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TROYHENIKOFF
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Paying for Services with Equity

February 11, 2020

Transcript

Welcome back. In the last couple of weeks, I've had the same question asked multiple times. Seems like a great opportunity to do a video. So I've had a couple of entrepreneurs who have asked me about how they facilitate paying for services from a contractor with equity instead of cash. You see, as an early stage business, many times you have more equity than cash and it sounds really attractive. And at the surface it is. The problem is that you have more equity than cash.

have to align expectations. And too many times these deals are done for a fixed amount. For

example, if someone wanted to build my website and said, oh, I'll build your website for 2% of

your company, that may sound like a fair deal, but actually neither side is happy in the end

because I always want more for my website. I always want more and more and more and more.

And the contractor who built it, they felt like, whoa, I already did all my work. I only got paid

2%. You can't keep coming back to me for more and more. And it creates tension. So I have a secret

I want to share with you as an interesting way that you can go to build this services for equity

transaction that is completely fair, has consumerism, and even the IRS likes it. Let's

take a look. Let's go to the whiteboard. Let's assume that you have a company and a contractor.

The contractor is going to build the website, and we don't know how much the website's going to cost,

and we don't know how much equity to give for the website.

So what happens is the contractor does a bunch of work and then sends over an invoice.

And they send over an invoice for the initial work, and let's just say that it's $2,000.

They send over another invoice, and when they send over the invoice, that one might be for $1,000.

Doesn't matter.

At some point the project is finished and when the project is finished we have a total amount that the company owes the contractor.

Sometimes you think the project's finished and it's not actually finished.

Oh we got some more work to be done so another invoice comes over for $500.

We now have a new total. This can keep going on and on.

The agreement between the two is I am not going to pay you the cash.

I'm going to hold on to the pile of invoices.

Now, at the time that I raise my first round of financing, that's when we'll settle up.

And here's how we're going to settle up.

The company is going to write the contractor a check for the amount owed, in this case $3,500.

But at the same time, the contractor is going to write the company a check for exactly the same amount, $3,500.

No cash, actually, net cash changes hands.

And the reason for doing this two transactions is the first transaction was to pay for the invoices.

The second transaction was the investment in the company.

You see, this $3,500 turns into stock.

And guess what?

The contractor got exactly the amount of stock that is proportional to both the amount of work done

and the price that was paid by the other investors.

It's perfectly fair.

Two other really interesting things have happened here.

The first is that there is a record of the work done by the contractor for the company.

That actually shows up as revenue on the income statement.

And it's really important that that check exists.

The other thing that's really important is there is a record of what the basis or how much the contractor paid for that stock

so that they will only pay capital gains on what's above it.

the IRS thinks of this as totally clean. So at the end of the day if you want to

work with contractors in a way where you pay them equity for the work performed

I suggest that you set it up that they bill you for the actual work performed.

You then have to make a consumer decision. Do I want more work done? Oh that's going to cost

me too much money. No I don't. Yes I do and you will decide exactly how much work gets done

and have control over what the total is.

In that next financing,

you do an exchange of the same amount of money you owe them

and then they write it back to you.

The check to them was to pay for the revenue.

The check back was to buy the stock.

In the end, they get the stock.

The net is $0 changed hands.

They've worked for equity.

They've gotten exactly what they deserved.

I hope this is helpful.

Often times early-stage businesses have more equity than cash, which begs the question, can I pay contractors with equity? Check out today’s MATH 101 for Troy’s tips for building a services for equity type transaction that is fair for both parties, and even the IRS likes it!

