*** Equity to Consultant Question ***

[directrpep]

Hi everyone,

I have a question.

I am starting a company.

I was inititially going to have a partner with me start this, but she decided to not be a partner anymore back in November. She said she would instead like to simply be a consultant so she could consult with other companies. So, since November I have moved forward and done everything to set it up and now I am at a point with clients and going to start business in February.

She is an engineer and and the company could benefit from her knowledge. Although I would prefer to have her Full Time so she can be involved in the day to day operations, she will not be so instead she will only be able to assist when she is available and also as needed.

We know eachother from working previously at another job. We work well together and I wish she chose to be a part of the company rather than a consultant, but that is her decision.

The problem is, is that she is asking for equity in the company as a Consultant. And as a consultant she would only be available for about 20 hours a week or less because she would like to work at other places as well.

From all my conversations with people, they have told me that this is not normal and that a consultant does not receive equity in the company and if so, then it is at less than 1%. But I value her work and would like to work together, but again, I want to make sure that I am making good business choices since this is a legitimate business and not a personal decision.

I would just like to know if this is something common or has happened before.

thanks.

[rogercbryan]

Hmmm.. how do I word this.. You may want to have her as a general contractor with rights to a percentage of profits based on her consulting (depending on your industry). This can tie her efforts to her earnings. If she takes an equity position in your company she in essence becomes a partner (consult an attorney for a better definition). I have a couple of questions..

1- What type of business / industry is this?
2- Why does she not want to go full time (pay, benefits, or other)?
3- Are you incorporated (or do you plan on incorporating)?

The answers to these questions may help to clarify things a bit.

[directrpep]

- Corporation C in Delaware
- Testing Quality Assurance for DVD's
- Does not want to go full time because she would like to do other consulting work with other companies in areas not related to this company. I have tried to convince her otherwise, but she insists on this.

I do not think the profits based on her consulting will work since the industry the company is in does not really operate as such.

[jasaunders]

Giving equity to consultants is not necessarily abnormal. The thing is, you don't give the equity upfront and hope she works as much as she says. The consultant should work and gradually become vested over time. You could, for example, say that you will give her 5% equity, where the equity will be vested in 1% intervals every six months.

[rogercbryan]

With the additional information you have provided I do like Josh’s idea. A vesting schedule for equity will allow you to motivate her to stay. Is there anything about what your company does that she may be able to take to another client?

In my industry when a contract sales person (consultant) says they want to work with multiple clients I get worried that they may use confidential information (leads lists and such) to the benefit of themselves and others. This is a slippery slope…

This may not apply to your industry… just an FYI

[BusinessAdviser]

With the additional information you have provided I do like Josh’s idea. A vesting schedule for equity will allow you to motivate her to stay. Is there anything about what your company does that she may be able to take to another client?

In my industry when a contract sales person (consultant) says they want to work with multiple clients I get worried that they may use confidential information (leads lists and such) to the benefit of themselves and others. This is a slippery slope…

This may not apply to your industry… just an FYI

I think Josh's idea of a vesting equity schedule is good, but I think your better option would be to profit share, if you can agree to get her to do so. With equity, even with a vesting schedule, once you give away a piece of the company, you no longer have it. I always prefer profit sharing because it gets the same result (she is not paid upfront, when you have no cash, but is only compensated for work when the business is successful), and you maintain 100% control and ownership.

[Cole Taylor]

This is one of those "it depends" situations. One main piece of information not mentioned in your post is what value you put on your company and what value you put on your consultants time. Another thing that you don’t mention is whether or not the consultant will also be paid in addition to receiving equity.

Which is more preferred 20 percent in your company or one percent in Google? Get your numbers in order and the answer really boils down to simple math.

Personally, I pay for as many services as I can with stock to preserve my cash; so long as I maintain controlling interest there is nothing preventing me from diluting shareholders.

Also, as Jsaunders stated, if you do provide this consultant with equity make sure you agree upon a vesting schedule.

[BusinessAdviser]

This is one of those "it depends" situations. One main piece of information not mentioned in your post is what value you put on your company and what value you put on your consultants time. Another thing that you don’t mention is whether or not the consultant will also be paid in addition to receiving equity.

Which is more preferred 20 percent in your company or one percent in Google? Get your numbers in order and the answer really boils down to simple math.

Personally, I pay for as many services as I can with stock to preserve my cash; so long as I maintain controlling interest there is nothing preventing me from diluting shareholders.

Also, as Jsaunders stated, if you do provide this consultant with equity make sure you agree upon a vesting schedule.

So, why would you prefer to give away equity rather than just to profit share in ANY situation?

[Cole Taylor]

In my current situation we're development stage, pre-revenue. Paying with stock allows us to use our funds for prototyping, salaries, etc.

So using equity is a win-win. Those recieving shares believe that the stock will be worth far more tomorrow than what they would be paid today. That's not to say that you're going to be able to pay everyone with stock. We have numerous situations in which we pay half an invoice with cash and the other half with stock.

In the long run, after a couple rounds of financing I'm probably only going to end up with a 30-35% stake anyway.

