Consulting for Equity: Different Types of Agreements

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How do you structure these things? There's a few different types of agreements that you might use. So the first one would be just a straight equity grant. That's saying, hey, okay, company, I'm going to come in, I'm going to do these things. Like Linda was going to do something and she says, It's $50,000 of services. You're going to pay me $10,000 now, and then 40,000 in equity. They say, fantastic. And then they're like, okay, here you go. Now, the downside to that is that if you get equity in a company that already has a valuation, then the government in most countries is going to say that's a taxable event the minute that you receive the equity. So in Linda's example, I think I said it was a $4 million valuation. Well, if she gets $40,000 worth of equity in that, then she would pay taxes that year on the $40,000 of equity she got. That would be considered as if the company had paid her $40,000 and then she chose to invest in the company. Now, here's what's cool about getting equity when you don't have to pay the taxes is that like, let's say that she's at a 50% tax rate. That means she'd pay $20,000 on the 40k they paid her, and then she'd only be able to buy $20,000 worth of stock. Right. Instead of that, if we can use a different type of agreement, like the next three I'm going to talk about, then there is no tax consequence and you effectively have, you know, if you're in a 50% bracket, you have twice as much. If you're in a 25% bracket, you have a bit. A bit less than that, but you get more money to invest. That's going to then accumulate value so much faster. So not getting a straight equity grant when there's already a valuation makes sense. Now, there are a couple of ways that you can get around that. And again, I'm not giving legal advice, so talk to your legal and tax advisors, but when you are. Nope, not but. But talk to your legal and tax advisors. That said, think about, what else could I do? Well, how could I not be receiving my equity interest in a company that already has a valuation? Well, if it's a new company and people are just putting their assets in and you're going to be part of that. Now, I don't like that as much because I don't like startups, right? I mean, I like startups, but I don't like to invest in them because the risk is too great of failure. So if it is though a startup, then they're really. Everybody's just coming in and typically there isn't going to be any meaningful tax. You could agree that it's $100, right? So then you're going to get equity in that. If you're getting equity in it for your services, it's going to be a very, very low amount. So if you think it's going to be worth a lot, you might want to go ahead and take a little tiny hit on taxes now, get the equity grant and then you're. The way the law currently is in the United States and most countries, you would. All of the growth in that would be not subject to tax until you sold it. You might also do what Peter Thiel did and say, I'm going to put that in a Roth ira, which we have here in the United States, that says I'm going to pay taxes on that money now, but then I'm never going to have to pay taxes on any of the gains. And that might go away because he's had so much success with it and there's been a lot of publicity about it. But. So that's kind of one way. The other way would be let's form a new company. And the new company that we're going to form, you're going to contribute all of the old company assets to, and I'm going to contribute my services to, and then you guys get to pick a valuation that's lower. So those are kind of the only two ways that I know of where you get a little wiggle room in the valuation. But if you do see that you're going to go into a company that has a long, a lot of upside and you want your equity now, that's something you can do. But just be aware that in most countries, you'll be paying taxes on that. So the next way that you could structure that is you could do that with options. Right? So option is simply the right to acquire equity in the company at a future time. Particularly with startups, you'll hear a lot about something called warrants. And a warrant is the exact same thing as an option. It just means that it's issued by the company itself. So if don And I did a deal and Don owns stock in XYZ company. And we did a deal, and I said, okay, Don, I'm willing to come in. Will you grant me some options on the stock you own 100% of in XYZ company then that would be an option. But if instead he said, well, why do you want to do that with me? Which he should. Why don't you just get the company to issue some options? Then those would be warrants. And the only real difference is because that's coming from the company and not from him. Okay, so whether it is warrants or options, one of the things that you can do is say, let me get an option to come into this company. And now the downside to that is typically that you would also need a profit sharing agreement or something like that, because the option doesn't generally entitle you to receive compensation from the company based on profits. So if you do a deal and you've got 10% options and the company makes a million dollars, you don't generally get distributed $100,000 because you don't yet own part of that company. They do typically have provisions, which we'll talk about a little bit later, that say, in the event that the company sells or there's a change in control of the company, then my options are exercisable immediately and. Or they vest immediately, because at that point you'll be able to get paid. You can pay the tax hit on whatever the value is and you've got cash to pay. But the big thing to think about is just an option will allow you to have the ability to get an interest in the company and not generally get hit with taxes at that time. But there is that downside of how that works. Okay, so now the next thing that you can do is phantom equity. So phantom equity solves the challenge of how do I get distributions, whereas option I'm typically not going to get distributions on profits. Phantom equity typically does provide that as you go along, you're going to basically be treated like a shareholder, only you are an equity owner, even though you're not. That's why they call it phantom, because you're not yet actually an equity owner. But for all intents and purposes, you are treated as if you are. Okay, except that you don't get to vote. So because you haven't exercised your equity or you don't have actual equity yet, you don't have the right typically to vote in the company that you would otherwise have if you were an equity owner. So phantom equity Basically says, hey, I've got the right to acquire an equity interest in this entity in this company and I get to participate in profit distributions as if I had this equity, but I don't actually have equity, so therefore I'm not able to vote. That's kind of what phantom equity is. And then last but not least, another, particularly in the United States way to do this is a thing called a profits only interest. And this is a, a doctrine that's actually kind of gone through the mill and, and it has, has been proven to work over and over and over as has phantom equity for that matter. Profits only interest says that, hey, I'm getting an interest in the company today, I have the interest in the company today, but it only allows me to have profits. And the government here in the United States says, okay, well generally if it's a profits only interest, you don't get the actual equity in the company. You've only got the right to receive the profits. So we're not going to say that you have to pay taxes now, but the profits only interest says when and if the company changes control, then I'll participate without having to exercise an option or anything. At that point I'll be able to participate in the sale of the company. So the profits only interest is the one that I use more often than any other. So unless for some reason the transaction doesn't qualify for that, I'll use this profits only interest. So profits only basically then allows me to receive, or you to receive the percentage of profits pro rata to whatever that interest would be. So let's say it's 10%. Whenever the company distributes profits, you get your 10%. Then when the company sells, you get your 10% of the sales proceeds, right? So the only thing that I really don't see that you get with the profits only interest that you would if you had equity is again the right to vote. Now, if the right to vote is terribly important to you, you might be able to enter into something called a proxy agreement with the owners that would allow you to vote. They would basically say, we trust you and we're going to allow you to vote our shares. The more of those things you do that causes your interest to start looking like equity, though, the more risk you would have that it might get reclassified as that. So I'd be careful about that. But basically with agreements, and this is just kind of a general good thing to know, you can accomplish almost anything that you can think of that's legal with an agreement. So just because attorneys Say, oh well, these things don't work that way just because Kleiner Perkins says, you know, well, we don't typically give more than 5%. Anything is possible. You just have to convince people to do it. Right? So remember that when you're negotiating that it's we're only limited by our own creativity and our ability to persuade. And there are other types of agreements that you could do, but these are the ones that are going to matter to me. I just say anytime that you're doing a new CO or you want to have the equity for whatever reason and you want to minimize the tax consequences to do it, then do that in connection with the formation of a new company. Even if the new company involves the contribution of the old company assets into a new co. If you're going to do anything else, to me, phantom equity or profits only is way better than options because you get to participate in the profits of the company company along the way. Now again, you could have a contract that was in addition to the equity options that says I'm going to get 10% of the profits of the company when I accomplish these things or in exchange for doing these things plus I'm going to get options. But a more clean way to do that would be phantom equity or profits only interest.

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