Whether you are an engineer, scientist, artist, developer, financial whiz or just someone with a useful asset, odds are you’ve been asked to join, help or participate in a startup company. If so, and you’re wondering what options are available to participate, this blog article is for you.
First, Evaluate Your Personal Preferences
Before I jump into the options available to benefit from contributing or providing cash, services, leads, knowhow, intellectual property or some other asset (collectively, “Contributions”) to a company, you need to ask yourself some questions. The answer to these questions will help you understand which options are right for you.
- Reimbursement? Do you want to be directly (or quickly) paid back for your Contributions, or are you willing to “donate” all (or a portion) of your Contributions for potential long-term gain?
- Risk Adversity? Are you risk adverse or otherwise concerned about liability attaching to you from the company? Is the company doing something particularly risky, or are you unsure of the other owners and want to be careful? (Read, What is Piercing the Corporate Veil?)
- Time to Devote? Are you able to devote your full-time attention to the company, or only part of your time, or no time at all?
- Visibility? Do you have other loyalties or perhaps are you employed by another company, and don’t want to create problems with someone else?
- Tax Concerns? Are you okay waiting to file your personal taxes until you receive a K-1 from the company? Do you trust the company to deliver K-1’s on a timely basis? Do you have other tax issues that could complicate the picture?
- Status of Contributions? Are you permanently handing over your Contributions to the company, or are you expecting your Contributions to be returned to you if you are no longer associated with the Company? Can the company license, transfer, create derivative works of, or sell your Contributions? Do you want the right to “buy back” your Contributions under the right circumstances?
Every person is different, and everyone’s goals and objectives are different. You owe it to yourself to be honest about your preferences and capabilities, and make sure you chose the right option that addresses your preferences.
Second, Determine the Participation-Contribution Ratio
The “Participation-Contribution Ratio” is a simple device I use to evaluate if the value of your Contributions is adequately compensated by the offered Participation.
When a company is asking for your Contributions, it’s likely the company is offering something specific in return (I’ll call this your “Participation”). In return for your Contributions, the company is offering some form of specific Participation in (or with) the company.
[Note: The word “Participation” is well-suited for certain arrangements (i.e. becoming an equity owner) and less-suited for other arrangements (i.e. giving a loan), but in the interests of limiting the length of this blog article, please bear with me.]
If you think about it, your Contributions have a certain “value” to you and to the company. Do you and the company value your Contributions equally? If your Contributions are cash, this is easy. But, suppose your Contributions are software or some artwork or a series of fictional stories and character development?
Ideally, the company will value your Contributions more than you do. Conversely, if the company doesn’t value your Contributions to the level you do, you may not have a good fit.
Participation, likewise, also has a certain “value” to you and to the company. If the company is a startup, and the Participation being offered is equity, it’s possible the “value” of this Participation is very low or even zero — and if so, the company is banking on the hope the company may increase in value someday.
The best deal for you, then, is where the company greatly values your Contributions more than you do, and where you greatly value the offered Participation more than the company does.
This is where the ratio comes in: Participation divided by Contribution. Because you’re the one doing the analysis, use your values for both Participation and Contribution. What is the result of this calculation? This is the ratio:
- Equal to 1? You have a fair and balanced exchange.
- Less than 1? This means the value of your Contributions exceed what you think is the value of the offered Participation. Not a great deal for you, and worse as the ratio approaches zero.
- Greater than 1? This represents a good opportunity. This is where the value of your Contributions Are less than what you think is the value of the offered Participation.
Therefore, the larger the Participation-Contribution Ratio, the better.
Third, Select the Option that Best Suits Your Personal Preferences and Maximizes the Participation-Contribution Ratio
The Participation-Contribution Ratio is important to understand, because while a company may offer you one form of Participation, there may be other forms of Participation that are more valuable to you or in greater alignment to your personal preferences. It’s also possible the company isn’t aware of (or hasn’t considered) other forms of Participation, and if you think it’s possible, then you should attempt to negotiate.
