Disclaimer: This is not meant to be a comprehensive post just some things to consider. Always consult a lawyer and accountant before making decisions related to equity. Don’t take our advice, we’re developers not lawyers.
A friend of a friend comes up to you and wants your help. “We’ve got this new startup, we’re early but showing positive traction. We need your help to get us to the next level. We’re broke, but we can slice you off a chunk of equity in exchange for advisory/consulting services. Interested?”
The company sounds intriguing and you’re willing to throw the dice. If you don’t have experience taking on equity, there are a few things that you should consider.
Investing in a good startup lawyer & accountant
Taking equity is complicated. Find a good lawyer (we love ours!) and accountant and make sure you talk to them. Spending the additional time and money up front can pay dividends (pun intended) down the road.
You should check with a lawyer to see if you are able to take equity. Check your accredited investor status and note that there are specific securities regulation exemptions based on the state in which the company you are investing in must comply with. However, most states have exemptions for offerings to a small number (< 25) of people and also for employees/consultants exchanging goods or services.
A common misconception is that there is no cost when taking equity. If you are being issued shares or a membership interest in a company, you will need to declare the value and pay taxes on it. If the company is early stage, then the value should be nominal. If the company has already raised funding (even from friends and family) or is generating revenue, then it may be greater than you expect. The company should be able to provide you with the valuation for any equity they issue to you. There are also additional costs related to legal, accounting, time, and effort to consider as well. You don’t want to do all this work and then have a $40,000 tax bill from the equity down the road.
Vesting / 83b
If the equity you are receiving vests over time, it is important to consider filing an 83(b) election. Filing an 83(b) within 30 days of receiving your equity can allow you to pay the taxes on the full amount issued to you up front rather than as it vests. This prevents the large tax bills that would arise if the company’s value increases sharply prior to being fully vested.
Equity vs. options
One possible way to avoid initial upfront taxes is by receiving warrants or options. By setting the strike price of the warrant equal to today’s market value, the warrant essentially has no value today. Only when the option is exercised (and the value of the underlying equity is greater than the strike price) do you earn and pay taxes on the difference. The downside is that you will have to pay a full tax rate on your profits when you exercise the option (as opposed to a much lower capital gains rate if you had taken equity).
How much equity should you receive?
This is always a tough question. You don’t want to take so much so that you are limiting the companies ability to raise money or attract future employees. If you are not a full-time hire, don’t expect to get more than a percentage point or two (and typically much less). Try to value your services as a cash rate and compare that to the value of equity you are negotiating. Make sure to discount the value you assign to the equity in this calculation to account for the many years it will likely take to become liquid and the very high risk that it never will.
How do you earn money on your equity?
The most common cases will be when a company has an IPO, is acquired, or raises a round of financing where the founders take money off the table (sell their equity).
If the company is an LLC, then typically any cash the founders take out needs to be distributed equally among its members (i.e. you would earn a percentage of the distributions). LLCs can be really flexible though and it is possible for the majority owners to change this. Be aware that if you are a member in an LLC, you will have a tax obligation on the profits/losses they record (they need to issue you a K-1 at the end of the year that breaks down your share of their profit or loss) so at bare minimum you should ask that the company covers, via cash distributions, your tax obligations on profits recorded.
Most companies provide specific language in the company shareholder or operating agreement limiting your ability to sell or transfer your interest. However, most often, you can ask for tag along rights (if the company sells shares, you can opt-in to selling the same percentage of yours) and they will request drag along rights (you can be forced to sell when the founders do). As a minority holder, it is unlikely you will receive any preference or other rights, and this is probably best for both you and the company. You should read and understand the shareholder or operating agreement of the company to understand your rights.
Expect to be diluted alongside the founders in any fund raising round. If you own 1% and the company issues a 20% stake to a group of investors in a funding round, your stake will be diluted to 0.8%. Most tech companies raise multiple rounds of financing with a 20-30% dilution each time: earlier rounds being typically more dilutive, and later rounds being less so. Also expect investors to get anti-dilution protection and liquidation preferences. The former could end up massively diluting your stake in the event of a “down” round, and the latter could prevent your stake from having much or any value in a distressed exit or “soft landing” scenario.
Is it worth it?
The harsh reality is that most startups fail and it is unlikely that your equity will be worth something. If you really believe in the team and opportunity, then go for it, but don’t expect to see a huge windfall. TechCrunch pins the average tech company acquisition at around $200 million, but we’d guess the median is in the low tens of millions—for the 10% of companies that return at all. In most cases cash is king and unless you are building a portfolio, you may be better off offering your services at a discounted rate or with deferred (post funding) compensation.