A common consideration for business owners, especially for owners who have just started their business or are still in the startup phase of development, is whether or not to give a service provider equity in the business as opposed to paying them a salary or fee for the provided service.
In general, when a client wants to give equity to a service provider, the first question Your Contact Lawyer asks is, “Do you really have to give the service provider equity?” A substantially easier and simpler approach to compensating a service provider is simply to establish a services agreement, which will allow you to terminate service and any corresponding relationship with the service provider at any time or upon some amount of notice defined in the agreement. The main benefit to this approach is that a services agreement allows you, the business owner, an opportunity to walk away and have no further obligation to the service provider once the services agreement has been terminated, which can prove useful if your relationship with the service provider is not working out as you had initially expected. Another advantage is that services agreements are extremely versatile and can allow you to compensate a service provider in any way you like, including providing them with a percentage of profits or revenue.
What if offering equity is really necessary?
If you absolutely have to offer equity to a service provider, it is important to tie the employment or services provided to the equity offered. Under this approach, you at least reserve the option to buy the equity back from the service provider if they stop working for or providing service to you for whatever reason, whether they quit or you terminate the service. In this scenario, you would have the ability to buy back their equity at fair market value at the time of termination; alternatively, you can also offer a punitive scale, wherein you are able to buy back the service provider’s equity at some defined amount less than fair market value if they do not provide services for a certain minimum amount of time. Implementing a punitive scale protects you and your business against the risk that a service provider ceases work only months after signing the agreement and instead elects simply to wait on collecting on their equity.
How to provide equity: upfront or vesting over time or upon reaching certain benchmarks?
In addition to tying equity to the services provided, you should determine how you want to grant the equity to the service provider. Whether you want to grant all of the equity upfront or only allow for vesting over time or upon the completion of certain, predefined benchmarks, this consideration should be clearly communicated and detailed in any agreement. Furthermore, it is worthwhile to consider the potential advantages of also defining a restricted period during which the service provider cannot transfer their equity, so that you can assure that they will continue their work at least until the completion of this period, which would ideally correspond directly to the length of time necessary for them to complete their work.
What agreements are necessary to formalize this type of equity-services transaction?
At least three types of agreements are required to document this type of equity-services transaction.
• An employment or services agreement, documenting the actual services provided, any compensation (other than equity) for such services, how and when the agreement terminates, liability of the parties for problems related to the services, and other important protective provisions in connection with the services.
• An equity agreement, whether it is a Vesting Agreement or Restricted Stock Grant Agreement, that grants them the equity and establishes the option to purchase the equity back in the event their services are terminated or they quit.
• An operating or shareholder agreement, if your company does not already have such a foundational agreement. This type of agreement is necessary to make sure management and voting issues and mechanisms for the transfer of equity to others are established, so you can set the rules and lay out a roadmap for the company. Remember, you gave them equity, and even if it is a minority percentage, you will need to establish who has a voice in the company’s decision-making and how owners of equity can sell or otherwise transfer their interests to others.