Working for equity

[SecondCor521]

Hi all,

Looking for input here. I'll provide the basic facts and then hope to get comments and input. I'll try to check back to answer any questions, too.

I have been working as a software engineer for the past two months developing a new product for a small startup (~20 employees + ~4 contract engineers). I am actually a W-2 employee of a contract engineering company and the startup is the contract engineering company's client.

The R&D director -- my effective boss as the startup company -- is somewhere between pleased and very pleased with my performance: my product has always been on schedule, organized, documented, and has more features and higher quality than they expected. I have worked with the R&D director at two previous companies and trust and respect him.

According to the R&D director, the CEO of the company wants the company to be cash flow positive in fiscal Q1 2009 (calendar==fiscal in this case). His rough plan seems to be to have the 4 contract engineers finish up the new products we're developing and testing, then lay us off ASAP to minimize the cash outflow, then sell the products like crazy to generate cash income.

I like the company, I really like the people I work with, I really like the guy I work for. I think the company has a pretty decent to good chance of survivability and even prosperity in the future.

I've raised the possibility of working for equity to the R&D director, who has briefly discussed it with the CEO, who apparently is willing to seriously consider the idea.

The company is privately held, has completed first round funding with *I think* an 85-investor consortium from a well-respected private equity group. The company is cash flow negative right now, obviously, but the product I'm actually working on could make them cash flow positive by itself (independent of the products that the other contract engineers are finishing up). They're looking for second round funding or angel investors but obviously in this climate people are not particularly interested in buying private stock in small startups. They were founded in 2004 and have a patent portfolio.

Their first rough idea was to pay me what the contract engineering company is paying me in terms of dollars, but then actually pay me in stock instead of greenbacks. This seems like a lousy offer because the company is wanting to pay me in something that has a definite risk of being very expensive toilet paper (let's discuss the idea that greenbacks might become toilet paper at some point in other threads), not to mention that they're currently paying 50% more than that to the contract engineering company (to cover employer half of SS taxes, my benefits, and the profit margin for the contract engineering company)

What should I think about? What are the gotchas? Any experiences to share?

Things I've sorta thought out to myself:

+ Need a risk premium for accepting equity instead of cash -- perhaps on the order of 50%?
+ Seems fair to split some of the overhead of the contract engineering company.
+ Do I have the cashflow to support myself while doing this?
+ Which is a better path: spending my time working for them "for free" vs. looking for another job?
+ This situation may cause the company to be put into a situation of having implied a job offer - legal theory of justifiable reliance if things don't pan out well.
+ Private company means hard to value stock. Also illiquid.
+ My contract engineering company would have to agree to let me do this. I'm pretty sure they would based on previous conversations I've had with them.
+ Conflict of interest and/or friction between me and the other employees being an investor and an employee?
+ I've been working hard for them trying to get on full time. Do I work even harder to prove even more that I'm worth hiring? Do I slack off now that they're clearly thinking about treating me in a very utilitarian way? Keep at the same level of effort (I vote for this choice)?

Thanks for the input, I know you folks will give me good things to consider.

Ask any questions and I'll answer them when I can.

2Cor521

 

[NW-Bound]

Well, I've got stock certificates of two private companies that have gone defunct, after burning a few million dollars from investors. One thing I did right was that I did not use my own money to buy even more equity in these companies, as they tried to talk me into it (red flags raised!!!). The loss of my sweat equity was bad enough. We had patents, but it cost couple of megs to defend them. Oh boy, this brings back bad memories, I'd better stop.

Don't let me persuade you, because who would know if any of these wouldn't become something meaningful?

PS. How about a compromise? 50% in cash, so you have something to live on, and 50% in equity, since you seem to believe in their future. I always try to be in a position where I will turn out to be 50% right, rather than all wrong.

