What is the best way to structure an equity and cash compensation package for a consulting firm?

We are a consulting company that builds web and mobile apps for our clients. We have been asked if we accept some portion of compensation in equity. We do actually want to for some of our clients, but I don't know the best types of arrangements. We are an s-corp, so would it be through the company or through the team individually? Is convertible debt the best structure? How do we decide how to proceed and what are the pitfalls?

The equity should be in the name of the company. That way, there is no debate about who owns the stock. You will need to check to see if S-Corp's can own other corporations -- I don't recall off hand.

I have seen this type of deal done a bunch of ways -- it really depends on how much cash flow you need and the amount of risk you want to take on.

Convertible dept is a good structure for the company because it does not dilute right away and they can retire it before a funding round. If you really want equity in the company, then you need to have the option as to how you want to get paid -- either cash, all equity or a balance.

Personally, I like the deal where the consulting company gets a modest fee and the rest is made up with equity or convertible debt. The reason this is a nice balance is because the consulting company gets show cash in and the startup gets more of their attention.

If it's a pure equity deal, then the motivation is not as strong. The startup can take the "it's free attitude" and not really put the effort in while the consulting company puts it lower on the priority list.

Check with a lawyer in your area on any fine points in terms of taking equity and the tax implications -- their may be some but I'm not sure (I was always on the "here's some stock, can you help me side").

This is an important question. Professional working with start-ups are often asked to take equity in lue of market-based compensation.

I think that for those of us who work with start-ups this is one of the most challenging stages in the relationship development with a new or prospective client. Being a service vendor is very different from being a creditor or investor. The roles and responsibilities are different. The power dynamics are also different. All of this must be taken into consideration when evaluating the opportunity to secure vendor business while also gaining a debtor/investment.

I have found that "un-bundling" the two decisions and evaluating them independently of each other is a critical step in doing the right thing for me, for my company, and for our client.

The first question is are we the right vendor? These are some of the questions you will be asking yourself:

• Can we do it?
• Do we have the skills and access to the human resources?
• Can we do it in a reasonable time lines?
• Can we do it with the proposed budget parameters?
• If things go bad, would we be motivated to make it work?
• Are there any reasons we should not do it? (ethical, moral, contractual)

The second quesition is -- do we want to be an investor? When the compensation put at risk is in the form of equity or a note -- you are being asked if you would like to be an investor in the start-up. these are some of the questions that you will want to ask yourself:

• Do we believe that the proposed product solves a problem people?
• Do we believe people will pay for the product?
• Do we believe there is a market for the product? Do we believe that there is a budget to bring the product to market?
• Do we believe that the team of people involved can execute a successful plan?

and the most important:

• Would I invest my own money in this start-up as an angel investor?

Most likely you have answered the first question; Yes. And you have determined the amount of compensation you need to receive in order to deliver a quality product. And the amount of money that you could put at risk. In my company that amount we need is what covers our cost of goods and overhead. The amount we can put at risk is the compensation that would be received by the principals.

Most likely you will answer the second question with "maybe". Maybe you would be an investor. There are often a bunch of "ifs" that go with that. If they did this. Or if they did that. Write these out because they will form the foundation of your negotiation. If your answer to the question of whether you would investor your own money is a resounding no -- then you should not be putting any of your company's compensation at risk. If it is "yes, if I had it." Then it might make sense.

Negotiating the Terms I recommend that you treat the negotiating of the agreement in two parts which copy the unbudnling -- first get agreement on the scope of service and how much it is worth to the client for them to pay you. Agree upon the amount. And then you put forth the portion of that you are willing to put at risk. Now you are discussing making an investment of that amount in the business. From that perspective you can not take under consideration what you want and need to feel confident about the investment.

Here are option you may want to take under advisement:

• A seat on their board
• Exclusivity contract on development
• Operational Involvement as the CTO
• Right of First Refusal on sale of the company
• Right of first refusal on additional "capital calls"

The structure of the investment There are lots of good reasons that can be discussed on whether to make your investment as debt, convertable debt or equity. Regardless the ownership of the position is in the name of your company.

