Piercing the Corporate Veil – Sweat Equity Consulting

corporate structure e1295308456616 274x300 Piercing the Corporate Veil   Sweat Equity ConsultingAs I mentioned Tuesday, since shutting down startupSQUARE.com, I’ve received a number of job offers. Some have been as co-founder, most have been as a consultant with the possibility of becoming an paid employee, “as soon as we close our funding round.”

This has been very generous and flattering. But much like becoming a co-founder, getting paid sweat equity is essentially becoming an investor in the company. Instead of putting in money, you’re putting in time. As such, you should make sure to think of the proposals as an investor and get a reasonable term sheet.

Here are some of my favorite things to avoid.

(Please note: I am not an institutional investor and I am not a consultant although I occasionally dabble/consult in projects I find particularly interesting. My point in writing this is not to call anyone out, but to offer my [dubious] perspective on things that scare me off of projects so that owners and sweat equity consultants can better avoid some misunderstandings of perspective. If you think I’m wrong, awesome. I’m wrong all the time. Go for it. All names redacted.)

Valuations

I think it’s difficult, if not impossible, to value a pre-revenue company with any reasonable accuracy. If there is traction, ok…there are some benchmarks and you can look at seed stage funding rounds. But unless you’re a professional investor, you probably don’t have that skill. If you did, why would you be consulting for sweat equity instead of investing as a VC or for yourself?

I was approached with one sweat equity offer that placed the valuation of the company at >$5 million pre-money and before even a seed round of funding. That seemed high to me.

The company did have some revenue and paying users, but not enough to make any judgement on the company’s future prospects. At least not enough for me to make that judgement. I would be very wary of accepting a valuation like this, simply because I’m not qualified and as a consultant, I shouldn’t have to be.

Instead of giving me a valuation that I now have to negotiate, why not just issue me debt and let me buy stock at the seed round valuation (maybe with a risk premium) with that debt. It’s not asking for anything more than the institutional investors will get, and prevents me getting screwed if the VCs argue the valuation down to something like $1 million after I’ve already invested my time at a higher valuation.

Unseen Metrics

The same company, didn’t have a system to accurately identify it’s own key metrics. They could give me some basic figures, but couldn’t show me a chart of how numbers like user engagement were progressing over time. to be fair, that’s why they wanted to hire me, to fix that issue.

However as an investor, would you invest in a company that didn’t disclose it’s user numbers to you? Would you invest in a company that didn’t know it’s own metrics? Me neither.

(Although I’m sure that there are many investors that will.)

That lack of knowledge represents significantly increased risk. It would have to be an extremely compelling offer to go for this sort of offer. I was sorely tempted in this instance since it was a subject area I find very interesting.

Non-compete

This is a tricky one. I was once asked to sign a one year non-compete agreement as a sweat equity consultant.

From the perspective of the company, I can see how this is entirely appropriate. I wouldn’t want to bring someone into my company, see how it works, then go and build something better.

From the perspective of a consultant, I’m just one guy. While it’s flattering that someone might think I’m capable of immediately grasping all the complexities of the business instantly, it’s a bit unrealistic. If I can copy your business by just looking around, then your company isn’t going anywhere anyway. You don’t have a defensible business model.

One year is a long time in the tech world. Without receiving a real salary, I’d be wary of signing a non-compete in an area which I have domain expertise in. If I was a full time consultant in IT security (where I have 5 years experience) and then signed a non-compete, I’d be putting myself out of work for a year without receiving a penny.

That’s a tough sell.

Three Card Monty Corporate Structures

This is my least favorite thing in the world, being offered sweat equity in a corporate structure that is unnecessarily convoluted. I already own stock in two companies which own no intellectual property. It hasn’t worked out well for me.

  • Which country’s laws does the corporate entity operate under?

If it’s in a foreign company, you probably aren’t familiar with the local laws and don’t know how much protection you have against corporate malfeasance, restructuring, etc. You just don’t know.

Your ignorance of legal issues is an added risk which must be factored into any investment decision. Basically, don’t do it. Talk to a lawyer familiar with those laws.

If you’re in a complex structure with several multinational entities, that risk is compounded. So you should discount any future cash flows against that risk. Now that $1 million dollar payout is more like $10 grand when you factor in your own ignorance.

  • Which corporate entity do the founders own stock in?
  • Which corporate entity owns the intellectual property and other assets?

It is, in general, a bad idea to own stock in a different company than the founders. It’s a terrible idea to own stock in a company with no direct assets. There is a reason the founders want it that way, and it’s probably not to help you out. It’s to reduce their own risk and maintain control.

Nothing wrong with that. It just doesn’t help you.

IMPORTANT CAVEAT:

Please note that I’ve been on both sides of this and there are very legitimate reasons for a founder to implement the example structure below. For example, taxes can be greatly reduced in a variety of creative ways and that directly benefits the shareholders.

I am not saying anyone who offers this sort of structure is trying to screw you or is the spawn of the devil. I’m just saying you should be very very careful. You need to understand why the founder is doing this and whether that helps you or not.

A Simple Example

Let’s say:

  • The founder owns 100% of Company A and 51% of Company B.
  • You own 49% of Company B. (The founder is very generous.)

The company with all the revenue is Company C.

  • Company C is owned 90% by Company A and 10% by Company B.

Do you see the problem yet?

Firstly, it’s irritating. Now I have to do math to figure out that instead of the 49% of the value I thought I had, I actually have 4.9% of the value. But that’s kids play and anyone can do a bit of multiplication.

Secondly, it’s confusing. Just talking this out without a diagram is a pain. It’s often made worse because some clever people like to name the corporations very similarly. For example, Company XYZ Limited and Company XYZ International Limited. I dare you to say Company XYZ International Limited ten times fast.

