Contracting For Equity? Get a Lawyer.

Andrew Kinzer · October 17, 2012

This post was written with collaboration from Saqib Rasool, CEO of Conceivian, and Joe Wallin, an attorney at DWT in Seattle. Many thanks for contributing thoughts and experiences. These atrocious illustrations are by Andrew Kinzer.

Watercolor drawing of sticks of dynamite with the fuse litEquity for contract work is something that appeals to the startup-er in all of us. You get to feel like you’re part of a cause, fighting for something you believe in.

It’s also a way for you to rationalize taking on a project that pays little to nothing for your time, and you’d otherwise completely avoid. At least this way you could make it big down the line right? Wrong.

Blinded by Glory

What newcomers don’t realize is that there are so many ways it can fail, that folks who have experienced it don’t repeat. For you naysayers – yes, there are glory tales of people making huge sums of money for work they did early on. Let’s be clear though that those are the exceptions, not the rule. I think it’s time people hear about all the ways this breaks, so they at least know the world of pain they’re walking into.

I’ve got a few friends here in Seattle who co-founded a startup called Conceivian, and after some time were getting close to running out of cash. They realized that taking some contracting gigs as a team was how they were going to keep everybody together.

They were in talks with a local business man with a promising idea who had a lot of experience working with small and micro-business. He had a few brick and mortar startups under his belt, a good reputation, and what seemed to be a good approach to market.

Oh, but There is Just One Thing...

Watercolor drawing of note that says - will be backBut of course, the client only had enough money for part of the project so he was willing to throw in a good deal of equity to make it happen.

A 40% stake in the company! Conceivian liked the idea so much, they reckoned it was worth the time and decided to kick it off. After all, they could do the work, get back to their own startup, and make a lot of money down the line if all went well.

That was about six months ago, and their perspective has so drastically changed after the series of events that unfolded, that they’ve allowed me to use their story to illustrate the mechanics of this arrangement and how it can all go so badly. The following are the lessons they’ve learned.

Lesson #1: Equity < 50% is not Authority

As the product became realized in the form of technology, features and user experiences, Conceivian formed perspectives of their own what it would take to achieve success.

Watercolor drawing of handcuffsYet, in this relationship they did not have authority to influence the direction of the product, regardless of whether the current path would get them where they needed to go.

As the client argued, at 40% ownership, the team held less equity in the company and did not have enough votes to overrule his opinion. Conceivian felt powerless to effect change, and had to ask themselves if they were investing more and more time in a broken product vision. Should they abandon now, or invest more time and see if it pans out?

Lesson #2: More Time = More Equity = More Emotionally Invested

Conceivian signed up expecting to work for a month or two, but there turned out to be more work by the week until it became a five-month engagement. Then the company hit a point where it needed cash to execute on a go-to-market strategy but the company was cash strapped (hence the equity).

Watercolor drawing of man digging a deeper holeConceivian was then saddled with the question, “If we’re already this invested in its success, and the company will have a reasonably difficult time going to market without this money, do we allow this to fall apart or do we pony up the bucks to make it happen?”

The more time you’ve sunk into a project, the bigger personal investment you’ve made into the company. When there are a thousand ways for a ways an early stage company can fail, the small things aren’t just your client’s problem; they’re your problem too. Don’t forget that investments you may be asked to make can come in the form of time, money, favors from friends, even your reputation.

What did Conceivian do? They made the decision to inject some cash to support the venture they took part in, and as you can imagine, their hole got deeper.

Lesson #3: You’ll Pay to Work for Free

Watercolor drawing of a guy with his pockets turned outOne thing Conceivian hadn’t thought through was the government’s perspective on this whole arrangement. As it turns out, Uncle Sam views the transfer of $200k worth of company ownership as an asset transfer worth… wait for it… $200k!

Oh, and the government wants a cut.

Conceivian had one of the worst situations possible: pay the government $50k out of pocket on a gamble that the company would find its way to profitability (a prospect many estimate at about 10%), or leave the equity on the table and scrap months of invested time and money. Oops.

Conceivian’s Final Message

As hard as it was to swallow, the only real option for Conceivian was ultimately to walk away from the whole situation, leaving behind the fruits of their labor to the founders. Perhaps one upside of finally leaving was that they didn’t get far enough downstream to deal with issues like getting strategically diluted, being forced to give the equity back or simply not being compensated.

Watercolor drawing of a ship sinking, and a guy in a lifesaverRegardless, after all that sweat and energy, Conceivian had lost claim to their equity, and of course all the months they spent on the project. Not only had they failed to bootstrap their own company, they had paid for their own living expenses while bootstrapping somebody else’s.

The most frightening thing about this topic is that companies tend to benefit far more than the contractor, and most contractors don’t have enough experience to really see their way clear of the pitfalls.

Conceivian’s final message is pretty simple: if you get pitched on equity for contract work, you should run away – run far, far away. Take the cash and run because given all the ways this thing can break, cash is the only thing you can walk away with at any moment.

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