 

[Rambler]

Well, even if you work for equity you will have to pay SS and income tax (been there, done that, company went under a few months post-Rambler). Cashflow issue again if you are working for all stock and have no place to sell it (illiquid). Whether you work for cash or for equity, you will be employed, or you will have to come up with some kind of service-in-kind contract (if an employment relationship is undesireable by one or the other parties). I don't think how you are being paid would create friction with other employees, unless the risk premium they are paying you is extremely large...but as an owner, you could always say "care to join me? I live off my savings and work here just for sweat equity." I think that would shut them up quickly enough. By the way, I would not accept a dollar per dollar trade for equity. I think the risk premium should be on the order of 100-200% or more while the company is in startup, but the risk premium should be given in some form of option or warrant, I think...otherwise the taxes will eat you alive. Reason for the high premium is because you are creating the product they will sell for millions, their stock is illiquid so in effect you are lending them money and paying tax on it from your saved funds. And you don't know if you will ever recover anything. Also, you will want to understand very well how they value the stock, so that they do not arbitrarily assign an unreasonably high value to it. I have experience valuing profitable companies, but have never attempted an unprofitable company, so I can't really provide advice on that. Finally, just ask yourself (and answer honestly) if you can afford to lose a year's wages, plus SS and income tax, plus your own support, plus your child support pmts, if this venture goes south. On the other hand, ask yourself if you are prepared to take the risk of such a loss if the probable reward is millions in an IPO a few years from now...only you can answer those questions. Good luck 2Cor.

R

 

[Nords]

This is a fascinating question and potentially a very good thread. No offense intended with my "what if" questions, but I'll raise some issues that are frequently used to evaluate startup investments. Hopefully this will be perceived as a financial assessment and not an interrogation of anyone's credibility (or gullibility).

I have worked with the R&D director at two previous companies and trust and respect him.
I like the company, I really like the people I work with, I really like the guy I work for.
I think the company has a pretty decent to good chance of survivability and even prosperity in the future.

How well you like, trust, and/or respect these people has very little to do with a company's financial prospects. It's better than working with Jeff Skilling or Chainsaw Al Dunlap, but other than (probably) minimizing criminal behavior your feelings for these people don't have anything to do with their performance.

Are they any good at what they're supposed to be doing? Do they have a startup track record? Previous exec experience? Have they ever had to survive a crappy recession before? How did the R&D guy influence the success of the other two companies? Have the current execs found other ways to keep the company going (or to reduce the burn rate) without [-]eating their seed corn[/-] laying off the very people who are arguably responsible for the putative revenues? Is this their last resort to "save the company" or is it considered to be standard practice? Have they previously crashed & burned to learn from their experiences, or has earlier success in a booming economy left them blissfully ignorant? You don't want to be the fodder for their next learning experience.

I've raised the possibility of working for equity to the R&D director, who has briefly discussed it with the CEO, who apparently is willing to seriously consider the idea.

Here's the devil's advocate version of that scenario:
"Free labor for company shares? Gee, I dunno… we'll have to think about this but I promise to give it my serious consideration… I'll let you know." (Closes door, checks to make sure they're alone.) (Then softly enough to be inaudible beyond the closed door & insulated walls "Woo-hoo!!"

Entrepreneurs are routinely warned that they'll have to hand over 95% of a company's shares in order to attract equity investors and eventually go public. Being bought out or taken over (instead of an IPO) leaves more shares in their hands but they're still giving away well over 50%. At crunch time, with payoff dangling just beyond their reach, execs start flinging their shares away in desperate attempts to bridge the profitability gap. In your CEO's equity-shedding mindset, you've not only volunteered to become the company's least-informed equity investor-- you've also volunteered to become its cheapest employee.

The company is privately held, has completed first round funding with *I think* an 85-investor consortium from a well-respected private equity group. The company is cash flow negative right now, obviously, but the product I'm actually working on could make them cash flow positive by itself (independent of the products that the other contract engineers are finishing up). They're looking for second round funding or angel investors but obviously in this climate people are not particularly interested in buying private stock in small startups. They were founded in 2004 and have a patent portfolio.

I don't think "well-respected" has anything to do with an investment record, either, but credible angel investor data is notoriously hard to come by even from nice guys. So pursuing this line of reasoning would be difficult.

But if angels have invested, then someone has done some degree of due diligence. Before you become a shareholder, it'd be nice to be able to see the presentations that the company gave to this group, and maybe even know more about the due diligence. If you're serious about working for equity then it's worth treating this as a cold-hearted rational investment, not just a different type of paycheck with good friends & mentors. If the company's not willing to share the information that they gave the angels, and perhaps to discuss issues that came up during due diligence, then they're not worthy of your money.

