If you are a startup founder, you may have engaged a contractor to provide services to help your business grow. If you are grappling with limited cash flow during this process, you are not alone! Founders often look for alternative ways to pay contractors for their services. One method of payment is issuing shares in the company in exchange for services. This article explores some of the advantages and disadvantages of paying contractors with an equity stake and considerations before paying contractors in shares.
Employees vs Contractors
You should first consider whether a worker is an employee or contractor before contemplating whether to pay them in equity. By law, employees have guarantees to certain minimum employment entitlements (such as a minimum wage). This means you cannot substitute an employee's minimum pay with shares. Unlike employees, contractors do not receive entitlements to a minimum wage. Likewise, they can agree to be wholly compensated for their services in shares.
Some factors pointing to the existence of an employment relationship include:
- leave entitlements (annual leave, carers leave, sick pay, etc);
- fixed hours of work determined by the company;
- the company's insurance coverage applies (and the worker does not have their own insurance policy);
- the worker's role is ongoing (rather than fixed for a period of time or project);
- the company withholds a portion of the worker's pay for tax and superannuation purposes.
The Downside of Paying in Shares
Implications Are Lasting
If you pay a contractor for services in cash, the transaction is usually complete once the contractor provides those services and receives payment. At this point, the customer (your business) and the contractor are free to go their separate ways. This is not the case if you pay a contractor in equity. The contractor, once issued shares, will become a member of the company. This means they will remain on the company's share register until they dispose of their shares. The contractor will also have rights under the law and the company's corporate governance documents. Consequently, you will have to deal with them on an ongoing basis.
In Australia, private companies must have fewer than 50 non-employee shareholders. If your business exceeds this number of shareholders, it may need to comply with more onerous regulations or convert into a public company.
Remember that there are limited spots on your company's share register. Hence, issuing shares to a contractor may become restrictive if you intend to raise capital by issuing shares to other investors in the future. In addition, prospective investors may perceive a clogged-up share register and cap table as a limitation to future growth. Unfortunately, this could deter them from investing in your company.
How Much Are You Really Giving Away?
Giving up a small piece of equity when your business is in its infancy and strapped for cash may seem like an inexpensive payment option. However, when you pay in equity, you give away part of your business before it has realised its full potential. Startups are notoriously difficult to value, particularly if they have not begun generating operating income or launching their product in the market. As your business grows, the value of the company's shares may also increase. As a result, shares that were worth very little when they were issued to the contractor may increase exponentially in value. This could result in the contractor being grossly overpaid for their services.
Structuring the Transaction Can Be Complex
Structuring an equity compensation transaction can be very complex. You should not give away hard-earned equity in your company upfront before the contractor has delivered the promised services. Yet, the contractor may be unwilling to go without compensation for lengthy periods, especially if they assist the company on a project that spans months or years. Striking a deal that is fair but also within the parties' risk appetite can be challenging.
Notably, some important questions to consider include:
- How much equity will the contractor receive, and what is the value of that equity?
- Will there be objective service levels (to ensure the contractor delivers services to an acceptable standard)?
- What happens if the contractor only delivers part of the agreed services, or if the services are defective?
- What happens to the deal if the company is sold or goes into liquidation?
- How will the contractor's shares vest (for example, will the contractor receive shares based on the number of hours worked or tasks performed)?
The Upside of Paying in Shares
Equity Is a Compelling Motivator
A contractor is more likely to care about the long-term performance of the business if you pay them in equity as they have a direct financial interest in the business. Creating this "ownership mentality" encourages a contractor to work productively and innovatively to achieve business goals.
Competing for Top Talent
Industry-leading contractors are often highly sought after and come at a hefty price. Unlike large corporations, startup founders usually cannot afford to pay top-tier contractors in the early days of the business. However, founders may be in a unique position to offer contractors an ownership opportunity, something that most large corporations cannot match. Therefore, paying in equity can provide a way to compete for the services of the best contractors in the business.
Capital Conservation
Retaining money in the bank is a significant benefit of paying contractors in equity. You can use the money saved upfront to cover operating expenses or build and improve other essential business functions.
Buy-In
The startup game can be unforgiving, and the road to success is not without bumps along the way. Typically, a contractor will only accept payment in equity if they truly believe in your business and want to "buy-in." Importantly, you should not underestimate the backing of people who believe in your business vision and are committed to helping you achieve it.
Shares or Options?
When you consider issuing equity to a contractor, it is essential to consider what form that equity will take.
In most cases, it is preferable for startups to issue options to contractors rather than shares. Options are a right to purchase shares in the future, which can be exercised if the option holder satisfies the conditions attached to those options (commonly time-based or performance-based conditions).
In addition to the advantages described above, there are also several other benefits to issuing options rather than shares, including:
- in startups, issuing options to service providers is more common than issuing shares upfront;
- issuing options is less risky for the company because the contractor does not own shares immediately (rather than will only be able to purchase the shares once they have satisfied the time-based or performance-based conditions);
- if you already have a share option plan in place for other staff members, it will be administratively easier for you to manage an equity offer to a contractor if it can fall under the same plan; and
- provided your startup meets certain eligibility criteria, the contractor may be able to receive the benefit of the ATO's 'startup' ESS tax concessions.
Key Takeaways
There are many benefits and limitations of paying contractors in equity, and it is not a decision you should take lightly. As a general rule of thumb, you should pay contractors in cash where possible, as equity compensation can have long-lasting consequences. However, equity compensation may be appropriate in certain circumstances, and it is essential that you structure the deal in a way that protects your business and its future investment prospects.