So a major issue faced by many startup founders, especially when they are bootstrapping, self-funded, or just watching their cash, is how they can get legal or other services with little to no cash. The fall back position is to give the advisor or service provider a “piece of the action.” The founder often wants to use stock in the company they formed or stock options to avoid using cash, but still obtain needed advice and guidance. Here are the main problems you will run into:
1) Valuation– You will have a difficult time agreeing on a valuation of the company’s stock (see Section on Valuation). The founder often feels that they have the next greatest invention or idea of all time and the company is already worth billions despite having no business model or revenue (just watch an episode of Shark Tank on ABC). The valuation is what you use to determine the value of the stock in comparison to what the services are worth. (e.g. 1,000 shares of stock valued at $1 per share in exchange for $1,000 worth of services) The service provider or advisor may have a different idea of what your company or idea is really worth. If you can’t come to some agreement on the value of the stock, you won’t get them to sign on.
2) Risk– Beyond the actual valuation of the company is the risk inherent in a start-up business. The majority of new businesses fail and often quite quickly. If the company doesn’t perform what they say they can or will, the value is going to drop even before the company goes out of business. The advisor needs to factor in the risk associated with the company when agreeing to equity. In the prior example, 1,000 shares of stock for $1,000 worth of services is a little to simple of an example. The advisor faces risk that the stock will be worthless down the road and has to factor that in beyond the actual valuation.
3) Transferable– Any stock granted for services or after exercise of an option for services is typically going to be what is called restricted stock under state and federal securities laws. That generally means that the holder of the stock has to keep the stock for a holding period (usually 1 year) before they can sell it. There are some exceptions and it is different if the stock is or becomes registered with the SEC and the stock may no longer be restricted, i.e. going public. However, when a company goes public, not all stock is required to be registered, so someone without registration rights holding stock may still be stuck with restricted stock. You also have to find someone willing to purchase the stock and sell based upon a fair market value. If the stock isn’t trading with significant volume on a national exchange and have numerous market makers to help sell the stock, the holder of the stock will have a hard time finding someone willing to purchase it. This is another risk that needs to be factored in.
Often people look to S-8 stock for services. S-8 is when a company registers stock with the SEC for use in compensation of employees. It has been expanded to include certain consultants as well. S-8 stock is unrestricted and free trading when granted so it is transferable; however, there are certain limitations on what it can be used for and who it can be granted to, so these are additional risks or issues to be addressed. It must be granted to a “natural person” and cannot be for services involving fund raising type activities.
4) Legal issues– The other thing when dealing with attorney specifically is the legal issues that will or may arise when they assist the founder. The main issue is conflict of interest.
In California, under the Rules of Professional Conduct 3-300: “A member shall not enter into a business transaction with a client; or knowingly acquire an ownership, possessory, security, or other pecuniary interest adverse to a client, unless each of the following requirements has been satisfied:
(A) The transaction or acquisition and its terms are fair and reasonable to the client and are fully disclosed and transmitted in writing to the client in a manner which should reasonably have been understood by the client; and
(B) The client is advised in writing that the client may seek the advice of an independent lawyer of the client’s choice and is given a reasonable opportunity to seek that advice; and
(C) The client thereafter consents in writing to the terms of the transaction”
So if the attorney takes an interest in the business with stock in exchange for services, the conflict of interest rules need to be complied with. The attorney has to disclose possible conflicts of interest to satisfy this rule which many lawyers may not be willing to worry about dealing with. Failure to follow these rules can result in professional discipline against the attorney. Also, in some cases, once a conflict of interest arises, the attorney may have to withdraw from representation. The main conflict is usually where the attorney may be a shareholder in the company and wants to do what is best to increase the value of his stock, but legally and ethically he may have to advise the company against doing something legally risky even if that means his stock value could suffer.
So these are the reasons why an attorney might cringe when you tell them you don’t have any money but will give them stock in your new company.
So what are your options? There are attorneys and firms who will accept stock or options for their services, so you just have to find them. Another way to limit costs is to ask for a fixed/flat fee for certain projects because most experienced attorneys will know about how much time it will take for each task. Another way to limit costs is to ask for the attorney to bill you, but defer payment on that bill until the company gets some funding in the door. I think that a hybrid can be good where the attorney gets a fixed fee up front for a certain set of services in the early stages, the attorney then continues to keep the company as a client and bills for additional services along the way and then the attorney has the option of taking stock options or warrants in place of cash. There are variants where it could be 50/50 cash/stock, etc. This helps give the attorney some up front money, keeps them interested in the success of the business long term, and hopefully addresses some of the risks.
Also remember that someone agreeing to stock or options in your company is going to want to feel confident that there is a viable company, so you may have to treat them as an investor to present your case for why your company will make it.