What keeps these people you like/trust from leaving the company in another quarter or two? Does the patent portfolio belong to the company, or is it the property of the execs who may or may not stay with the company?

I don't have any business experience and I don't know about standard industry practices, but what kind of company employs 20 people when all the potential revenue-generating contributions are coming from just four contractors? (I'd think that four employees and 20 contractors would be a more reasonable ratio.) How are these employees justifying their existence? Do you want to be #21?

Again, it seems like a big flashing danger signal that a company plans to lay off anyone whose project execution is critical to their success. You would think that the execs would want you to start working on v2.0 or enhancements or even hang around for post-release bug fixes.

Their first rough idea was to pay me what the contract engineering company is paying me in terms of dollars, but then actually pay me in stock instead of greenbacks. This seems like a lousy offer because the company is wanting to pay me in something that has a definite risk of being very expensive toilet paper (let's discuss the idea that greenbacks might become toilet paper at some point in other threads), not to mention that they're currently paying 50% more than that to the contract engineering company (to cover employer half of SS taxes, my benefits, and the profit margin for the contract engineering company)

More details that you've already thought of: Assuming that the company places a fair valuation on their shares (good luck with that) and another fair valuation on your salary, how long are you willing to work like this? Who pays for your health insurance? Who makes up for lost 401(k) & IRA contributions? How many hours per week, or what deliverables, or what milestones/deadlines? What happens if you can't work due to health issues or decide to leave for a better job offer? Will you be expected to travel, supervise others, go to department meetings, muster for mandatory sexual-harassment training, or attend the mandatory-fun holiday party? Do you have to contribute to the office gift fund for the departing admin assistant? Can you sell the shares back or do you have to wait for a buyout/IPO? How do your terms ($$ for shares) compare to the angel investors or to the founders/family/friends? How badly will your equity be diluted by subsequent investment rounds? Will you have a chance to preserve your share of the equity by buying the shares of departing investors or by participating in subsequent rounds? Do you get your investment back before any of the profits are shared among the investors?

Angel investors are always cautioned to make their investment in a company in at least three annual (or faster) increments: "Welcome aboard!", "Here's a valuable opportunity to participate in another funding round", and "We really need you to save us from bankruptcy." In at least six out of 10 startups, that third investment is shortly followed by "Well, thanks for stopping by…" I'm not sure how your contract-equity employment would be subject to these tactics. When do you walk away? Are you penalized if you do walk away?

Some states (Hawaii is one) offer tax credits for angel investments in certain businesses. Are there any federal/state/local tax benefits offered to angel investors in your area? Any other "angel benefits" that you'd want to have as an equity-paid employee?

I don't know much about negotiating the trade of paychecks for equity, but I bet it's a lot more complex than negotiating contract employment. You'd have to find concrete examples of other arrangements to figure out what's standard and whether you're selling yourself at a fair value or just giving it away. For starters you'd want to know that your equity arrangement is at least as lucrative as the lowest-paid of the other 20 employees. As you can tell, I have a really hard time figuring out how those 20 are contributing to the company.

Fundamentally you're saying that the people whom you like, respect, and trust are going to lay you off because they still don't find you valuable enough to keep. That may be "only business" but I'm not sure it's a good reason to invest more of your human capital. If a company treats its top contractors that way, are their shares worth anything?

Perhaps the best way to approach this decision would be to compare it to alternatives. For example, if you found a contract job with another company for exactly the same terms that you have now, would you invest your earnings from that hypothetical company as an angel investor in your current company? If you did decide to work for equity and it became toilet paper, what would the impact be on you? The lost opportunity to make 401(k) contributions and IRA contributions at some other job? Having to pay for your own health insurance? A stained résumé?

We haven't even discussed the issue of having the majority of your net worth tied up in one investment-- and your paycheck too. And as you've pointed out, it's also highly illiquid.

While your trust & respect for these people is a sign of hope, there's a lot more research to be done before you can decide whether you want to link your success to their dreams.

 

[W2R]

Excellent post, Nords.

SecondCor521, I think Nords covered a lot of issues that bothered me too, not to mention many more that never even occurred to me.

