Service for equity deals can be great for both parties, but you need to understand the risks and have a structured approach.
Right now, we’re in the process of cleaning up another agency’s poorly executed service for equity deals. Unfortunately, we see this all the time. Because they didn’t have the right advice while structuring their deals, nor a standard approach to executing them, it may cost them a lot more in taxes than anyone had ever anticipated.
As many agency owners know, these deals are just part of working with start-ups. Everyone knows that cash is king, but sometimes you have a great project from a promising company that is too good to pass up. It’s even better if you’re in a lull between projects.
When accepting a service for equity project can be smart:
The project is discrete: To both minimize the potential tax burden and vesting complexity it’s important that the project has clear deliverables and a short, defined time parameter. Pragmatically it helps you move through a project lull and back to cash generating projects
Founders are sophisticated: Equity deals are complicated. If you’re working with an unsophisticated founder you’re more likely to negotiate a bad deal that may result in higher taxes and will cause future headaches
The company is pre-angel investment: This will help limit the valuation of the equity you’re receiving. But, most importantly, a start-up with funding should be paying you in cash (or at least mostly in cash)
So, you want to move forward with the deal…
A lot has been written about these deals from the start-ups perspective, but they rarely consider the risks and needs of the agency. In almost all deals the agency is committing real cash, via payroll and taxes on phantom income. Plus, you’re committing to being a shareholder in an early stage start-up.
Here are some important considerations for you before charging ahead.
Invest in a good lawyer & accountant. We, and good business attorneys, see these deals all the time and can help you quickly reach a good deal (or tell you to walk away)
Consider the costs. It’s a common misconception that service for equity deals are free. But, because you’re being given something of value the IRS expects you to report income. Additionally, if you’re vesting in your equity and don’t file an 83(b) election with the IRS, your tax bill can grow exponentially if the value of the company rises. Finally, you need to consider the costs you’re going to incur servicing the work
Figure out how much equity you should receive. How much you could expect to receive depends a lot on the nature of the relationship. For example, is it a quick design project, a custom-built app or a long-term marketing relationship? Regardless, you don’t want to complicate their cap table and limit their ability to raise money. Expect between 0.25% and 2%. It’s important to structure your services based on these expectations
What type of equity should you ask for. Most deals should be structured as common stock (or units in an LLC). It’s simple, it doesn’t complicate the cap table. If you’re going to have an extended engagement; stock options or vesting profit units can help manage your tax bill. This is where working with an attorney is critical
To vest or not to vest? Too often agencies accept multi-year vesting schedules or vesting based on hard to verify benchmarks. Unless you’re asking for a lot of equity or promising certain outcomes this just complicates everyone’s life. For a short-term project for little equity you should try to receive the equity as soon as you deliver the final project
Assign a value. We’ve seen a number of agencies claim, in their SOW, that their price is 20 – 30% higher in a service for equity deal than if it was a cash deal. Their idea is they will get more equity by doing this. But, you usually just end up with a higher tax bill. Often, you can expect to get around half the equity for your fees than if you had invested cash. To manage your tax bill, it’s critical to work with your finance team on structuring the scope appropriately for the equity you receive
Take a long-term approach. If these sorts of deals are appealing to you, it’s important to set up the right structure. One service for equity deal is unlikely to pay off.
If you find the right channel you can build up a portfolio of investments that have a better chance of paying off. The key is getting enough deal flow that you can quickly slot in a service for equity project during slower periods.
The other aspect is working on a standard approach with your attorney and accountant. In a sense, being able to come to the table with solutions and a defined way of operating. This will allow you to work through these deals quickly and cheaply.
*Important Disclaimers & Considerations: The above information is based on my own experience in working with our clients’ service for equity transactions but is not representative of every scenario out there. To be sure of what is right in YOUR situation, be sure to consult with an attorney and finance team.