agreed to take 25% of a $10,000 fee in equity doesn't mean you'll get stock worth $2,500. The value of private-company stock is a negotiable matter. "I worked with a consultant who, in exchange for $50,000 in services, got $40,000 in cash and options with an exercise price of 20¢ a share for 7,500 shares," says Horwitz. "It's interesting to figure how $1,500 worth of options relates to $10,000 in services, but the two parties simply reached an agreement."
Any equity-for-services discussion between you and a start-up should also cover how you want to receive the equity: as actual stock or as stock options. Many equity deals allow you to negotiate various terms, such as providing for a payout should an acquisition take place before you exercise the options. With options, taxes are deferred until the options are exercised. With stock, however, you have to report income right away. But Warren Goldenberg, partner at Hahn Loeser & Parks LLP in Cleveland, points out that getting actual stock can mean tax savings under certain circumstances. "If you think there's going to be a huge appreciation, you might take actual stock and pay the income tax up front. When you dispose of the stock, any appreciation will be taxed at the capital-gains rate, which is far lower than the general income rate," he says.
Accepting equity as payment for your services also engenders an intangible set of concerns -- ethical ones. Not the least of those are possible conflicts of interest. Last April, Evan Scott, president of Evan Scott & Associates (ESA), in Yellow Springs, Ohio, was thrilled when his marketing firm was offered equity by a promising start-up.
But in the end Scott wanted nothing to do with an equity-for-services transaction. He also turned down a board seat. His concern was this: What if a prospective investor came along and loved the start-up but didn't think that ESA was the best marketing firm for the start-up or that Scott was board material? Scott didn't want investors to feel that they had no say on such serious matters. "I didn't want to jeopardize the start-up's investor prospects," he says.
How you might affect a start-up's funding prospects is just one consequence you'll need to ponder when taking equity. Some others might be: Will you be making the customers in which you don't take equity feel like second-class citizens? Will your employees expect to receive options in your start-up customers? The chief thing to remember is that what works for one company, in one state, on one particular deal may not work for that same company on another deal.
"About the only thing that's certain," says Horwitz, "is that it's case by case."
Ilan Mochari is a reporter at Inc.
For more information on this topic, see our Guide to Equity as Compensation.
Equity Issues at a Glance
Taxes: If your company is a C corporation, you run the risk of facing double taxation on appreciated stock held upon the liquidation of your company. Look into setting up an LLC or S corporation for your equity transactions.
Risk: You should evaluate the risk involved in taking equity the same way you would a normal investment. Liking a start-up isn't enough; determine whether you're getting a fair deal.
Cash flow: Decide how much cash per project -- and per month -- you're willing to forsake for the sake of taking equity. Would you be satisfied with taking only enough cash to break even? Does that break-even number include your own salary? What will taking equity do to your cash flow?
Miscellaneous what-ifs: Say you take equity in a hot high-tech start-up, and then its biggest competitor seeks your services. Would being a shareholder in the former create a conflict of interest for you? If you take equity in a customer's company, will your workers demand options? Will customers in which you don't take shares feel as if they're flying coach? The bottom line: consider who else will be affected if your company takes equity in its customers.
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