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October - 2000 - issue > Legal Advice
More Valuable Than Cash
Sunday, October 1, 2000

There’s a new type of legal tender in the marketplace that is an outgrowth of the new dot-com economy, and it’s being used in nearly every type of industry from retailing to insurance. Companies are using their own stock or promise of stock instead of cash to pay for everything. From rent deposits to legal fees to headhunter fees, these deals have become a standard in the high tech business. Put three service providers and one tech company in a room together and the question is invariably asked, “Have you begun accepting equity for services?” More and more the answer is “yes.”

It’s long been a practice for companies to use stock options as a means to attract and keep senior employees. But it has been the advent of the fast-moving dot-com companies who are looking to get to market as soon as possible who have learned to use equity as a valuable tool. They use equity to lure senior employees from established organizations to join their startups for a fraction of their former salary. They use equity to retain employees in a competitive job market that is unprecedented. They use equity to motivate employees to meet important product development milestones. The fact that these shares could shortly be worth 20 to 100 times their pay-in is a powerful motivator. And now these high-tech executives, no fools they, have reasoned that equity could also be an effective currency outside of their four walls.

And a more receptive market would be hard to imagine. Long have attorneys and other service providers helped shape startup companies, but then sat on the bench and watched as their clients hit the jackpots. By taking equity in lieu of partial or full fees, companies create partners in their businesses. Partners that have vested stakes in seeing these companies succeed will go beyond the call of duty to see that they do. And these tech companies, most of which are startups (i.e., cash-poor), can conserve their dollars and provide a currency that many find more valuable. In many cases, vendors will value one dollar of stock at a higher valuation than one dollar in currency. And while the odds do not favor the company becoming the next Yahoo, all it takes is one hit to erase many prior mistakes.

But proceed with caution. Companies considering the use of equity as payment for services need to be aware of the issues that can result from this practice.

Startup Perspective

Here are a few things to keep in mind if you’re the startup in this situation:

Guess who’s in your khakis? Are your new partners going to be on your back every time a key decision is being made? Are you creating a new group of Monday morning quarterbacks to critique your business decisions? Will they be able to dictate who you use for other services? Will they let you run the company as you see fit? Although most vendors will not receive sufficient equity to exercise control of the company, that doesn’t mean they will behave accordingly. Address these issues early on in the transaction.

Whose side are you really on?

If your attorney or consultant suddenly has a financial interest in your company through the use of equity as payment for services, the reality is that it may be more challenging to be impartial and objective. A consultant’s fiduciary responsibility may be impaired by their personal involvement. For example, if you hire a professional advisor to help study a potential merger with another company, the consultant’s opinion might be clouded by the immediate gain of the merger offer rather than helping the company grow. A consultant interested in a short-term personal gain might overlook what might be beneficial for your company in the long term.

You want how much?

Once out of the realm of dealing with cash, many vendors grow fanciful as to what equity deal they can command. Their argument is that there is risk involved and therefore it should be worth more in equity than in dollars. Although smart tech execs know they will become significantly diluted in their ownership as time progresses, there is no reason to hasten this process. When negotiating an equity-for-services deal with a vendor, convert the total package into dollars using the most current valuation of the equity. In that way, you know the scope of the deal you may be entering into. Vendors entering into these transactions need to be cautious as well.

Vendor Perspective

Here are the issues on the vendor’s side:

Taxation without monetization

Even though you received equity instead of cash for your services, don’t think for a second this was a tax-free transaction. Be serious. There was a value for that stock and Uncle Sam and Gray Davis both want a share of it. And while equity is a valuable commodity, you can’t pay your taxes with it (yet). You’ll need to come up with hard cash. They’ll want even more once you exercise your warrants and will get one more cut once you sell your shares. An advance call to your tax consultant would be in order.

What do you mean I can’t sell my equity?

Because this is not legal tender currency, your equity is worthless as long as the company remains a private company. And even after the company becomes publicly held, there are restrictions placed on these arrangements as to when they can be sold. The worst case would be to watch your piece of equity skyrocket on opening day and then crater, knowing you are powerless to reduce your loss. There are sophisticated equity techniques such as collaring and derivatives that are available in some cases to preserve equity, but in controlling the downside risk you give up some upside opportunity.

When you throw enough against the wall, sometimes all you get is a messy wall.

Not every stock is going to hit. And by believing in the “throwing enough against the wall” theory, it’s more likely that you will end up with stock certificates that might only have practical use in covering that messy wall. To avoid real losses, vendors need to take their money off the table. In other words, never enter into deals that are all stock. At least cover your costs and overhead with good old-fashioned cash. And a little research into whether the deal is worthwhile would be advisable. Does the valuation make sense in today’s market? Is the company offering a sustainable product? Some old-fashioned due diligence still makes sense in the new market.

As the Internet economy continues to evolve, companies will be faced with new and unexpected opportunities, which may change the way they do business. Not every scenario will work for every business. However, as the dot-com investment mentality becomes more widespread, it appears more people will be willing to trade their services for a piece of the high tech pie.

Jeff Ong-Siong, CPA (jongsiong@corp.siliconindia.com), is a partner at RBZ, LLP, specializing in the hospitality, manufacturing and distribution industries. Steve Cleland, CPA (scleland@corp.siliconindia.com), is a manager in the general accounting and auditing department.

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