The Wall Street Journal recently detailed the increasing willingness of service providers to startups to accept the startup’s equity as payment for services. With the startling growth of so-called unicorns, private companies like Uber that have achieved stratospheric valuations, there is a hope among many vendors that they’ll get lucky with one or more of the startups in which they accept equity. I previously wrote on this topic, focusing specifically on law firm payment arrangements. That post mainly addressed the possible conflicts of interest that can be associated with equity compensation, but for today I want to focus on whether it makes sense, as a business matter, for service providers to accept equity.
I think the way to conceptualize this is to analogize to an individual’s personal finance strategy. Most financial advisors would suggest that you keep only a limited portion of your investments in illiquid (hard to sell) vehicles, like private company stock, so you don’t have too much of your money tied up if you need it in case of job loss or other financial emergency. Similarly, a service provider would not be well-advised to take all of its payment for services in the form of startup equity if the service provider is counting on fees to cover ongoing expenses. It doesn’t help you as a vendor to know that you own equity in a promising startup if you need cash to make payroll this week. Even if you are diversified by having stock in lots of startups, you have no assurance that you will cash out of the investments on a regular basis.
How to put this into practice? If you want to accept stock from a significant amount of your clients, you would only do it as part of a hybrid arrangement involving some cash payment. For example, you could accept a small amount of equity in exchange for deferring a cash fee payment for some period, where you believe there is a reasonable chance that you will eventually see that cash. Or you could accept all payments with a split of cash and equity, where the cash is at least sufficient to cover your expenses. Alternatively, you could have a general approach of not accepting equity from your clients, but you could take a flyer on a select few clients that you view as particularly promising, with the knowledge that your remaining clients will supply the cash to keep your business’s lights on.