No matter how much funding you’ve raised, it always feels like cash is tight in the life of a startup. And yet, every once in a while, an opportunity comes up to offset cash expenses with equity. A recruiter, vendor, or contractor might suggest that they are willing to take part, or all, of their fee in equity. There are times when this may or may not make sense so I want to share my learning from having gone through this many times before.

Why using stock can make sense:

• Clearly, for a cash strapped company, the opportunity to use stock instead of cash can be compelling. In addition, by giving a vendor equity you may be giving them a longer term incentive, beyond the term of their involvement, to see the company succeed. 

• Often consultants want an ability to participate in the upside of the company and so they will be willing to offset some of their fees with stock. Some recruiters demand a portion of stock in addition to their cash fees and many publishers have been known to offer ‘media for equity’ partnerships where they exchange media for an equity stake in a potential startup advertiser. 

• The most important consideration in these partnerships is that what you are buying is the exact same whether you pay for it in cash or stock. Your equity is worth arguably more than cash so don’t take a discount on the product/service it buys. In some cases, you may be able to get a premium on the value of your stock because the vendor believes in the upside opportunity.

How to structure:

• There are two main ways to structure the equity component. Companies can grant options or restricted stock. For the company, there is little difference between the two except that restricted stock is a bit more expensive to paper (generally the recipient will ask the company to file an 83B on their behalf with the issuance of stock). However, for the recipient, the two carry very different tax implications. An option is not taxed upon receipt whereas stock is taxed on the value of the stock. On the flip side, with an option, the recipient would have to pay the exercise price and may face worse tax treatment upon exit depending on whether capital gains is triggered. As a CEO, I always gave the recipient the choice between these two paths since it made more of a difference to the recipient than the company. 

• In either case, you should determine the vesting period and exercise window. Depending on the situation, you should try to make the vesting schedule match the delivery of the service. For example, in the case of a recruiter, the stock could vest upon successful completion of the search. From an exercise perspective, you may want to determine if an early exercise is permissible or how long the recipient can hold the option without needing to exercise. Ideally, whatever you determine should be fair for all sides and consistent with past or future agreements. 

How to set value:

• The tricky part is how to determine the value of the stock as compared to the cash that it may be offsetting. The easiest and likely more defensible way to do this is to use the last round’s price per share to set the value. In my view, regardless of the recipient’s choice between an option or restricted stock, both should be valued the same. 

• Before you determine the number of shares at stake, make sure that you have enough room in your option pool and know how much this agreement will leave in your unallocated pool. 

• As an example, let’s assume your company raised a $5m round at $25m post-money valuation and the price per share was $4 (implying 6.25m shares). If you plan to offset $25k with stock, then you would issue 6,250 shares (either via an option or restricted stock agreement). Some may push back that they are receiving common stock whereas the price per share was based on preferred stock. While that is a fair argument, the reality is that the company raised money at that price so at a lower price, the company would be better off paying in cash. While the company’s value may have appreciated since the round closed, it’s impossible to quantify so the most recent transaction is the most fair / objective method. 

• Alternatively, a more complicated approach to setting value is to determine the price per share based on what the current or future value might indicate. This approach may make sense if the company’s last fundraise was a while ago or if revenue traction is growing quickly. When possible, the company can justify a valuation based on an agreed upon formula like the company’s revenue multiplied by a revenue multiple. 

In most startups, cash is always constrained so using your stock as currency may be a great idea but comes at a cost. Be careful not to dilute the value of the equity by giving it away unnecessarily and realize that just because you can use stock, doesn’t mean you should. Lastly, these agreements can get complicated so try to avoid getting too weighed down by negotiation and know when it's time to draw a line. 

If you’re thinking through some of these questions and want a sounding board, please drop me a line (gautam at m13.co).