15 Comments

  • Linda March 7, 2021
    Does this arrangement get listed on the cap table?
  • Troy Henikoff March 7, 2021
    It only appears on the cap table after the equity transaction (where the vendor writes the check to invest). Prior to that it is strictly an Accounts Payable on the part of the company. Then once the payment is made to the vendor (it comes off AP) and they write the check back to invest it appears on the cap table as any other investment.,
  • Dana Todd March 18, 2021
    What kind of contract would be recommended for both parties to feel good entering this kind of agreement? Is it a simple one, or one that’s more complex like an investment agreement?
  • Troy Henikoff March 18, 2021
    Dana, When I have done this, it was a simple one page agreement that says the vendor will issue the invoices and it is understood that the company will hold them (or a portion of them, depending on the percentage you agree to) and not pay them until the next financing round or 12 months whichever comes first. It then describes the payment of the invoice and the investment in the round. All the legal work of the investment details are in the investment docs that are part of the round. That way every investor has the exact same terms, etc.
  • Kenneth Obel May 25, 2021
    Nice video, Troy. I would add one comment on an issue that you did not raise: This transaction involves a tax obligation for the contractor – the $3,500 technically paid to her or him is reportable compensation. It’s not the company’s obligation to pay the tax, however, the company might have an obligation to issue a 1099 to the contractor and file a copy with the IRS (if the amount meets the threshold, the payee is an individual or an LLC, etc.) In our practice, we find that entrepreneurs and their contractors overlook the need for the taxes to be paid and appropriate tax documentation to be filed filed when paying for services with equity or other securities. It’s a bigger issue for the company when the recipient is an employee, because in that case, the company has a withholding obligation on the amount paid and must cover its share of payroll taxes as well. Failure to do so can result in interest and penalties. File the 1099, pay the taxes. NOW the IRS is happy.
    • Troy Henikoff May 26, 2021
      Ken, You are 100% correct – I assumed that since the company paid out the cash (which then was turned around with a separate check to invest in the company) that the 1099 would be automatic. YES – the cash payout needs to be reported even though it is coming right back!
  • Victor May 26, 2021
    Thanks Troy! Super helpful. I have found that contractors typically like to base the compensation/equity on the previous round’s valuation or somewhere between the previous and the next round. What benefit would the contractor gain by waiting until the next round and pay the same price as other investors when they are taking the risk now?
    • Troy Henikoff May 26, 2021
      The price is a negotiation point, it all depends on timing. If the last round was two years ago and a financing is coming soon, makes more sense to tie to the new funding. If there is no pending round, maybe a vendor would be sophisticated enough to try to tie to last round, or could have a cap on valuation. All depends on who you are dealing with…
  • Vlad Filippov November 8, 2021
    Hi Troy, thank you for the quality content! Can the convertible notes be used to pay for services in this case, or is it not advisable?
    • Troy Henikoff November 8, 2021
      YES! What I outlined was effectively a convertible note, but if you want to make it more formal, then you can basically pay for the invoice they send you with a convertible note – it is just moving a sort term liability (A/P) to a longer term liability (convertible note). I see nothing wrong with that at all!
  • Ada November 8, 2021
    Would the contractor need to be an accredited investor for this to work?
    • Troy Henikoff November 8, 2021
      GREAT Question! It certainly is clean if the contractor is an accredited investor, for sure. There are exceptions for people who have significant familiarity with the business (think of employees that exercise stock options for example) you should DEFINITELY talk to a lawyer about whether a particular contractor qualifies or not. (and I am not a lawyer and cannot give legal advice!)
  • Matt Wolf November 9, 2021
    Hi Troy, thanks for making this video on an often-discussed topic. What if the company doesn’t succeed in raising a round of financing? Shouldn’t the agreed-to converted amount be greater than the actual cost of the services delivered in order to compensate for risk (that the company doesn’t raise a round)? Would appreciate your thoughts on this. Thank you!
    • Troy Henikoff November 9, 2021
      Yes, I agree with you (this is why convertible notes/SAFEs almost always have a discount) – So, for the more sophisticated vendors, you will likely have to structure it like a convertible note/SAFE with a discount, and maybe even with a cap on price. I was trying to keep the concept simple but have definitely seen it act much more like a conventional note with a discount and a cap… Thanks for bringing this up!
  • Alex Harrison February 27, 2024
    This is pure gold.

Comments are closed. These were carried over from the original post.

Originally published on the MATH Venture Partners blog.