I’m now going to talk about some common forms of Participation, but it’s important to note that these are not all of them, and it’s possible to combine them or create hybrids. The possibilities are truly endless, and only limited by what you and the company are interested in contemplating.
Equity Ownership or Partnership
Equity is a common form of Participation, especially for startups. Equity means you are an owner, and the two most common forms of equity are “economic interest only” and “voting interest.”
“Economic interest only” ownership means you have absolutely no say in the direction or management of the company. You participate in economic and financial benefit only (if there are any). The problem with economic interest only, is that you need very careful “formation documents” to limit the powers of the management, and to make sure the management doesn’t do anything to create a conflict of interest in their decision-making with your economic participation. For example, if the management (or voting interest owners) want to pay themselves exorbitant salaries, there will be no profits to distribute to the economic interest only owners. Similarly, if management issues themselves additional equity or bonuses, your participation value will become significantly diluted and/or your economic interest worth very little. Finally, if your Contributions were not money but intellectual property or an asset, you may lose control of those Contributions if your agreement is not very carefully drafted.
“Voting interest” ownership means you can participate in the say and direction of the company, usually pro rata according to your ownership interest percentage. This is obviously preferred and therefore valuable, especially if you own a large percentage interest in the company and your vote carries weight. It’s a lot less valuable, and starts looking similar to “economic interest only”, when you own a small percentage of the company and your vote carries little weight.
Regardless of the form of equity ownership, there are significant pros and cons. The benefits include:
- Distributions and/or profit sharing may be taxed at a lower rate than your ordinary income.
- If the company increases in value over time, the value of your ownership interest may also increase over time (note this isn’t always true — if your ownership interest is diluted over time).
- Assuming you opt for equity early in the game, your returns will be greatest assuming the company increases in value over time.
- You could experience a windfall, if there is a successful “exit,” such as by going public or selling the company to a third-party.
There are some serious negatives to equity ownership, however, and it’s important you understand them:
- If the company is a “pass-through” entity for tax purposes, you must include a K-1 issued by the company on your personal taxes. This complicates your personal taxes, and if the company is late doing its taxes, it may make you late doing your taxes. This will increase the cost of your taxes.
- Note that “profits” do not equate to “cash to you” in many instances. Therefore, it could be possible you end up increasing your tax liability due to the pass-through profits of the company, yet the company has made no cash or distribution payments to you.
- You can be subject to personal liability, if the company does (or any of the other owners do) something stupid. Personal liability can attach to equity owners under the legal doctrine of Piercing the Corporate Veil.
- Remember that most new businesses fail. Therefore, it’s probable you will not receive anything for your Contributions if you haven’t been paid for them.
- Your ownership interest is subject to dilution, as it brings on new owners. This will decrease the value and percentage ownership interest over time.
- If you don’t want anyone to know you have an ownership interest in the company (i.e. you have an employer or competitor), and the company is not “anonymous”, your name and information may be required to be published with the Secretary of State. You can avoid this, if you form an Anonymous LLC to represent your ownership interest, but expect the company to be concerned your entity doesn’t jeopardize its tax status, if the company is taxed under Subchapter S.
If your Contributions are anything other than cash, and you have any expectations whatsoever in regards to how your Contributions are handled or may be returned in certain circumstances, you will need the proper documents to ensure this happens the way you want.
Option to Acquire Equity Ownership or Partnership in the Future
This is very similar to the above Equity Ownership, except that instead of obtaining equity immediately, you have the “option” to obtain equity later. By so doing, you have an opportunity to determine the competency of management, whether the company moves in the right direction with respect to your values and expectations, and more.
This option has the same advantages and disadvantages, but allows you to moderate or control the impact of those advantages and disadvantages.
Therefore, the advantages of an Option to acquire an equity ownership (over just taking equity from the start) are:
- Reducing the chance of personal liability
- Delay having to deal with K-1s and more complicated personal tax issues
- Less headache dealing with a new company
- Reduced risk of loss
But, there are a few disadvantages utilizing an Option, versus obtaining equity early:
- First, you need to be careful about the price you pay when exercising the option. If you pay a discounted price, you end up with “ordinary income” associated with the difference between the fair-market value of your new equity and what you paid. For private companies, this means you get a piece-of-paper, yet have to pay real-money taxes on that difference.
