Gross profit royalties vs non-voting equity

I began work with a small startup last year, working as a consultant. Consulting didn't last long because I saw great potential in the company and made it clear I wanted to be a part of it.

I ended up in a gross profit royalty share with the company. To summarize: I get X% of gross profit for 10 years (which included a short vesting period, since passed). The agreement also included a clause which forces my royalty to be bought out (for "fair value"/independently assessed) in the event of a buyout.

At the time they did not want to give me equity because they were in the midst of a client negotiation and did not want to complicate that negotiation, plus no doubt they had other worries.

A year of full-time work rolls past and we have not made any significant money yet. I am working from my savings. But a big contract is on the horizon that could be worth millions...

I have two worries:

• The royalty agreement is only 3 pages. Neither party wanted to get bogged down in complicated legal frameworks at the time, and in my experience a personally binding relationship (they are good friends) is worth more than any contract. But now with millions on the table I am worried that agreement is not tight enough or tested. I trust them, but things are open to interpretation
• In terms of tax, any royalty I get paid out will be regular income and could potentially come as huge lump sum. So I would lose out big time on tax (i.e. lose ~50%). I am anxious that another remuneration structure could be more tax effective.

Because of this I have recently discussed becoming a shareholder with them, and it turns out they happy for me now to join with them as a shareholder.

So now a new negotiation is on the cards.

• What percentage equity should I get?
• What type of equity?
• What are the pros and cons for me trading royalty for equity?

As far as equity percentage goes, it seems they are willing to offer a 1:1 royalty % for share %. But I am not sure how much each is worth in proportion. One of my friends tells me that gross profit share is worth more than equity.

The other thing they have made clear is they want to give me non-voting shares. Because there are only two shareholders (they each have 50%), if they give me a vote then I will effectively have the balance of power which neither of them want. OK, that seems fair enough for me, but at the same time my understanding is that if someone wants to take control of the company, they could ignore my shares thus bypassing my equity. Once they have control they could do things to make my shares less valuable (or even useless?).

So yeah, I guess I am just looking for some advice on this.
Thanks

First of all I'd make sure everyone is in agreement to the money owed you at the moment. Total up your percentage of the gross profits to arrive at a figure owed right now. To keep it simple, let's just say it is $1000. Write it down and make everyone sign it so it can never be disputed later.

Now, from their stand point, they have several options. One, they can pay you the $1000 today and just let everything continue on as is with no contract changes. If so, you get the cash and owe taxes on $1000. Or two, they can exchange the money owed now for shares in the company. This is where it gets dicey.

Sometimes being granted shares is the same as taking a cash payment, and you'll owe taxes on the shares. But who's to say what one share is worth? A voting share is worth more than a non-voting share, but still it's hard to place a hard value on any of the shares. With a big contract in the wings those shares have a greater perceived value, but it's all still guesswork. Make it clear you are living off savings and cash is of primary importance right now. And from what little I know so far I'd leave the arrangement alone.

Even if you have to plan for taking one large lump sum payment should the contract materialize, you can still plan for this. There are ways to reduce your tax liability after the cash is in hand. With that cash comes the ability to make some financial moves you wouldn't ordinarily have.

OK, breaking down the question into its components Assets + Expenses = Equity + Revenue + Liability

and gross profits is Revenue-Expenses and you get X% but only for 10 years. Since equity is by definition Assets-Liability - Profit the question is whether the profit is retained (goes into the asset column) or paid out as dividends (apportioned to equity). So if there are debts, then your friend is correct in saying that gross points is better than shares but not if the bulk of the profit comes after 10 years. Also valuation of the equity portion factors in growth which the vulture capitalists salivate over due to the supposed J-curve.

royalty == lumpy income ... now whist this is a tax issue which varies across jurisdictions, there are standard ways to handle it without renegotiating. The obvious is to assign to discretionary trust (if contract allows) then let the trust dribble out as necessary. More complicated financing firms can buy out the revenue in return for once off lump-sum which could be interpreted as capital which in some jurisdictions has tax benefits in rolling over to a new startup. I'm not an accountant so don't quote me.

working from savings - presumably the others are doing also or are they coughing up extra money for the day-to-day expenses? there are too many variables to give any answer to what is a fair % because reward should follow risk ... if the 2 founders saw the market opportunity first and you didn't (initially consultant) then that indicates that hard work is not sufficient. From their PoV are you band-riding or have you put in the effort that distinguishes an employee from founder? Should you need to chip in cash as well (but then they take out labor costs in expenses column)?

share structure/class - if they want to create a 2nd tier shareholding which is purely financial, then this is a debt/equity swap (debt considered your time if paid market rates). There's no indication what it is relative to the Class A shares but presumably there's a formulae that everyone is happy with. The voting is a different question as an owner has specific legal rights and recourse under law (again depending on jurisdiction). This is dangerous if the voting rights can allow them to alter or change the share-structure at will, potentially squeezing out minority shareholders (or more likely allowing investors to have preferential rights). This is where a shareholder agreement comes in handy indicating what happens during liquidity events or dilution ... that 3 pager rapidly expands to mind-numbing detail !! Here you have to ask yourself the question, are you the type that is good at being a director (ie corporate governance) or have sufficient experience to make long-term decisions?

What you are asking doesn't have an "obvious" answer but I've crafted the framework to think about it (if engineer, 5 variables should be trivial). Is there scope for diddling the books? Is the risk-return curve appropriate (horizon of time-frame and appetite for risk ... money now or later). If you had to put yourself in a box, would you be (passive) owner, director, or manager/employee?