Contractor Equity Stake
We received this from a contractor who has been offered a contractor equity stake instead of pay at the company where he is contracting. He asks Dr McLaughlin what he should do.
Robin the Contractor
I‘ve been working as a contractor for this small company who are building this product for a niche marketplace.
However, the funds have run out and they haven‘t paid me for a few weeks now.
The product has not made much money yet but it has huge potential especially after they fully develop the software part of the product.
Now they are offering me an equity deal with shares in the company which would involve me waiving my contracting money for the best part of the next year.
It is very tempting.
What should I do, Dr McLaughlin?
Dr McLaughlin‘s IT Surgery
Don’t even think of doing this by yourself.
You must involve professionals or you‘ll most definitely lose out.
You need to come to an agreed valuation of the company.
Company Insolvent
As there is little income and it looks as if this company is to all intents and purposes insolvent this shouldn’t be high.
The only thing it can be rated on is potential.
However, as they‘ve run out of money and income is far less than costs then they are, in reality, offering you a stake in nothing.
Company Valuation
That‘s not to say that you shouldn‘t still look at it but don‘t jump in blindly.
SO, ask yourself why they are not able to raise further equity in the marketplace.
I would get your accountant involved if you have one and get him to talk to the company’s accountant to come up with an agreed valuation using company valuation techniques and parameters.
So, iIf they can agree then you need to look at what you are effectively putting into the company.
All the money you haven’t been paid so far and all the income you forego in the future should be taken into effect.
Investment in the Company
Say, the company is valued at £150,000 and you are going to forego £100,000 of income this is effectively you putting an injection of £100,000 into the company which would now be valued at £250,000 with your cash injection.
This would put the equity stake you need as being 40%.
After all, if an investor came along and gave them £100,000 then they would expect a 40% stake.
As their money has run out, and they need you, you are in a great position to bargain.
Don’t just take any measly offer that they give you.
Play hardball with them.
Contractor Equity Stake – Wait Till Company Insolvent
One thing you don’t say is how much you need the guys who currently own the company.
If they are good then all of you working together would be good for the company.
However, at the moment they have created a company that is heading towards insolvency.
Another alternative is to wait till it actually goes bust, which it most surely will do unless they can find a mug investor, and then buy it for peanuts from the administrator or receiver.
Contractors Undervalue Themselves
Contractors (and permies) tend to undervalue themselves in these situations and end up working for nothing for a year or so for maybe a 5 to 10% stake in the company, which would give the company a valuation of 10 to 20 times the 100 grand you are effectively putting in.
This would give a valuation of £1m to £2m which is ridiculous for a company about to go under.
You have to take care and get more advice as to whether this will work, or not, and eventually be successful or you could find yourself working for nothing for a year and the company never makes enough money and goes under anyway.
How well, as an IT Contractor, do you really know this marketplace and whether the product will sell – enough to bet a hundred grand on it?
I‘m not saying don‘t go ahead but don’t sell yourself too cheaply, get proper advice and do a proper analysis of the prospects for this company before you take your contractor equity stake.
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I agree, this is a recipe for being screwed over
I would want to see the directors putting personal assets on the line as part of the deal, possibly with then being held in escrow
Company valuations of non-PLCs are practically random numbers
A contractor buddy of mine got screwed over in this manner. He was one of a bunch of contractors who worked for equity on a gaming app.
When the app was almost ready, the company owners had the company wound up, claiming insolvency (which they were), but – and this is the screwy part – had sole rights to the Intellectual Property.
So they merely started a new company complete with a ready made product and no existing debts or liabilities. Both he and me suspect that was the intention right from the start.
My friend should have been sitting on a pile worth a good few hundred K, if not a million by now, but in fact had been supported by his wife whilst he worked almost a year for free.