My suggestion would be to talk to the contract engineering company and see what else they can come up with! There's always a possibility that the startup company you are presently working for might hire you back as soon as they get back on their feet a little more firmly.

 

[sailor]

Nords raised good points.
I've been there and got burned. Twice
Even with angel investors having excellent track record.
I guess my advice to you would be to think about it like you would think about gambling.

 

[Bimmerbill]

A bunch of my IT friends are on their 3rd, 4th or 5th startup where they are paid less in return for equity stake in the company. None of the gambles have paid off so far. They are always saying "just one more start up!" in hopes of hitting the big one.

Some got bought by bigger companies, some went out of business or merged. None paid much on their equity. The owners of the companies ususally came out smelling like roses, but the workers didn't get jack.

 

[FUEGO]

What is your exit plan? Is this a venture that could hit it big with an IPO in a few years? Might your share of the equity be valued in the millions? I would have to receive a rather large risk premium to make this deal worth while.

Maybe consider an offer in compromise of receiving a "stipend" that is set around the amount that you need to get by on (assuming your barebone living expenses are much less than a market wage), plus an equity stake. Definitely need an exit strategy though.

 

[clifp]

Nords covered the areas to watch out for very well. (We are in the same Angel investing group..)
I know several serial start-up addicts who've never made a dime from stock options despite working for 5+ start ups as well as a couple of guys who made a million+ at two or more companies. The first group is much larger than the second group. In my case I was 2 for 3 in stock options and 0 for 1 in start up options.

It isn't a crazy idea to want to work for equity, but it is important to look at what you are doing from an investment perspective. If you give up salary for say a year you are investing the equivalent of >$100,000 in a single stock, and a penny stock at the level. On the other hand if it is successful you've moved up your FIRE date by a number of year, plus it an be fun and rewarding. Although we are talking a boat load of work, but you knew that.

I second NW suggestion of maximum 50% salary and the rest in stock option. In fact, I start the negotiations from your contract engineering salary + options and work your way down to 50%. I wouldn't go below because you do need eat, you want the company to value your contribution, and if it does fail, you want to be able to put down a salary for your next employee.


For tax reasons I'd highly prefer options than having to pay taxes on an illiquid stock in a private company. If they received money from a private equity firm they almost always have a set aside a portion of the company stock for employee stock options.

Valuing a start up is extremely difficult. As a starting point, I'd ask to see the term sheet that the equity firm invested in. As a general rule of thumb, I'd want to see the potential for a 10x return on my money or deferred salary if everything goes great and a 5x if things go well but not perfect. One caveat do not excited about the total number of share they offer you, what is important is the percentage ownership. A senior engineer should be looking at something in the neighborhood of 1-3% of the ownership of the company.


Still working for a start up was one my favorite years in my career (despite the 80 hour weeks and lost money in stock. the fact you've worked with and like the R&D director in the past, is worth a lot in ways that can't be easily measured with $.

 

[SecondCor521]

Thanks to all who replied.

Here's a few additional comments and clarifications:

1. Startup is a broad term, I guess. It sure seems like it is an established small company; I just know that it happens to be funded by angel investors. It's got real customers, good revenues, developed products, patents, etc. It's way past the "two friends in a garage" stage.

2. Business valuation is done by an independent accounting firm. Common shares last value are $.80, preferred are $.95, the difference represents the risk premium associated with liquidation payback priority. I think there are 18M shares outstanding. The CFO says any arrangement with me would be the common shares. CFO also says there are no buyback arrangements, so the shares are about the most illiquid thing on Earth. Basically in 5 years they'll end up being worth $0 or maybe up to $10 per share (I haven't seen the financials yet, but I plan to look at them).

3. Founder is still there, but he's CTO because he's more an entrepreneurial type than a business type.

4. Employee roster, may not get all of them:

*1. CEO
*2. CFO
3. IT guy who keeps the phone system and PC's going.
*4. R&D director (my boss)
*5. Hardware engineer
6. Order fulfillment gal (runs the credit cards through and puts in orders)
*7. Director of product development
*8. Marketing director
*9. VP / COO / Manufacturing mgr.
*10. VP of sales
11. Salesman #1 (inside international)
12. Salesman #2 (inside regional)
13. Salesman #3 (inside regional)
14. Salesman #4 (inside regional)
15. Salesman #5 (outside)
16. Salesman #6 (outside)
17. Technical customer support guy
18. Business planning person
19. Receptionist / gal Friday
20. Order fulfillment tech #1
21. Order fulfillment tech #2
*22. Founder / CTO

People with *'s before their numbers are those who I think are paid more than I am.