[BusinessAdviser]

In my current situation we're development stage, pre-revenue. Paying with stock allows us to use our funds for prototyping, salaries, etc.

So using equity is a win-win. Those recieving shares believe that the stock will be worth far more tomorrow than what they would be paid today. That's not to say that you're going to be able to pay everyone with stock. We have numerous situations in which we pay half an invoice with cash and the other half with stock.

In the long run, after a couple rounds of financing I'm probably only going to end up with a 30-35% stake anyway.

Here's the thing, profit sharing, in my experiences, is always better for the owner than giving away equity. Why? Either way, the consultant, in this case, will gain when the company gains. With profit sharing, when the company turns a profit, the consultant takes her part. With equity, when the company gains, the consultant takes her part. The benefit, then, of profit sharing over giving away equity is that the owner still maintains ownership. Thus, the consultant only gets the benefit while working for the business.

Obviously, it is in the consultant's best interest to be given equity rather than just profit sharing opportunity, because equity, even a minority interest, is more valuable, since it will continue to pay even after work has ceased and can be sold. As a result, as an owner, you might be UNABLE to get the consultant to agree just to profit share rather than taking an equity stake.

However, the point is that in any situation, since equity is more valuable than just profit, an owner should prefer to maintain equity and share profit rather than giving away equity.

That is just my opinion though. Can you think of a reason why an owner would be better off giving away equity than just providing for profit sharing, if either is available?

[Cole Taylor]

I hear what you're saying, yet I still tend to think profit sharing is more an internal performance incentive than a way to reward and/or compensate outsiders.

I think the assumption of profits in a start up venture is a pretty big one and even if that were the case I would still prefer equity.

Pros:
- Improves cash flow
- Long term incentive for consultant
Cons:
- Dilution

Dilution can be addressed through the issuance of additional shares, so it really is not an issue. I understand your mentality however. In fact, at one point I so closely guarded the stock and wanted to maintain as much interest as possible. Again, we're talking pre revenue where cash is king. We're small and keep things pretty damned lean and getting money out of me is near impossible, yet we still have a six figure per month burn rate.

The trick is stock based compensation. If I issue 200,000 shares for services do you think my percentage changes? The answer is no.

The brutal reality of it all is the stock, at this point in time, isnt worth the paper it's written on.

[BusinessAdviser]

I hear what you're saying, yet I still tend to think profit sharing is more an internal performance incentive than a way to reward and/or compensate outsiders.

I think the assumption of profits in a start up venture is a pretty big one and even if that were the case I would still prefer equity.

Pros:
- Improves cash flow
- Long term incentive for consultant
Cons:
- Dilution

Dilution can be addressed through the issuance of additional shares, so it really is not an issue. I understand your mentality however. In fact, at one point I so closely guarded the stock and wanted to maintain as much interest as possible. Again, we're talking pre revenue where cash is king. We're small and keep things pretty damned lean and getting money out of me is near impossible, yet we still have a six figure per month burn rate.

The trick is stock based compensation. If I issue 200,000 shares for services do you think my percentage changes? The answer is no.

The brutal reality of it all is the stock, at this point in time, isnt worth the paper it's written on.

You're exactly right in your last statement. Neither the stock nor the contractual right to profits are worth anything in terms of current income. However, because stock is more valuable than a right to profits, would you be better off keeping the more valuable of the two if you are able to while still getting the same results from your consultant?

I guess I'm asking this: If you have a consultant who will agree to work for you for a few years for either 20% stake in the company or 20% of profits, why would you prefer to give away the 20% stake?

That's why I arrive at my conclusion that, if you have the option between the two, it is in your best interest to share profits rather than equity.

Does anyone else see this? Or am I in the minority of people who understand that you want to keep what is more valuable? Basically, if you have the option of purchasing a certain apple for either $1.00 or $0.50, why would you choose to pay $1.00?

[BusinessAdviser]

I still tend to think profit sharing is more an internal performance incentive than a way to reward and/or compensate outsiders.

Why?

And let me ask you this: Why would companies reward their employees with profit sharing when they could reward them with equity?

The answer is that it is less expensive.

That gets to why, if you as an owner have a choice between the two, you should prefer to pay with a profit sharing plan than with equity.

See what I mean?

[Cole Taylor]

And let me ask you this: Why would companies reward their employees with profit sharing when they could reward them with equity?

A key incentive for management is thier ESOP. This of course assumes the stock is marketable.

I guess I'm asking this: If you have a consultant who will agree to work for you for a few years for either 20% stake in the company or 20% of profits, why would you prefer to give away the 20% stake?

Think about it this way:
If I give you a 20 percent stake in the company, calculated at present by the number of shares issued and outstanding, what are you really entitled to?
Some form of monetary compensation? Not necessarily. Will I ever declare a dividend? A say in how the business is run? Not while I have controlling interest. So what are you really getting? It’s really about control not the number of shares you own.

[BusinessAdviser]

That's your opinion. Personally, I would prefer to retain stock, and instead agree to share profits, for the above mentioned reasons.