- Similarly, because you become an owner later, you don’t experience as strong of a gain, assuming the company increases in value over time.
- Finally, what the company looks like when you want to exercise the option could look very different from when you first negotiated your Contributions and the company’s offered Participation. You may end up with a lot less than you anticipated.
Option to Purchase with Conversion Option
This is a variation of the “Option to Acquire Equity Ownership or Partnership in the Future”, and can potentially reduce risks.
A “Conversion Option” gives you the right to say, “I don’t want equity,” I want to get paid instead. Basically, you have a document that entitles you to either demand some equity or demand some specific payment, or a combination of both.
While this may sound like a good approach, the problem is, it’s only helpful in the scenario where the company is successful (and therefore can pay the amount owed), but you just for some reason don’t want the ownership. In other words, this option doesn’t actually guarantee payment — if the company cannot satisfy its debts.
If your Contributions were other than cash-based, you might consider a lien or security interest on your Contributions or otherwise be very clear in your contract the status of your Contributions so that you protect them as appropriate to meet your expectations.
Loan to Company or Purchase of Your Contributions
Another option, instead of obtaining an ownership interest in the company, is to simply get paid for your Contributions. You can do this as a loan, or to get paid up front (assuming the Company has the money).
This could be as easy as a vendor relationship to the company, where the company is paying you as appropriate for your Contributions. Or, it can be somewhat complicated, where you provide your Contributions now in return for a promise for future payment.
If you elect future payment, you need to be careful. You want to consider some form of either promissory note or security interest agreement or both. You want to protect your Contributions, especially if they are assets that you intend to have returned to you. You also need to be careful if your Contributions are subject to loan payments or otherwise have a lien on them. You will want to be able to ensure loan payments are being made, or that your Contributions are being used or utilized in the right manner without breaching any Notes.
Fourth, Make Sure You’ve Done Your Due Diligence and Entered Into the Proper Agreements
Assuming you’ve figured out the approach you want to take, you need to conduct some due diligence and make sure you have the right agreements in place.
The possibilities are endless, but let me give you some general rules-of-thumb.
First, if you are considering any form of equity, then you really owe it to yourself to have an attorney review the “formation documents”, so you know what you’re getting and that you’ve checked to ensure the right checks-and-balances are in place, that management cannot create conflicts-of-interest, and more.
Second, remember that equity ownership means partners. This could become as serious to you as a marriage, but more expensive and harder to get out of. Be sure you like and respect the other partners. Really try to evaluate the partners, and make sure to Avoid a Narcissistic Partner.
Third, if your Contributions are anything other than money, and you have some expectations on how your Contributions will be used or treated, then you owe it to yourself to inspect where and how those Contributions will be used. How easy will it be to recover or reclaim your Contributions? If Intellectual Property, how can you control or manage derivative works?
Fourth, you really need strong contracts in place to represent your Participation. DO NOT RELY ON VERBAL PROMISES. They are meaningless. Furthermore, without a strong contract, what is promised to you today can change over time — legally — without your ability to do anything to protect yourself. For example, they can promise to pay you royalties on your intellectual property, but unless you define derivative works and “reverse engineering,” the company could create its own IP in the future and cut you out of future royalties.
Finally, fifth, remember that cash in your pocket today is valued differently than cash in your pocket in the future. This is called the “future value of money.” Don’t expect to get paid the same today, as you expect to get paid in the future. Getting paid today is very valuable to you, but very costly to the company. Conversely, it’s much more appealing to the company to promise to pay you in the future, versus having to pay you now — so the company will negotiate better payment terms for you if you can wait.
Use the comments. Do you have other ideas of Participation? Do you have other suggestions?
Law 4 Small Business, P.C. (L4SB). A little law now can save a lot later. A Slingshot company.
