Everyone loves to talk about the painter who did some work for Facebook and took payment in the form of company stock, which was worth hundreds of millions 7 years later at the company’s IPO. Especially potential clients that are trying to negotiate engineering work in a similar manner. For many new consultants, no offer of equity would ever be enough for one reason: you can’t eat equity. New consultancies can’t be bothered with anything that doesn’t result in hard cash. But for the consultancies that are developed enough to take on work that likely won’t pay off for many years, if at all, it can be a real option.
Taking equity for work is fun way to diversify an investment portfolio and work on a project with some real skin in the game. However it is a far more complicated agreement than cash when it comes to contracts, present value, future value, taxes, risk, and the possibility of getting screwed.
First to consider is the contract: what is the stock worth? The current value of a startup is almost always a load of garbage since it is based primarily on speculation. You can spend years researching company value, but the only important question is if you personally think the current valuation is acceptable to you, all things considered. If a company has raised financing from investors there can be a higher level of confidence in the value negotiated by them, but honestly they are making everything up as well. If you think it isn't a reasonable rate, NEVER try to convince a startup owner that the valuation is wrong – you’ll never convince them (and you’ll likely offend them). Instead, adjust your consulting rates based on the fact that payment will be delayed until the shareholders can sell. Stock ownership is basically offering payment terms of net-infinity.
Next, how will you take payment? One option is to simply accept stock in the company and make sure you get the appropriate paperwork to denote ownership (since the company won’t be listed on any stock exchange). The downside is the transfer of stock ownership is a taxable event. If in 2014 you take $5,000 in stock, income tax must be paid on that $5k. And then if in 7 years down the line the company fails, you are only left with a $5,000 investment loss to write off against other investment gains. The other path is to accept stock options. Stock options do not have any taxable value until they are exercised and traded for stock so there is no tax. But since options aren't actually ownership, they are strange things and carry with them strange rules that would take a lawyer to help sort through (such as when they must be exercised, and limits on when the shares can be sold) .
There is more risk involved than the failure of the company. Legally screwing someone over in a cash deal is very difficult to do and usually involves bankruptcy. However, when placed in units of ‘company shares’ it is much easier to change value because the ratio of dollars-to-shares is not fixed and can easily be skewed. The most common change is equity dilution. The simplest implementation is where a company worth $10 million (M) takes on a 5 million dollar investment. If the company was worth $10M, and now has $5M in extra cash, then the company value should instantly rise from $10M to $15M. Therefore the company creates $5M worth of new shares to give to the new investor. Existing investors who used to own 10% of a $10M company now own 6.66% of a $15M company, resulting in a smaller ownership stake in a more valuable company. Hopefully the new cash will allow for growth and everyone makes more money, but note that the initial investors don’t see an increase in value due to this new investment. The darker side to dilution is that new shares can be issued only to specific shareholders, diluting out those that don’t get more shares. This essentially transfers value from some shareholders to others and can be implemented with nefarious intentions. I’m sure there are all kinds of laws related to this, but it would take a lawyer to work it out.
While company stock is a complicated, risky, and slow way to get paid, the potential upside is often more than enough reason to accept the terms. I currently hold options in two companies in exchange for work. The work is mostly completed, but it will be some time before I can realize any cash from the investments. I look forward to being able to report back on how it works out, hopefully from a first-class airplane seat bound for Hawaii!
James Benson is writing a series on 'Engineers As Consultants' to educate and encourage salaried engineers to consider if hanging a shingle is right for them. New posts on the first Monday of every month.