From Silicon Valley to Peoria, Illinois, cash-strapped startups look for inventive way to finance their business – often handing out equity to employees, consultants, vendors, and other service providers.

It’s a logical solution. After all, cash may be in short supply, but there’s a virtually endless amount of work to be done, from coding and web development, to PR, sales, general operations, or sage advice from an industry veteran. Seen in this light, it seems harmless enough to dole out some paper shares or options to get critical services that will take your business to the next level. And giving equity as compensation can help build loyalty among contractors and consultants, as they now have a truly vested interest in your company’s success.

Pitfalls in sharing equity

While equity can be a great tool for compensating early on, the drawbacks are significant. For starters, people tend to grossly underestimate just how much record keeping is involved. Speed is often of the essence early on in the startup lifecycle, and that often means rushing into casual arrangements. The lack of proper paperwork can lead to issues down the road.

And perhaps most importantly, equity is a business’ most precious resource, and the amount you give a contractor in stock can end up being worth many, many times more in a few years. Not to mention the fact that every time you compensate with equity, you dilute your own ownership of the business. For these reasons, experts often counsel startups to only give stock to contractors, vendors, and service providers as a last resort.

Tips for compensating with equity

When it comes to structuring your startup and staff, there’s no single right answer. However, if you are thinking about compensating non-employees with equity, make sure to consider the following points:

1. Plan upfront.

Any decision to hand out stock or stock options should be made within the big picture context of your company’s valuation and the total number of shares you’ll be granting. It’s wise to create a stock options pool that includes all the employees and contractors you plan on hiring in the next 18 months and how many shares each might get. Many young tech startups reserve 15%-20% for employee stock options. Note this figure would include consultants and contractors, but wouldn’t include founders’ shares or any early employees that are working mainly for equity.

2. Put it in writing.

4005320314 bdb6755711 m 220x220 Cash strapped? How to pay for services with your startup’s equity You never want to give out equity without proper paperwork in place, period. All too often, startups grant stock options to people based on a handshake, rather than written contract. Imagine if you grant stock options to a handful of consultants. When it comes time to sell the company or go public, you’ll need to know exactly how many shares are vested as that will impact the price per share. Without the proper paperwork, it can be a nightmare to reconcile and formalize these past arrangements.

It’s best to put together a written agreement with the help of a lawyer. Consider adding the following into the agreement to protect your interests down the road:

  • Right of first refusal
  • Share transfer restrictions to prevent consultants from selling their stock to others (like your competitors!)
  • Terminable at will, meaning they can be cancelled at any time

3. Don’t give equity to an unproven contractor.

Whenever possible, it’s best to avoid giving equity to a contractor or consultant until you have worked with them first. Remember, your equity is your company’s most precious commodity. You don’t want to dilute your shares until you know the individual is worth it. And by making your consulting agreements terminable at will, you can terminate your relationship with a consultant if they’re not performing well. In most cases, you’ll only be losing a few months of vesting on the stock.

4. Give equity based on performance, milestones, or deliverables.

When compensation packages are tied to deliverables and milestones, it helps incentivize people to be highly effective and help grow your business. But beyond motivation, there are more pragmatic factors at play here too. By linking number of shares to hours worked or other quantifiable measures, you run the risk of establishing the price per share of your common stock or options. You don’t want the flexibility to keep your future employee price as low as possible, so you don’t want to have evidence of higher prices.

5. Don’t jeopardize your S Corporation status.

If your business is structured as an S Corporation, be aware that the IRS places certain restrictions on who can be a shareholder. All S Corp shareholders must be individuals (not LLCs or partnerships) and legal residents of the United States. Don’t jeopardize your S Corporation election (and pass-through tax status) by granting shares to a consultant or advisor that may be structured as a Corporation or partnership.

Final thoughts

While compensating contractors, consultants, and vendors is not for everyone, it can be a useful way to get critical resources for your company when cash is tight. If you decide to take this path, be sure to consider your company’s big picture and future plans carefully.

Header Image: tarale via Flickr

Paperwork: Robert S. Donovan via Flickr