Ellen is a founder of a law firm serving small and mid-sized businesses, many of which are in the startup stage and do not have the cash to pay her fees. Ellen also has a passion for yoga and teaches at a local studio.
The yoga studio owner wants to retain Ellen for legal advice, but instead of paying cash that she doesn’t have, she offers Ellen a small percentage of ownership in the business.
Should Ellen take the deal?
Ellen’s options are to forgo the potential business, reduce fees to an amount the owner can afford, or take the business, delaying payment to an unknown date and for an unknown, but potentially larger, amount.
If Ellen decides to either decline the business or lower her price, it depends on her need for current cash flow and her time available to take on the work relative to potential customers who might have the ability to pay.
But if Ellen chooses to trade fees for equity (and become an owner) in the customer’s business, there are a few issues she should explore first.
Here are seven things to consider if you’re thinking about trading services for equity:
- What is the business’s financial forecast? Ellen’s ownership and eventual payout is a long-term decision, so she needs to know if the business is profitable today, and its three- to five-year financial profit forecast. Also, is there a well-thought-out business plan to support the projections? Fortunately, Ellen has some experience in the yoga business; if she did not, she should seek expert opinions. She should also look at traditional financial profitability measures as well as cash flow.
- What is its current financial position? Ask for the company’s financial information and the owner’s tax returns to understand the studio’s current financial position. If the owner is not forthright in providing this information, it is a red flag. If Ellen goes forward with the deal, there needs to be a clear understanding of her rights to company financial and operating information.
- How are key decisions made, and how will your investment position be protected? Since Ellen has her own business to run, she will likely be a passive investor/owner in the yoga studio. But she should still review the studio’s governance structure. In particular, she should find out how the owner’s compensation is determined and approved, how she decides to obtain loans or other investors to buy equipment or grow the business, and if the business were to close down, how that decision would be made.
- How can you “sell,” or monetize, your investment in the future? Look at the studio’s operating agreement if it is an LLC, or bylaws, if it is an S or C corp to understand the procedures for selling an ownership interest. The studio may have a 10-year horizon, but if Ellen has a four-year horizon, she needs to determine how she can pull out her investment.
- What is your legal liability? If the company has liabilities other than accounts payable, like lawsuits, judgments, fines, or tax delinquencies, what responsibility and liability falls on owners?
- What is the company’s valuation? A company valuation determines the amount of ownership. For example, if the amount of legal services provided is $50,000 and value of the company is set at $500,000, then Ellen will receive a 10 percent ownership in the company. However, if the valuation is $1 million, then Ellen receives a 5 percent stake. Usually, there is a disconnect between the founder’s high valuation and an investor’s, which is much lower. Sometimes, a high valuation is based on a company’s customer list, but in a community with several yoga studios, that is of limited value as potential customers can move freely between studios. If the studio owns assets like the building in which it is located or has an attractive lease, that can increase valuation.
- How will your relationship with the owner change? Ellen now consults with the owner to set her teaching schedule. Going forward, if Ellen becomes an investor/owner in the business she will have another, very different, relationship with the majority owner. Ellen should project how the owner will be as a partner and steward of the business; this will be a subjective evaluation based on her interactions with the owner and her assessment of the owner’s operating style and approach.
An alternative to trading services for equity is trading for a loan to be paid with interest at a specific date. The research is much the same, with a focus on evaluating if the studio will have the cash at the time to pay off the loan.
While we used Ellen as example for this post, remember the same thinking applies to accountants, consultants, or anyone else providing a service for a fee. Make sure you’re researching a business fully before agreeing to take an equity deal.
- Trading services for equity in a customer’s business substitutes current pay for future pay at an unknown time and amount.
- You will be a small, passive investor, so make sure the governance structure protects your interest.
- Determine how you can get out and monetize your investment.
For more business planning advice, you can find more of Hal’s posts here.