If you are a consultant to small businesses, you might be a small business yourself. So the delicate balance between cash and any other form of compensation you take must be carefully considered. If you are a risk taker, believe in your ability to impact the outcome of the business, you might consider asking for, or accepting, an equity position in place of all that cash.
Stock: Better than Cash
What this means is that in theory, you, as the consultant, are taking the stock at the face value it has been given by the small business. This might be 1 cent a share, five dollars a share or ten dollars. For every buck of services you deliver, then you need the equivalent in shares. Why would you take equity (or stock) in a company rather than the cash in the first place? ROI-Return on Investment.
Some firms have an "exit strategy´ plan for the company which fall into two primary categories. The first most common exit strategy is to Sell. In this situation, the stock is purchased and those investors who hold Equity get a Return on Investment. You as the consultant might have been given shares at .10 cent per share, and the company sold for .15 cents per share. You´ve just made 5 cents per share. The second most common exit strategy is for a firm to Go Public. In this situation, your .10-cent share price might have jumped to several dollars. When I accepted OnDisplay as a client back in 96, my original project was $15K for creating a series of product and joint development agreements with technology vendors. What´s the real ROI?
OnDisplay had 6 employees, had just hired a new CEO and after conducting research on our possible outcomes, I pitched the CEO Mark Pine, on taking $3,000 dollars worth in stock. He agreed on one condition: I´d only get the stock if we hit the primary milestone, which was a joint development agreement (JDA) with one of our partners. Sure enough, three months later, we announced a JDA with Microsoft and I got my 3,000 dollars worth of shares at the bargain basement price of .10 cents a share.
There´s always a Catch
The catch is this. You have to start the clock ticking on the vesting of the stock, and when you are a consultant, the only way to do that is to Purchase the stock. So I had to fork over a check for stock (not that big a deal at $300.00) to OnDisplay. That year, I had to claim the $3,000 on my tax returns as if I´d actually received cash. That didn´t feel good. But the simple reason is this: I paid taxes on the value of the $3,000 whether or not I received any money from it.
Fast-forward three years. OnDisplay went on to create many more partnerships, sell a lot of product and go public. It got the double lift from an acquisition. At its height stock was about $92.00 a share. When I went to sell a few shares, my taxes were a lot less since I´d held the stock several years and started the clock ticking (my memory is fuzzy but I think it taxes were 15% instead of 35%). Now, lest you want to kill me for making this kind of money, I was caught up in the bubble like everyone else. This was going to be my retirement, so I only sold enough to take a vacation. Sure enough, in March of 2000, (remember that month?) the stock market started to tumble and drop. So my stocks and I pretty much lost the whole shootin match.
But that is a great example of why you would take stock in a company-the ROI is a lot more than the cash equivalent. Obviously, you have to hold onto it for a while and the pray that the exit strategy does in fact, occur.
Stock Protection Clause
This is the critical piece-don´t sign an agreement for equity unless you can protect your stock position. This is technically called an Anti-Dilution clause. It means that no matter what happens to the company to cause the value of the stock to go down on a per share basis, your stock is protected. I will tell you most CEOs and boards kick and scream against including this clause, but it´s a requirement. And here´s why: Your services are worth every dollar-literally. And by the way, you have to report taxes on that dollar regardless of how you take it-cash or equity. So let´s say you accept equity for a buck, and then 5 months later, the client accepts another round of funding, and the stock value goes down (since everyone got diluted). Oh, and by the way, you aren´t given more stock to make up for that dilution. Suddenly, your buck is worth thirty cents. When the company gets acquired or goes public, your ROI got a whole lot smaller.
Another real life example. My firm completed a large project for a client and we worked a deal for our milestone-based bonuses to be paid in stock. I´d never heard of, or experienced a Reverse Split. The cash value of the program was $150,000, so I took 1/3, or $50K in stock. The project itself was about a year in length and I spent time on the effort along with several employees. About three years later, when the company (a software firm) went public, I calculated my shares and was elated to learn that the value was about $300,000. I was getting ready to sell-sell-sell. Then I learned the stock had been repriced before the IPO. In short, the I-bank decided the company had too many shares outstanding so the number had to be reduced to get a higher market price. All of us with common stock (e.g. anyone not a board or executive management team member) took a major haircut when the stock value went from 5 bucks down to 2. So for three years of holding onto the stock, I made $25,000 instead of $225,000. Should I complain? No. But I could have probably taken the $50,000 in cash and re-invested it into something else.
That said, I only needed to learn that lesson one time-Anti-Dilution clauses are your friend.
Who does this work for?
Nearly any type of service providers. Many attorneys accept (and require) equity for small business clients in the technology, biotechnology and other industries where exit strategies are considered a matter of course. I don´t think accountants can, since it would be a reason to cook the books-but I´m not an accountant, so better check on that one yourself. Human resources (staffing) should ask for this more often, all types of management consultants, you name it. In fact, a lot of leasing firms and real estate (office building) developers require this as well. This is particularly the case if you live in a technology-centric city.
Should you take equity in all types of firms?
Not all, but most firms that are likely to get acquired are good bets. Think a small, gourmet cracker company, or a game board company, fruit juice company, clothing manufacturer or high-end toys. All these products/companies are unlikely to go public but are possible acquisition candidates if they are well run and have a unique advantage. Consider the following:
a) Market conditions
b) Competitive advantage
c) Management team
d) Business plan
e) Your risk/cash situation