In the early stages of a company’s growth, entrepreneurs never seem to have enough cash.  At the same time, entrepreneurs in this situation need to retain advisors, professionals, and key employees to grow their businesses.  Given the shortage of cash to pay market rate service fees or competitive salaries, entrepreneurs often opt to compensate these individuals by giving them a “piece of the company”.  This often-used technique is considered by many entrepreneurs to be a no-cost solution for companies with limited cash resources. 

Before undertaking these types of transactions, entrepreneurs, and the individuals whose services they wish to retain, should understand the consequences of each transaction to the company and the individual.  A failure to understand these consequences can lead to significant problems down the road.  Before giving away a “piece of the company,” entrepreneurs should consider the following issues. 

• To be validly issued, shares of stock must be issued for valid consideration under applicable state law.  Under both Arizona and Delaware law, future services are not considered valid consideration.  As a result, an entrepreneur who wishes to hire a financial advisor to assist the company in securing financing cannot issue stock in exchange for a promise to provide those services in the future.
  
• Stock may be issued as consideration for services previously provided, but generally the issuance of the stock will trigger a taxable event to the grantee, taxable at ordinary income tax rates.  Unless the grantee has sufficient liquid assets, the tax triggered by a grant of illiquid stock is likely to be an unpleasant surprise.
  
• Stock or options issued at less than fair market value may trigger undesirable tax and accounting issues for the company and the recipient.  This is especially true if the company sells stock or grants an option at a price significantly less than the price at which the company is offering the stock in a concurrent private offering.  Under current accounting rules, the company may have to reflect this difference as a charge to earnings.  For the individual, the difference between the fair market value and the price paid for the stock ordinarily will be treated as taxable income.
  
• Entrepreneurs often do not negotiate, or at least do not negotiate aggressively enough, when giving stock or options in lieu of cash to obtain the services of a desired professional or employee.  In short, the grant of stock or options, especially for past services or less than fair market value consideration, is not a no-cost proposition.  Entrepreneurs who fail to understand this concept too often grant too much stock to too many advisors, which has a dilutive effect on the company’s existing stockholders, including the founding entrepreneur. 

A number of techniques are available to address these issues.  First, issuing stock as early as possible, before the fair market value of the stock increases as the company’s value appreciates, in exchange for cash equal to the fair market value of the stock, avoids adverse tax or accounting issues and enables the recipient to initiate his or her holding period for capital gains treatment. 

Second, if the company’s value has appreciated significantly and the recipient does not have sufficient cash to pay for the stock upfront, consider granting options at an exercise price at least equal to the fair market value of the underlying stock.  This technique allows the recipient to avoid a large cash outlay upfront, has no adverse tax consequences to the company or the individual, and enables the recipient to share in any appreciation in the value of the company’s stock following the date of grant.  The primary drawback to this technique is that the gain realized from the sale of the stock will be taxed at ordinary income tax rates unless the stock is held for more than 12 months following exercise of the option.

A third technique involves the grant of restricted stock with a corresponding 83(b) election.  Under this technique, the company grants stock to the individual subject to certain conditions, such as the passage of time or the provision of agreed upon services.  Generally, no tax is triggered until the conditions lapse. If the individual makes an 83(b) election, he or she can pay the tax immediately on the value of the stock received, based on its fair market value on the date of grant, and preserve possible long term capital gains treatment for any appreciation in the stock following its date of grant, assuming the individual holds the stock for the required 12 months before sale.

There are a variety of more exotic techniques to address the concerns of either the company or the individual in these circumstances.  In each case, entrepreneurs should understand the consequences of any particular technique selected and avoid the common misperception that giving somebody a “piece of the company” rather than cash is a no-cost solution without consequences.