Then you have contractors #1 through #4, which are all software/firmware/hardware engineers working on new products and or development of existing products.

5. As I understand it, the CEO wants Q1 to be cash flow neutral come heck or high water in order to be able to attract more capital. Hmmm. It's supposed to be part of his job to raise capital, and he has only raised about 40% of the his goal (for this round, I think). If he can't raise capital from investors, is that because the company isn't profitable or is it because of the current climate where people are investing in T-Bills at 0%?

6. The real question is whether Q1 represents a cash-flow crunch or not. Is it the end of the beginning (optimistic viewpoint), or the beginning of the end (pessimistic viewpoint)?

NW: I am willing to consider mixtures of cash/stock grants/options. I also wouldn't do this much beyond Q1. I can probably swing it financially if they pay me with $$$ through mid-Feb and then equity for the rest of Q1. Beyond that I'd probably want to find a regular cash-paying job. So we're looking at a maximum bet of about six weeks of working for equity.

Rambler: I talked briefly about some of these issues with the CFO today. I explained I didn't want to be writing a check to them to cover my IRS obligations. Her thought was to write a contract that would award me one chunk of stock at the end of Q1. My former employer also had the notion of grossing up to cover taxes, and she said that would be a possibility.

Company is looking to be acquired, not do an IPO. Timeframe is maybe 5 years, but I know from other things I've seen that they'd sell it tomorrow given the right buyer and price.

Nords, thank you for your valuable input. I will reread it carefully. To most of your questions the answer is "I'm not sure" which isn't a great answer, I know. The majority of the company's expenses are salaries, and the CEO is of the erroneous impression that it is hard to lay off employees. I'd like to ask if he's reducing his salary, but I'll have to think how to ask that the right way. Founder/CTO owns about 15%, remainder is among about 100 investors -- some of which are family and friends (earlier investors), the rest are angel investors. I agree they should share their investor type information with me. The key employees are compensated in options, so that is their golden handcuffs. I did a patent search and found three patents that are assigned to the company.

As to your question about "revenue producing", I think there is an emphasis on sales, as that is the most obvious point at which cash rolls into the company coffers. The CEO's general plan seems to be to furlough the expensive contract engineers after they've finished their respective products in early Q1, then sell sell sell like mad to increase revenues of said products and the company overall, get the company to profitability, then either (A) attract more capital -- easier because the company is profitable, and/or (B) hire engineers back to develop more products in Q2/Q3. This seems very short-sighted and tactical to me, but I've been in R&D for about 15 years, and this CEO has little or no experience with technology R&D (he was hired more for his fundraising abilities I guess). Overall my R&D manager and I are of the same mind on this, but the CEO controls the R&D budget approval, so there's the rub.

They'll keep me around as long as they think they need me, which does include post-release bug-fixes and tech support stuff. But v2.0 could not be developed fast enough to produce revenues in Q1, so it would have to be done post-cash crunch.

Yes, health insurance and 401(k) stuff has been mentioned, but not discussed in depth.

Assuming sort of the most risky thing I would do -- 6 weeks at 100% equity, and assuming my current salary (which would not account for the equity risk premium I should demand, nor the adjustment for benefits, nor the adjustment for cutting out my contract engineering company) -- I'd be looking at risking about 3% of my net worth.

I don't believe I would be penalized for walking away, nor quitting to accept a better job, at least not by the R&D director. Perhaps by the CEO.

W2R, yes, I plan on talking to the contract engineering company. Since I am a W2 for them, if the startup furloughs me and the contract engineering company can't find me a new assignment, I would be able to collect unemployment, which would increase the latter company's rates. So they have an incentive to help me find a different position.

In general I appreciate everyone's caution, as I am apt to be too optimistic about such things. clifp hit on something, though, and that is that I am really liking working at this company -- except for the "we don't have cash to pay you" part, it's been my favorite place to work in my life.

2Cor521