Often times early-stage businesses have more equity than cash, which begs the question, can I pay contractors with equity? Check out today’s MATH 101 for Troy’s tips for building a services for equity type transaction that is fair for both parties, and even the IRS likes it!
14 Responses
Does this arrangement get listed on the cap table?
It only appears on the cap table after the equity transaction (where the vendor writes the check to invest). Prior to that it is strictly an Accounts Payable on the part of the company. Then once the payment is made to the vendor (it comes off AP) and they write the check back to invest it appears on the cap table as any other investment.,
What kind of contract would be recommended for both parties to feel good entering this kind of agreement? Is it a simple one, or one that’s more complex like an investment agreement?
Dana, When I have done this, it was a simple one page agreement that says the vendor will issue the invoices and it is understood that the company will hold them (or a portion of them, depending on the percentage you agree to) and not pay them until the next financing round or 12 months whichever comes first. It then describes the payment of the invoice and the investment in the round. All the legal work of the investment details are in the investment docs that are part of the round. That way every investor has the exact same terms, etc.
Nice video, Troy. I would add one comment on an issue that you did not raise: This transaction involves a tax obligation for the contractor – the $3,500 technically paid to her or him is reportable compensation. It’s not the company’s obligation to pay the tax, however, the company might have an obligation to issue a 1099 to the contractor and file a copy with the IRS (if the amount meets the threshold, the payee is an individual or an LLC, etc.)
In our practice, we find that entrepreneurs and their contractors overlook the need for the taxes to be paid and appropriate tax documentation to be filed filed when paying for services with equity or other securities.
It’s a bigger issue for the company when the recipient is an employee, because in that case, the company has a withholding obligation on the amount paid and must cover its share of payroll taxes as well. Failure to do so can result in interest and penalties.
File the 1099, pay the taxes. NOW the IRS is happy.
Ken, You are 100% correct – I assumed that since the company paid out the cash (which then was turned around with a separate check to invest in the company) that the 1099 would be automatic. YES – the cash payout needs to be reported even though it is coming right back!
Thanks Troy! Super helpful. I have found that contractors typically like to base the compensation/equity on the previous round’s valuation or somewhere between the previous and the next round.
What benefit would the contractor gain by waiting until the next round and pay the same price as other investors when they are taking the risk now?
The price is a negotiation point, it all depends on timing. If the last round was two years ago and a financing is coming soon, makes more sense to tie to the new funding. If there is no pending round, maybe a vendor would be sophisticated enough to try to tie to last round, or could have a cap on valuation. All depends on who you are dealing with…
Hi Troy, thank you for the quality content!
Can the convertible notes be used to pay for services in this case, or is it not advisable?
YES! What I outlined was effectively a convertible note, but if you want to make it more formal, then you can basically pay for the invoice they send you with a convertible note – it is just moving a sort term liability (A/P) to a longer term liability (convertible note). I see nothing wrong with that at all!
Would the contractor need to be an accredited investor for this to work?
GREAT Question! It certainly is clean if the contractor is an accredited investor, for sure. There are exceptions for people who have significant familiarity with the business (think of employees that exercise stock options for example) you should DEFINITELY talk to a lawyer about whether a particular contractor qualifies or not. (and I am not a lawyer and cannot give legal advice!)
Hi Troy, thanks for making this video on an often-discussed topic. What if the company doesn’t succeed in raising a round of financing? Shouldn’t the agreed-to converted amount be greater than the actual cost of the services delivered in order to compensate for risk (that the company doesn’t raise a round)? Would appreciate your thoughts on this. Thank you!
Yes, I agree with you (this is why convertible notes/SAFEs almost always have a discount) – So, for the more sophisticated vendors, you will likely have to structure it like a convertible note/SAFE with a discount, and maybe even with a cap on price. I was trying to keep the concept simple but have definitely seen it act much more like a conventional note with a discount and a cap… Thanks for bringing this up!