Getting Paid in Stock, Options or Promissory Notes: Negotiating Terms of Non-Cash Payment for Consulting Services

The consultant who gets paid in stock, options or promissory notes must negotiate for tax favored equity with the best upside and clear enforceable note terms.

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 Presentation for IEEE Consultants’ Network, Waltham, MA – May 26, 2010

By Robert A. Adelson, Esq.

 

 

EQUITY COMPENSATION ARRANGEMENTS FOR HIGH TECH CONSULTANTS

 

EXAMPLE  (Hypothetical and Fictitious)

 

SuperpowerSoft Co. 

                                                                        Employees: 5 (3 being part-time)

                                                Shares             Sales: -0-; Developmental State

EdisonPres., CEO                  40%                 Assets: 250k   Liabilities:      10k

Kwertzberg, VP Operations   40                    Cash:   50        A/P      10

Other Part-Time Employees  2                      Equipment      50

Investor Stocks (FFF)             10                    Technology     150      Sh/h Equity: 240k

Mansey, VP Mrktg (if vested) 8                    P/L: (30k)

 

Part-Time Consulting for High Tech Start-Up Company

 

            Tim Mansey was a senior officer at software giant, Zen Development Corp. inCambridgeuntil Zen’s acquisition by an even larger out of state computer corporation.

After leaving Zen, Mansey decided that, rather than job search for a full-time position, he would seek job assignments from different companies, selling his engineering, marketing skills from 15 years at Zen and other known companies on Mansey’s resume.            

Over the last year, Mansey developed a consulting business for software companies under the name, “CEO Strategies”. He has an ongoing 1-day a week assignment and completed job assignments with large and smaller companies, including assistance in marketing , product design, technology validation and some software development work.  One company has asked Mansey to join its board of directors.

Most clients have paid on time, and with one or two exceptions, the work of CEO Strategies has been very well received.  Originally, Mansey’s assignments came from colleagues at established firms, but now he also approaches start-up and emerging companies, even though most cannot pay Tim’s daily consulting fees.

Recently, Tim discussed a part-time spot in one such startup: SuperpowerSoft Co., newly founded by Tom Edison who invented the SSC proprietary technology, and Mitch Kwertzburg, who was with Tom at DEC and with family, etc. contributed the cash capital.

Formed 6 months ago, SSC now has 3 other techies part-time, leases space inBurlington, and has a product nearing completion.  SSc still has funds from investment by Mitch, family, friends, etc., but no one takes a salary.  So, Tom and Mitch thought it time to recruit a “sales guy” to help market the product.  Enter…Time and CEO Strategies.

Tim believes SSC has a breakthrough technology with ready markets.  With his industry background, Tim believes that he can attract licensing & strategic alliance partners (he sees ChyBase as likely 1st match) to speed SSC market entry but Tim needs authority.

Tom and Mitch like Tim, but don’t want him taking over and are not sure how much stock to give him.  They have several questions on compensation, terms and pitfalls. 

 

 

 

 

IS EQUITY FOR PAY A GOOD DEAL?

 

OPPORTUNITIES AND… PITFALLS

 

QUESTIONS OF THE CONSULTANT:

 

  • When does taking equity as your pay make the most sense?
  • What are the types of equity? Stock options

Or other arrangements a client can offer you?

  • How do we value the stock or options you get?
  • What taxes does the Consultant pay?
  • How do you avoid dilution
  • What other structuring issues should you ask about to protect your equity stake?

 

QUESTIONS OF THE COMPANY:

 

  • When does offering equity make sense to a Company?
  • Can this equity be paid based on performance? Or loyalty? Can we measure performance?  How much stock to give?
  • What if things don’t work out: Can we get the stock back? What if Consultant dies? Quits? What if we sell the Company?
  • Is stock (or options) paid deductible by the Company?
  • Will giving stock now hurt us later? In seeking financing? In morale with current staff? In recruiting new talent?

 

 

 

Equity Compensation for Services

  1. Forms of Equity
  • Common Stock: voting or non-voting
  • Preferred Stock:

Preferences in liquidation

Dividends, cumulative or not, management

  • Warrants or Options
  • Convertible Debt
  • Phantom Stock/ other deferred comp

 

  1. Vesting Schedule
  • Acceleration on change in control
  • Buy-back rights on Termination

 

  1. Stock Purchase Agreement
  • Investment warranties by purchaser
  • Company disclosure, business plan
  • Anti-dilution protections, pre-emptive rights
  • Company covenants, reports
  • Registration rights
  • Cash-out Rights

 

  1. Stock Option Agreement
  • Grant Date & Option Period
  • Exercise Price and Method
  • Company Plan, restrictions if qualified
  • Enhanced flexibility, if non-qualified.

 

 

 

 

 

 

 

 

Valuation of Company Equity

 

  1. Current (Tax) Fair Market Value

Rev. Rul 59-60: Assets,Indus, History, Comps.

