Most companies seeking angel funding need far more than investment capital and angel investors are more likely to be successful if they take an active role in their portfolio investments. Working for equity can be a great way to add value for both entrepreneurs and investors, but it certainly has its trials and tribulations. To find out how to make working for equity more effective, I spoke with four people well versed in start-up investments:
DuWayne Peterson, founder of the Pasadena Angels/Colorado Angel Investors and mentor at the Rocky Mountain Innosphere
Max Shapiro, longtime angel investor and founder of People Connect Staffing/Employees Without Paychecks
Brandon Smith, managing partner at Whitefield Capital
Peter Edwards, partner at Sage Law Group and former partner at the Altira Venture Capital Group
Q: How would you suggest structuring an equity agreement?
For consulting agreements, most of the respondents recommended working for a predetermined project-based compensation structure with outlined key deliverables and milestones, as opposed to working on an hourly basis.
“The key suggestion I would give anyone who is interested in working for equity is to make sure you have a clear understanding of your deal with a written agreement that you have reviewed with your lawyer,” said DuWayne Peterson. “All possible situations should be clearly spelled out so there is no misunderstanding on what your arrangement is. A handshake won't cut it. As we all know in the start-up world, ‘stuff happens.’”
Q: Do entrepreneurs value employees/consultants who are willing to work for equity less than those they pay with cash compensation?
Three of the respondents said no. As Peter Edwards said, “If the entrepreneurs are well-advised, they think through the implications of their awards carefully against the backdrop of their growth and fundraising plan. If they understand the value of their equity, they don't take equity compensation lightly.”
Brandon Smith was the exception. "We require at least some cash compensation because entrepreneurs take their cash-compensated consultants more seriously,” he said. “If you ask any entrepreneur, they'll tell you that finding cash can be far more difficult than finding a few helping hands in exchange for equity. Cash is generally spent as a last resort in most startups. As such, extraordinary value is placed on those investments."
Q: How should the amount of equity earned be determined?
Most respondents suggested having a clear idea ahead of time of the market rate for cash compensation for the work to be performed. “I think the best way is to determine what similar companies would be willing to pay in cash for the work to be done and then use a current valuation for the company assuming the company raised money with equity from outside investors,” Peterson said.
Edwards suggested gaining an understanding of how much a startup would actually pay. “Just because a financial person received $150 an hour at their last gig doesn't mean the company should pay that much. This is a startup!”
Max Shapiro says an easy rule of thumb is to give the person an amount of options or warrants equal to what their monthly base salary will be. “For example,” he said, “if Susie will be earning $8,000 a month once she goes on the payroll, she would receive $8,000 in options per month until funding or until she goes on the payroll as a full time employee.”
Q: Are there any key suggestions you would give to others interested in working for equity?
“Be sure that there is a strong likelihood that the company is going to get funding within three months or so,” Shapiro said. “Without funding in a short period of time, everyone will be wasting their time.”
“Working for equity is a very tricky area for founders and investors in start-ups to deal with,” Peterson said. “The best approach for entrepreneurs is to agree on a salary for an employee and pay what they can and defer the rest. This should be accrued as a liability. Therefore, it would be the first expense paid if the company goes out-of-business with some assets. However, the reality is there are situations where the start-up needs to hire employees or contractors and it cannot pay the going rate and deferring the compensation is not an option. It is only in these circumstances that equity compensation should be considered. “
Edwards offered a handful of tips:
• No anti-dilution. It gums things up later.
• Put a cap on ownership percentage or on shares to ensure that someone does not have the ability to amass a great storehouse of stock.
• Make the agreement terminable at will, at any time, for any reason or for no reason.
• Define very, very specific milestones
• Rewarding people for fundraising requires competent counsel. There are both legal and practical issues to consider.”
“Deferred equity compensation is the best for the company,” Edwards said. “Require it to be converted to stock at the first equity round price. There are tax implications, so a creative structure must be put into place, i.e. an equity award subject to buyback by the company at par value (essentially zero). The amount of the buyback will depend on the first equity round price and how much stock has actually been earned.”
It’s clear from this group of experts that a great deal of forethought and planning should be involved before entering into any equity compensation agreement. It can be a great way to reduce your risk, preserve your capital and increase your return, but much care should be taken in choosing a company and structuring your compensation.
Elizabeth Kraus is an active angel investor and co-founder of the Impact Angel Group, a Boulder, Colo.-based investor group dedicated to making a difference and realizing a return. They apply best-of-breed practices to impact investing and connect viable social entrepreneurs with financial, intellectual and human capital.