Paying Vendors With Equity

Q: I have some people working on my company's business plan and am currently negotiating with another company to incorporate my ideas into a working Web site. I'm paying these people with equity. How much should I offer, and how much should I keep for myself?

A: Every deal is different. What you offer depends on your business, the contractors and the size of the opportunity. Your equity is your currency, and you've only got 100 percent to spend. Every but you spend now is less you can spend later.

You're buying goods, services and cash with equity. The equity's value depends on the company's value. If you value the company at $10 million, then you would offer 10 percent of the company for $1 million in services. Equity negotiations involve valuing the company and basing percentages on the negotiated value.

For example, if it's just you, an idea and a business plan, you may value your company at $2 million. (In practice, $2 million would be high unless you have proprietary technology, a prototype or some other reason to believe you're viable.) You could then purchase $100,000 worth of goods for 5 percent ($100,000 divided by $2 million) of the company.

The problem with paying vendors in equity is you don't want your valuation negotiations to hamper later negotiations with VCs. If you pay vendors using a valuation of $1 million, a VC would be rightly skeptical if, two weeks later, you claim the company's value has jumped to $10 million.

One solution is to structure the vendor's contribution as debt. The vendor tracks time and materials and gives you a loan to cover their work. The loan goes on your company's books as a note payable. During the first investor round, the debt converts to equity at the same valuation the investors are using plus a bonus (e.g., 40 percent) for doing the work on faith. Use a lawyer with start-up experience when structuring this kind of deal-doing it right may involve regulations and subtleties I don't know about.

Make sure anyone you pay in equity understands that their share will almost certainly get diluted. If your round-one investors buy 30 percent of the company, the original shareholders see their percentage ownership drop by 30 percent. Someone who had 10 percent will have only 7 percent after the investors enter. In theory, however, you only accept an infusion of money if it helps the company become worth enough to make up for the dilution.

As a benchmark, after your first professional investor round, you can expect the equity to be split into thirds: one-third for the founders, one-third for employees and managers, and one-third for the investors. Unless you wish to reduce the founders' ownership, that only gives you 33 percent for attracting your executive team and star employees. A CEO will often want 5 to 10 percent of the company, so you want to be sure you have enough left over after paying your contractors to attract the rest of your management team.

As an entrepreneur, technologist, advisor and coach, Stever Robbins seeks out and identifies high-potential start-ups to help them develop the skills, attitudes and capabilities they need to succeed. He has been involved with start-up companies since 1978 and is currently an investor or advisor to several technology and Internet companies including ZEFER Corp., University Access Inc., RenalTech, Crimson Soutions and PrimeSource. He has been using the Internet since 1977, was a co-founder of FTP Software in 1986, and worked on the design team of Harvard Business School's "Foundations" program. Stever holds an MBA from Harvard Business School and a computer science degree from MIT. His Web site is a http://www.venturecoach.com.

The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.