Starting a business is no small feat. It requires an enterprising idea, hard work, and strategic know-how to turn a start-up into a successful business. And it requires money — something many start-ups don’t yet have.
When cash is tight and a service is critically needed, many entrepreneurs turn to offering shares or options (also called equity) in their business to key service providers or contractors. The situations in which I most often see these arrangements include professional advisors, such as lawyers or accountants, technical experts – for services such as web or App development, fundraisers – for help in raising capital from investors, and marketing professionals for promotional campaigns.
Advantages of offering shares
The upside to offering equity for services is that it enables a business owner to retain key consultants it could not otherwise afford without incurring out-of-pocket expenses. This stretches the company budget. It may also encourage a contractor to provide a higher quality of service because his or her compensation is ultimately linked to the company’s success. By accepting equity for services, consultants take a risk — the company’s success bodes well for them, the company’s failure does not.
Disadvantages of offering shares
There is however a downside to paying consultants in equity.
First, if you pay in shares (as opposed to options) you immediately have a business partner whether you wanted one or not. Even as a minority shareholder, the consultant has certain rights within the company. Depending upon the class of shares issued and the presence (or not) of a unanimous shareholders agreement, the consultant may have the right to receive annual audited financial statements and the right to vote on certain key decisions — including the board of directors. And even if the consultant holds a very small percentage of shares and cannot impact the outcome of key shareholder decisions, the need to obtain his or her consent in writing, or to provide him/her with a chance to vote on the matter at a shareholders meeting, can be administratively cumbersome.
Another downside many entrepreneurs fail to consider is the ultimate cost of paying a consultant in equity. Offering 5% of the total shares of a company to have a desperately needed web site or App developed may seem like a cheap deal when the shares are issued and company prospects are uncertain, but that same 5% could be worth hundreds of thousands or even millions of dollars in the future. If you are betting your time and perhaps even life savings on your ability to create a valuable company – why sell that future cheaply now?
It is also important to keep in mind that when equity is offered in return for services, it is necessary to comply with the Ontario Securities Act (or similar legislation outside Ontario), which restricts the situations in which equity can be legally offered.
Best option is to pay cash
While offering equity to key consultants to extend an already stretched budget can be an attractive option for many business owners, as a general rule it is always cheaper and easier in the long run to pay cash whenever possible. And if you must offer equity to a consultant to achieve a strategic milestone for your business, you should do so carefully, thoughtfully and only with the advice of a lawyer.
A good lawyer can help you structure the deal in a way that makes sense by using specially crafted share classes, and/or a shareholders agreement, and/or share options that are linked to successful delivery of the promised services, and will ensure your arrangement complies with applicable securities legislation.