Many times a start-up company will need services, for example software development, but doesn’t have the money to pay for them. At that point, many founders offer to give their key contributors “a piece of the action” by issuing equity in the company in exchange for the services. The services contributor might be willing to accept that bargain because the ultimate value of the equity stands to be much greater than the value of the time put in. Sounds like a win-win proposition.
However, there are numerous factors to consider before agreeing to such a deal, on both sides of the equation, and these factors interact with each other.
From the standpoint of the people whose company it is, letting someone in from outside runs the risk of disagreements over the direction of the company (if all the stock is of the same class and has voting power), and the question always arises whether the services contributor will take the stock, walk away and wait for the value to go up. While most start-ups issue “restricted” stock, which cannot be sold without the company’s consent or must be sold back to the company unless it’s part of a public offering, the services provider might be willing to sit it out until that very event. And there’s the all-important question of how to value the equity when the company is young, there’s no market, and no history of operations or revenue; a company could hive off a larger portion of itself in exchange for what turns out to be a fairly modest contribution of services.
From the standpoint of the services provider, the risk of long-term illiquidity and the possibility the company will go under before the stock has any value looms larger as time goes by. And if the stock was issued under an arrangement in which parts of it “vest” (become fully owned without any possibility of cancellation if the provider leaves the company), the employee becomes subject to income tax on the vested portion as soon as the restriction lifts—a tax that the employee might not be able to afford without being able to sell the stock.
There are various ways all these concerns can be squared, with each side understanding the trade-offs, but they usually involve creating moderately complicated schemes like classes of stock (so that some might be non-voting, though doing so prevents the company from electing Subchapter S tax status), options, rights units, and so forth, that can be rather expensive to create on the fly (business lawyers themselves very seldom work for stock), and a company that can’t afford to pay cash for the services of developers is unlikely to have the cash to pay lawyers to create such plans.
As entrepreneurs set up their businesses, they can most effectively utilize their resources by putting a plan in place up front to provide for equity compensation, before the need for some particular person’s services becomes so acute that the company is forced into doing something that is sub-optimal in the long run. All of which is to say: plan ahead, and use the talents of your business lawyer and accountant to come up with solutions before there’s a crisis.