I personally prefer convertable debt because I do not want the legal obligations and responsibilities of equity until I know more about the people and the company. Usually they have incorporated in a state that gives very little rights to a minority shareholder. there is nothing I would hate more than to have my compensation tied up in a minority position of a company that I have no influence over.

Other people like debt because it shows up on the books, and that may even have a payment structure or schedule. They correctly assume that if another round of capital comes in there will be a debt to equity swap and that will be done in accordance with the terms of the negotiated options.

Keep in Mind Whenever our team is negotating the structure of the investment portion this is what we keep in mind:

The company will be successful -- or it wont.

If it is -- you will recover your investment and benefit from the upside. You will have earned a client for life for believing in them early on. Whether you maximized your investment opportunity and got as much equity as you possible could have is for VC motivated by greed to argue about. You took a risk and were rewarded.

If it is not -- then you will lose your investment. If you walk away from it at the right time with honor and integrity you will have earned a referral source for life for believing in them early on and sticking with them until then end.

Final thought Balance your portfolio . You need to get paid. Your business needs revenue. Your mortgage company doesn't take equity. The local food store doesn't accept options. Every start-up looks and sounds great-- but you know the truth of how hard it is and what the failure rate is. Even with fabulous software designed and built by you. So don't put your company at risk by carrying a disproportionate risky debt or equity portfolio. A good investor tries to make sure they are converting on at least 30% of their high risk portfolio. You should strive to do the same with your "compensation at risk portfolio"

I will add my 2 cents here as my company does this actively now, and its a good thought exercise for me.

We have invested in around 8 companies over the years, each one has taken differnt forms, but personally I like to get a direct ownership / shareholding of between 8 and 25% depending on the stage they are at and the amount we are contributing.

• One successful company we started off at 25% and now have 50% ownership in. It is targeted at a specific vertical market with a product suite. We now own 80%+ of the vertical for our local market and are expanding. Its clients also call on our consulting side of the business so it has worked out quite well for us.
• We had several where we won awards for the company then the marketing/sales side fell apart and we weren't in a position to continue without them ... thus lost a few years hard work with only minimal payment ... that one hurt.
• Another one we had an agreement with "one party" of the partnership and didn't realise we were siging with 2 instead of 1 ... the second party didn't find out for 3 years and then didn't agree to the terms and it got rough (I was 20 years old when this one started, so big learning curve) ... Trust doesn't come into it, time changes everything especially perspective and memory ... get it in writing.

Problems we have encountered.

• It starts off being cheap for them so they expect more for less, their dreams expand, more becomes possible so the "space" is quickly filled up.
• They start promising their clients everything because it isn't a problem for them to do so. This is good and bad. You get a better product built and clients who are really engaged (because it doesn't cost them much so why not) but your staff are madly working at well below standard earnings.
• At some stage you need the company to pay its way, you can't be free/cheap forever.
• You may feel its time to cut your losses and move on, make sure you can ... and if you do, what happens to the IP/effort gone in so far? Your partners give up or move on (or die in 1 instance) do you have enough in place and are you capable of continuing without them?

Second time around I either do or should do:

• Setup an agreed multiplier (like convertable debt) which if we put in sweat we have a 2-3x return or accumulated debt given our risk and oppurtunity cost.
• Agree on a limit of sweat equity per month I could commit to. Any requirements over this either were at full rates or went into an "agreed multiplier band" so that it cost the startup something, even if it wasn't right now.
• All "client work" we have an agreed 80/20 or 70/30 split (developer/other) where we get paid a real amount for our work for their clients (this is seperate to their primary development). Getting this right is very good for both parties and a key motivator as they can earn money and you don't need to do the sales effort ... and your both growing your asset.
• Get everyones signiture from their side ... all directors not just one. So if they disolve you can chase all of them for what your owed.
• Get a first right of refusal OR buyout of everything should they quit and we want to continue.
• Have an escape clause from our side. Ideally which we still get paid "something" if we opt out down the line.

Hope this helps.