Wouldn’t it be great to paint some walls for a hot new startup and get paid in stock instead of cash?
That’s exactly what David Choe did 10 years ago. He painted Facebook’s headquarters in Palo Alto and received stock, which today would be worth more than $1 billion (based on its current value of $76/share).
Wow! $1 billion for painting walls. Where do I apply?
Of course, this may not happen to everyone. David Choe was an artist who painted erotic murals at the request of Sean Parker, the notorious founder of Napster who was then Facebook’s President. Apparently, the universe wanted David Choe to receive a big pay off.
But maybe the next big payoff could be yours!
Maybe you know a hot new startup. Maybe they need your services. Maybe they will make the same offer to you that Facebook did to David Choe. You could get paid $60,000 in cash or in equity. What would you do?
As great as that sounds, David Choe won the lottery. Most service providers who take stock or other equity don’t get that big of a return, if they get paid at all. The big problem is not just that the stock could be worthless, but they don’t always get stock. Or if they get stock, they get hit with a huge tax burden that forces them to sell the stock immediately in order to pay the IRS.
The Basics of Investing
If you are thinking of swapping your services for equity, you need to understand some of the basics of investing. Whether you are investing your time or your money, the same principles apply. What many service providers don’t realize is that they are doing the same thing as venture capitalists, except without the training or experience.
When a venture capitalist contributes their time or money, the first thing they do is what’s called “due diligence“. Due diligence means that they have taken the time to investigate the company, its founders, its organizational structure, its market, its sales, its finances, and a hundred other items that appear on their due diligence checklist. It is by going through this process diligently that they then decide whether or not to make an investment.
And venture capitalists have a portfolio of companies. So, if one company does not pay off, they have many more that will. They do not put all of their eggs in one basket nor do they devote a significant portion of their assets to one investment.
Put on Your Investor Hat
If you want to take equity in start-ups, then put on your investment hat. You are the venture capitalist or angel investor. Take care to invest your time and services wisely so that you can get the big pay off. If you want to get lucky, play the lottery. The cost of a lottery ticket is much lower than the value of your time and in many cases the odds of winning are just as good.
As an investor, you need to do your due diligence. You wouldn’t believe how often I see service providers who contribute tens (or sometimes hundreds) of thousands of dollars in services but have not done any research on the company. Often they are afraid to ask for a “cap table” because they think that would be asking for too much information or it might offend the company (and sometimes it will, for good reason).
Forms of Equity
If you decide that betting on a start-up is better than betting on the lottery, then you need to know a few things about equity. First, not all equity is the same. Stock options are popular, but options just give you the right to purchase stock; you do not actually own any stock. The biggest problem with stock options is that they may expire when you leave the company, or they may require a large cash outlay when you need to exercise them, or they may subject you to hidden taxes or tax penalties when you later file your tax return.
Instead of options (or other forms of quasi equity), I generally recommend that service providers ask for “restricted stock” or “founder stock“. Restricted stock is real stock that you receive at the time you provide services or sometimes even before you provide the services. These shares are “restricted” because they are typically subject to restrictions on their sale or transfer. The advantage is that you actually own shares of the company and you have the right to vote your shares.
Show Me the Money
So, if actual shares of stock (or membership interests) are the way to go, why are they so seldom offered? Taxes. If you ask the company why they don’t offer you restricted stock, they will simply tell you the reason is taxes. Although, there may be other reasons. If you receive restricted stock for services, you will have to pay taxes, but this is okay. For some reason, people assume taxes are an insurmountable problem. The truth is taxes are not the problem. The real problem is value.
If the company offered to pay you $100,000 in cash, no one would object to paying taxes. But if the company offered to pay you $100,000 in stock, then no one wants to pay taxes. Why is that? Perhaps because either you or the company are not convinced of the stock’s value. Yet when venture capitalists buy stock, they have no problem paying cash. Why? Because they have done their due diligence and they believe in the value of the stock.
Creative Solutions
There is nothing wrong with paying taxes when you receive stock. If the stock later proves to be worthless, you get to deduct the tax loss. However, there are a number of other creative ways to deal with taxes. One way would be to have the company pay for your services partly in cash and partly in stock so you have money to pay the taxes. Another way would be to have the company loan you the money needed to pay taxes. Or if the company was feeling generous, the company could pay your taxes as a bonus.
And for your part, don’t undervalue your services. If you believe your time and services are valuable, then you should expect value in return. The only way to be sure the equity you receive for your services has value is to put on your investor hat and do your due diligence. If the company has value, then why not pay the taxes and actually receive ownership in the company. Who knows, you could be the next David Choe.
Roger Glovsky is a business lawyer who believes legal documents should be accessible, affordable and comprehensible. As author of ContractsGuru.com, Roger coaches business owners how to draft and negotiate their own contracts through workshops, teleseminars and online programs. As founder of LEXpertise.com, he plans to make it easier for business owners to find the right legal documents when they need them. Originally from Massachusetts, he now lives in Boulder, Colorado.