As a Phoenix emerging business attorney, I am often asked by startup founders whether it is a good idea or not to give equity in exchange for the services of a freelance developer, designer, or [insert type of vendor here] or to just pay for their services outright?
I have been asked this question enough that I finally found it to be blog-worthy. While every situation is different and must be examined individually, the following are my accumulated thoughts on the subject from both the legal and business perspective. All things being equal, I almost always recommend finding a way to pay the services and own any deliverables outright in order to preserve your equity. I say this for a number of reasons:
Newton’s First Law of Startup Companies
OK, so there is no such thing, but there ought to be. In general, as a founder you want to conserve your equity at all costs. Before the angels and VCs get involved, you need to fight to keep every “point” you can, however you can, since you will almost certainly need that equity later. Basically, equity should really only ever be used to launch your company and get you to revenue, not for one-off expenses, e.g., designing your killer mobile app, office furniture, doing your corporate tax return, etc. Let me be clear; equity to lure top talent is something different, because actual talent is difficult to find, and you want people who are willing to buy in to what you are building, your culture, and what it will actually take to for the business to reach its goals.
Like diamonds, equity is (or can be) forever
I’m not breaking any headlines when I say that the client-vendor relationship is much simpler than the client-vendor-turned-partner relationship. When paying someone for a service, you are solely focused on the quality of the service or outcomes. That’s it. If your vendor fails to perform, you fire them and find someone who can get it done. But when you decide to give someone equity, it changes the entire dynamic, including what you are looking from them (and in them). From the legal perspective, they also now have legal rights which have to be honored, either through the organizational charter, Bylaws, or operating agreement of your business or, if you don’t have any of those things in place yet, through your state’s statutory and common law involving the rights of shareholders. I expand on this more below but the short version is: pay your freelancer for something, and it’s over and done with; give someone equity and it could be a saga that lasts forever.
Honor’s in the dollar, kid…
For better or for worse, we live in an instant-gratification society and, simply put, people just work harder for money. There are not many freelancers/ICs who value equity as much as cold hard cash, and even fewer who will put the same valuation on your company that you probably do. Rightfully or not, the average freelancer on the street would probably view the 1, 3, or 5% stake you propose in the company as a mere token amount. What does this lead to? Possible problems of not prioritizing your business/project over more immediate cash-in-hand opportunities elsewhere, maybe devolving into you constantly having to harass your new “partner” daily to prioritize the company’s needs, which in turn could result in you being months late to market.
Many freelancers (and even more than a few founders) think their promised equity is going to be considerably more valuable within a 6-12 month timeframe when the reality is it usually takes a few years to build a company that anyone would be interested in acquiring. When your startup has its inevitable stumbles, is your new independent contractor partner going to be frustrated by the actual time frame it takes to get to a financing round or, worse yet, constantly pester you to buy her out? These are distractions that you probably do not need.
Equity is not a Powerball ticket
Few freelancers or specialty personnel make good long-term business partners. I am not putting down freelancers or skilled personnel, or saying that these situations can’t work out, however when they do it is usually when you as founder are gaining a true long-term partner who is a believer in The Cause and is willing to go through the long, hard slog to get to there. Basically, if the person you’re offering equity to is just viewing it as a lottery ticket, then you should re-assess and think about whether you truly need them as a business partner.
Ben Bhandhusavee is the Managing Attorney for BhandLaw, PLLC, a Phoenix business and technology law firm working with start-up companies, creative intellectual property, Internet and digital media matters, and complex corporate M&A and technology transactions. Ben can be reached at (602) 222-5542 or by e-mail at email@example.com