The “name every corporate shell almost the same thing” is an incredibly common convention that makes just talking through the equity split confusing. I know one particular individual who used to do this deliberately. (I admit that I somewhat admire the deviousness.)

Thirdly, you may have a board seat in Company B, but Company B doesn’t make any decisions. So don’t think you have any say over what goes on.

Lastly and most excitingly, it is very very easy in this structure to cause Company B to go bankrupt.

The founder who owns 51% of Company B can elect to pay himself a salary of $1 USD. With no cash, Company B is now bankrupt. With no cash, Company B now must sell its assets including the 10% of Company C. At what price? Whatever the founder decides with 51% of the stock.

I’m not a lawyer, but my impression from some of the subsequent lawsuits I’ve heard of is that this is illegal in many countries and if Company B sells it’s ownership of Company C at less than market value it’s corporate malfeasance as far as I’m concerned. But maybe not in all countries and the cost of litigating will probably be more than your tiny share is worth.

This is an extreme example, overly simplified, and some would say unrealistic. I have seen something very similar happen more than once.

(BTW: putting your staff into a separate corporate entity and then forcing bankruptcy is a time honored way of getting rid of undesirable employees without having to pay their severance packages.)

The ‘A’ in company A stands for Advantage. The ‘C’ in company C stands for cash. I’ll leave it to your imagination what the ‘B’ stands for.

Summary

Again, I’m not saying everyone is out to screw you with sweat equity. Just be careful.

You’re an investor now. If you wouldn’t mortgage your home to put in the cash, don’t put in the sweat.

So…what should I post next? Tweet to tell me what to write:

Show me how to test product market fit!

or

How can I do lean startup in my friggin' huge company?

10 comments

  1. Real, practical advice. Thank you for posting!

    • Tristan says:

      Thanks Kevin!

  2. Cody Boyte says:

    Thanks for the advice. I’m learning many of these lessons a little at a time the hard way. I’ve put in tons of sweat equity (and often additional expenses out of my own pocket) on projects that ended up worth nothing. In a couple of cases the other person actually made out with a fair bit of cash and I got screwed. Not that they were trying to take advantage of me necessarily, but it happened because of the deal structure. You have a few more years experience than I so thanks for the heads up of further potholes to avoid going forward.

    • Tristan says:

      Thanks! Yeah…way too many tricks out there to know ‘em all. If you can add anything specific I’m sure others would appreciate the know-how. If you don’t have a blog, I’d be happy to publish it.

  3. Tristan,

    From your perspective, which I find very insightful, how would you structure sweat-equity agreements for start up corporations?

    Notes:
    Assuming that the idea is neutral; that the business’ “widget” has merit, that what ever the company wants to provide / sell is worthwhile to the prospective investor.

    Also that the agreement is taylored specifically to bring in an IT professional.

    Best regards,
    Vince

    • Tristan says:

      Hi Vince,

      It probably depends on what your goals are. I will just tentatively assume that the goals are:

      1) Get everyone to work immediately and make the company worth something.
      2) Get buy in from any consultant for the long haul.

      Most people have a per hour consulting rate they would charge. I would give any consultant their per hour rate as a convertible note and negotiate an interest rate on top of that. (This would of course be in regards toa single corporation which holds all the IP and revenue.)

      If the company does an fundraising round, the consultant can buy into the project with their convertible note at the same valuation an investor would. Alternatively, they can opt out and just stick with their debt if they feel like dropping out of the project at that point.

      That way there is very little to negotiate, you can get to work, and the consultant is highly motivated to make the company worth something.

      My two cents,
      Tristan

      • JimP says:

        Hi Tristan,

        I just had a discussion this morning with my lawyer about bringing on a consultant for their per hour rate that converts to shares. The legal firm’s labor specialist strongly advised against this because it gives evidence that they are an employee rather then the consultant. This then opens you up to risk from the IRS as well as the consultant.

        I’ve been burning lawyer hours on the back and forth over this one. Do you know of any site that has good examples for consultant agreement fee structures?

        Regards, Jim (a techie)

        • Hi Jim,

          Very fair point. My only suggestion there is to look at which is the higher risk. Not being able to get the right guy onboard or the possibility you have to pay slightly higher taxes?

          I am not a lawyer, so don’t listen to me on this one. However, I imagine there is a way to structure it in two transactions, one where you issue an IOU and one where the consultant becomes an investor in the company. If you’re really worried about the guy turning around and trying to sue you as an “employee” that’s not the guy you want to hire anyway.

          Remember that lawyers are paid to mitigate any form of risk, they are generally not paid to judge if a risk is worth taking (although the good ones can.)

          In any case, I think it’s aside the point.

          The above comment assumes that your goal is to get buy in from someone who you eventually want to become an employee but can’t afford to hire now or pay their regular consulting fee.

          If you can afford to pay lawyers to debate the issue and you’re worried about potential tax implications, this advice is definitely not for you. Just pay the guy a standard consulting fee and avoid the issue entirely. Certainly your lawyers are probably more expensive than any other type of consultant.

          Cheers,
          Tristan

  4. Robert Payne says:

    Tristan

    Excellent summary.

    I am facing the sweat equity and deal structure issues for the first time after two years of product development, some seed money from friends and family, and product testing with one customer that has been successful.

    The customer has indicated an intention to invest up to 25% for a passive stake and we are working the details. After reading your piece we will simplify, simplify, simplify.

    Thanks

    Robert

    • Tristan says:

      Ha, you may be on the other side of this. You may want to make it so complex that the customer doesn’t understand it! ;)

      Just kidding. I always think simpler is better. I prefer to have partners in a win-win situation.

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