Discounts for Illiquidity, blockage, minority

 

  1. Forward (Investor) Value from Business Plan

 

a.      Product, Technology, Uniqueness, Edge

b.      Market, Competitive Strategy, Penetration

c.      Management Team, motivation, track record

d.      Financial forecast, underlying assumptions

e.      Capital Sought, financing stage, funds use

 

  1. Blend Valuation with our without Services

– Entrepreneur’s investment, upside potential

-Present value of future using 35% ROI

 

Stockholder Agreements related to Equity

 

1.      Goals:       stabilize management, ownership, provide liquidity, valuation of shares

 

2.      Means: share transfer restrictions, voting agreements

 

3.      Involuntary transfers

 

4.      Voluntary transfers – 1st Refusal toCo., Shhs

 

5.      Control Change Co-Sale: Drag & Tag-along

 

 

 

 

 

Taxation of Equity (in lieu of cash compensation)

 

1.      Stock Issued – Purchase Plan

 

  • Not restrictive; open to Consultants
  • Tax Paid when no subst’l risk of forefeiture & stock has readily ascertainable FMV
  • §83 Ordinary Income Tax
  • §83(b) Election can accelerate the Tax

 

2.      Stock Option – ISO (Incentive Stock Option)

 

  • Restrictive Plan – FMV, limits on amount, exercise
  • No Tax on Exercise; Capital gain on sale
  • Limited to current company employees

 

3.      Stock Option – Non-Qualified Plan

 

  • Restrictive Plan NOT IRS Required

Tax Paid on Exercise of option

  • Capital gain on Later Apprec. Paid onSale
  • Not limited to current employees

 

4.      Equity Based Compensation Plans

 

  • Phantom Stock; Stock Apprec. Rights (SAR)
  • Tied to co. growth, no equity but payment rates
  • Not restrictive; open to Consultants
  • Taxed as Paid; All §83 Ordinary Income Tax

 

 

 

Payment by Promissory Note

 

1.      Installment payments – fixed time-table

 

2.      Debt obligations – promissory note

 

  • Unconditional promise to pay sums owed
  • Interest on outstanding debt
  • Warrants in client stock – Equity “kicker”
  • Defining “events default” & consequences
  • Collection of costs & Attorneys fees
  • Collateral security for debt
  • Perfection of security interests

 

3.      Installment taxation on payments received

 

4.      Benefits of note for enforcement

ABOUT THE SPEAKERANDPRESENTATION

 

            These materials were prepared by Robert A. Adelson, Esq., Partner at Engel & Schultz, LLP, 265 Franklin Street, Suite 1801, Boston, MA 02110, (617) 951-9980, fax: (617) 951-0048, e-mail: radelson@engelschultz.com

 

            Mr. Adelson is a graduate of BostonUniversity, Phi Beta Kappa, and Northwestern University Law School in Chicago where he was a member of Law Review. He has an LL.M. degree in Taxation fromNew YorkUniversity, and is a member of theMassachusetts,New York and U.S. Tax Court Bars.  He began his legal career in 1977 as an associate at major New York City law firms, first Dewey Ballantine and later Weil Gotshal & Manges, before returning home to Massachusetts in 1985, where he has been a partner at several Boston firms before joining his present firm as senior business law partner in 2004.

 

            Mr. Adelson is specialized in corporate, taxation, business and technology transactions.  In those areas, he frequently represents (1) small companies with their various business needs, including shareholder and employee issues, financing, commercial contracts, intellectual property, joint ventures, mergers and acquisitions, succession planning (2) senior executives, in negotiations over severance, employment, relocation, stock options, compensation and stockholder arrangements, and  (3) consultants – in liability protection, intellectual property protection, trade identification, vendor, client and subcontractor arrangements.

 

            Mr. Adelson’s firm, Engel & Schultz, LLP, is a small but broad service law firm of 6 attorneys inBoston’s Financial District.  The firm complements Mr. Adelson’s work in business and tax law with seasoned attorneys in family, probate, real estate and litigation matters. 

 

            Mr. Adelson is a frequent speaker at business forums and Chairman of IEEE BostonEntrepreneurs Network www.boston-enet.org .  Further information on Mr. Adelson’s background and his past published articles is available at his law firm website.  To view many of Mr. Adelson’s past articles, see http://www.engelschultz.com/index.php/category/publications/  or https://robadelson.wordpress.com/

 

The speaker thanks Ron Goodstein and Tom Vaughan for the invitation to speak for IEEE Consultants’ Network on the topic of Getting Paid in Stock, Options or Promissory Notes:  Negotiating the terms of on-Cash payment for Consulting Services” at the Emerging Enterprise Center, Waltham, Massachusetts on May 26, 2010.   

The example on page 1 of these Materials are hypothetical and fictitious although the questions on page 2 are drawn from actual client questions.  The purpose of the example is solely to illustrate contracts issues, strategy and planning concepts and stimulate meeting discussion.  The remainder of these materials are to offer rough outlines of broad areas of major contracting situations for technology based business. It is hoped that these materials will inform discussion and be useful reminder of topics covered for the attendees.  These materials are not legal advice and not intended as any substitute for professional advice or counsel in a particular case.

©2010 ByRobert A. Adelson

Author: radelson

Robert Adelson has been a corporate and tax attorney since 1977. He began as an associate at nationally prominent New York City “mega” law firms, first at the Wall Street firm Dewey Ballantine Bushby Palmer & Wood and later at the Park Avenue firm Weil Gotshal & Manges. In 1985, Adelson returned home, where he has since established himself as a respected Boston business attorney. He has attained partner at several small and midsize Boston law firms, most recently at Lawson & Weitzen LLP and then Zimble Brettler LLP, where he was a partner from 1994 to 2004 before becoming a partner at Engel & Schultz LLP.

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