One of the many talents that successful entrepreneurs possess is the ability to use what they have to get what they need to start and sustain their businesses. Since early-phase entrepreneurs often lack cash, some variation of the question “can I pay for this with equity?” often surfaces.
Unfortunately, there is no one ‘right’ answer to this question. Here are a few of the challenges and issues to consider:
Equity is not cash
The value of your equity is unknown. Common wisdom is that 90% of startups never become sustainable businesses, so the equity results in nothing. On the other hand, maybe you are hatching the next unicorn. In which case, equity is a very expensive way to pay for services.
You can’t make more equity
The total amount of equity is 100%. I’m frequently surprised by the number of people who are ready to offer 10, 15, as much as 20% in equity for everything from accounting services to a ‘full-stack’ programmer. In the same breath these entrepreneurs declare “I will never own less than 51% of my company”.
The difficulty with these positions is a matter of simple math.
Equity Dilutes
Just because you receive 20% in equity doesn’t mean you will have 20% of the company when the equity can be converted to cash. Since total equity can only be 100% — though early equity deals can sometimes feel more like a remake of The Producers than a business transaction — bringing on new investors means dilution for current equity holders.
The challenge here is at least twofold:
- Dilution does not always occur uniformly. Services-for-equity holders may feel that they are being taken advantage of.
- Services-for-equity may perceive their equity as collateralized debt and may see their dilution as an unfair reduction in pay.
The volatility and risk of early-stage equity makes for ample opportunity for misunderstanding and disappointment. This can lead to hurt feelings, damaged reputations, withheld services, and fails deals.
Equity is not debt
Having equity is no guarantee that you will ever be paid.
Equity is Worthless
You can’t pay your rent, buy a car, or get groceries with equity. Equity only becomes valuable when some kind of conversion event occurs. But what will trigger that conversion?
Generally, equity converts on the influx of some cash. But there are a few challenges: If you are an investor, do you want to see your investment go to building new capabilities or paying off old debt?
About 80% of the companies on the INC 5000 are completely self-funded (no external investment). When and how will there equity value be calculated? convertible?
There may be better options
Working with limited funds is always a challenge – doubly so in early startup phase. Handing out equity can lead to a confusing and unattractive (to future investors) cap table. At best this can lead to contention over dilution rates among current equity holders. At worst it can completely scuttle a deal.
Convertible notes have long been a staple of the startup world, but they can make the balance sheet unattractive to investors.
The folks at Y Combinator have developed the safe note as a means of overcoming many of these difficulties.
In the end, funding startups is difficult – and one size never fits all. The point is, it’s probably best to avoid a ‘knee-jerk’ “will you do this for equity” and consider all of the options – then make sure you have adequate input from financial and legal professionals.
Photo credit: SHARING by flickr user Lena
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