Cash-for-Equity Compensation

[Stewie Six Toes]

I think I've found someone to partner with to develop my business. I don't have much cash and expect initial compensation to be in the form of of equity. My potential partner proposed a cash-of-equity arrangement which would work like this:

1) He and others he brings in would bill the company at an agreed to rate.

2) The company would pay the invoices with I.O.U.s due at a predetermined time in the future.

3) At that time, the company would perform a valuation and could either buy back the I.O.U.s with cash or trade them for equity in the company.

On the face of it, it sounds good, but the more I think about it, the less sense it makes.

A) Presumably, someone is doing work for the company because they anticipate a larger pay out down the road. If, when the company's successful, the I.O.U.s could be bought back at face value, then one's just differed today's paycheck for the same amount a few years from now.

B) In the case of trading the I.O.U.s for equity, if $10,000 in I.O.U.s buys 1% of a $1 million company, that still means waiting a few years for the same amount of money one would've been paid today.

C) What if the company's valuation is $100,000 and the outstanding I.O.U.s are worth $150,000? If the company has no cash and is forced to trade in equity, there won't be enough to go around.

Obviously, there's something I'm missing here and would appreciate it if someone would fill me in.

Also, before I agree to work with anyone, should I form an LLC to ensure that I'm not personally liable in case the business fails. Are there other means of ensuring that when the I.O.U.s become due, I'm not expected to pay them out of my own pocket.

[Jonathan Chance]

Hell, yes, form a corporate to protect yourself. And avoid, if possible, any agreement that requires you to personally guarantee any corporate losses. I've done it, and many start up entrepreneurs have done it, but that doesn't make it easy.

The system you've defined sounds a bit wonky. Generally, if there's a work-for-equity agreement involved it's the belief of those getting the equity that they'll be able to sell the equity on the open market for a greater rate. Are you sure the agreement isn't something like:

1. Person(s) work for company at agreed rate of compensation.
2. Persons are awarded equity at an agreed upon rate per hour or whatnot.
3. Later, at cash-out time, the persons are paid off by selling equity either to the company or others at the current valuation of the company.

In other words...

They do work that awards the $10K in value of stock.

The work adds 200% value to the company

They then present the firm with a bill for $20K to redeem their stock. If the company can't make that payment they pursue outside money to convert equity to cash.

In any event, it seems unusual. Are these professional Venture Cap or Angel Investors you're dealing with? Because usually those guys will go after a majority share and not give an option to reacquire control to the entrepreneur. It's outside , WAY outside, their normal behavior pattern.

-Jonathan 'Been dealing with similar issues for years including currently' Chance

[Stewie Six Toes]

3. Later, at cash-out time, the persons are paid off by selling equity either to the company or others at the current valuation of the company.

In other words...

They do work that awards the $10K in value of stock.

The work adds 200% value to the company
Would you describe this part in a little more detail? The way you describe it sounds similar in some ways to what my potential partner is saying, and it's likely that I've misinterpreted it. Thanks.

Also, since you've got some experience in this area, is there any reason not to form an LLC now and then convert to a S Corporation once the business exists in more than name only and a board of directors, etc., is practical?

[Long Time Lurker]

I would assume the IOUs would have an interest component. That interest would either have to be paid off, or the accrued but unpaid interest would convert into equity at the agreed upon conversion rate.

I'd suggest an LLC, but you'll want legal advice to get it set up properly. An LLC is much more flexible than an S-corp, but more complex as the form is heavily reliant on the operating agreement. S-Corps are not usually a good choice for equity investment because you cannot have multiple classes of stock.

[Jonathan Chance]

Well, it's absolutely true that, prior to forming any sort of corporation, you should hook up with an accountant and consider all the implications. No one on a message board (even this one) can answer all of your questions to your satisfaction.

In terms of the equity imagine this:

1. Guys put in $10K worth of effort. Firm at the start is worth $100,000 (numbers made up). They have 10% of the shares and are therefore valued at $10K.

2. After the guys put in their work you go on and move on...building value. Eventually the firm is worth $1,000,000. They still hold 10% of the shares. Those shares are now worth $100,000. They sell and get $10 for each $1 they put in via effort and work.

Were I you I'd made damn sure whatever contract you came up with listed carefully:

1. What work is to be performed.
2. What the value of the work is ($$$ value) and the total percentage of shares transferred. You don't want to be in a position where their $10K of effort ends up controlling 95% of the shares! That would, in technical terms, suck.
3. Shares transferred (and what price each share is rated at...this allows you to set a bench mark for the value of the firm)
4. WHEN they're allowed to sell them and in what manner.
5. What sort of valuation procedure would be put in place to establish the value of each shares. So if YOU buy them back you don't have to bicker over price.
6. Try to get yourself a 'right of first refusal' to allow you to buy the stock back at the established valuation.

There's more, I'm sure. But those would be my hot button issues.