Like employees, consultants may also be eligible for equity compensation, which is a kind of non-cash payment. Businesses often provide equity payout when they cannot compensate with enough cash or provide salaries below market. Equity payout can be done with different types of equity compensation, which include performance shares, stock options, and restricted stock. Based on the type, businesses need to structure equity compensation with vesting schedules and exercise terms. All these types of equity payout provide investments that give them a stake in the business. With vesting restrictions in place, equity payout enables consultants to partake in the firm’s earnings via growth and may promote alignment of interest and retention. If you want to provide equity payout to consultants, you need to understand all its advantages and disadvantages alike. We will discuss that and more in this article to help you make informed decisions about equity payout.
Equity payout or Paying Consultant with Equity
Companies, both public and private, but particularly startups, often offer employees and consultants a chance to receive a portion of their pay in the form of equity. Equity payout is an option for startups to recruit top talent when funding is tight, or the company wants to reinvest profits in expansion. Let’s understand equity payout for consultants in detail.
Reasons why a company may choose to pay a consultant with equity
Cash-strap startups often offer equity because they do not have funds to afford to pay the top talents. However, with equity payout, a consultant may not earn returns immediately but have an opportunity to cash in case the startup grows to become an extremely profitable corporation. Startups usually offer equity for paying consultants to get off their feet without boring a hole in their initial cash flow.
Advantages of paying consultants with equity
There are several benefits of offering equity payout to consultants, especially for early-stage startups that are low on funding and still want to attract the best talent.
- Attract top talents – When companies don’t have adequate cash flow, they can offer equity as a promise to share profits. Due to its several tax benefit and the possibility of high returns, it is a great way to attract top talents in the industry without having to pay more in cash. According to research conducted by Aptitude Research Partners, companies that provide their employees with equity get 26% higher calibre of hiring and are 42% more likely to have positive reviews on Glassdoor.
- Save cash/improve cash flow for the company – When a company is in its initial stage, it may not have enough funds to pay a great salary. By offering equity, the business can improve cash flow by giving the consultants a stake in the business instead of making cash payments.
- Higher returns possibility – When an employee or consultant gets paid in equity, they have a chance to earn higher returns in case the business grows to become a corporate giant. Even if the growth is not as magnanimous as Google’s or Tesla’s, they stand a chance to get a cut from the profit the business makes.
- Tax advantage – When equity is provided in the form of NSOs or Non-Qualified Stock Options and ISOs or Incentive stock options, they can offer tax advantages to the employer and employees. Non-qualified stock options, for instance, exclude companies from reporting their recipients’ receipts or the date of exercise of the option. Now, when an ISO is granted, it does not immediately result in taxable income. Holding the shares in the year of acquisition and the execution of the option to purchase them both do not result in any immediate income.
- Alignment of interest – Equity incentive schemes are being used by many businesses as a means of reducing staff turnover and fostering a culture of sustainability by better connecting the interests of the business and its major stakeholders. The interest of the person getting equity is aligned with the long-term performance of the firm because of the potential growth in the valuation of the stock.
Disadvantages of paying consultants with equity
Despite all the above-mentioned advantages, there are some disadvantages with equity payout that both the business and the consultants much consider. Consultants must remember that there is always a degree of risk involved with receiving equity payout. Let’s look at some disadvantages outlined below:
- Risk of a consultant if the company does perform not well – Just as the consultant stands a chance to make money from the profits, they also stand a chance of not making any profits at all. Additionally, the consultant has to deal with not getting paid while toiling to provide work to a startup without guaranteeing they may ever get money in their pocket.
- Potential for Dilution of equity for existing shareholders – When investors play a role in the growth of the startup, there is a potential danger of dilution of equity for current shareholders (aka the consultants). Say the founders decided on a $15 million valuation and issued $1.5 million shares with a cost of each at $10. But an investor with a different opinion proposes a different valuation of $2 million, seeking 25% ownership. If the founders give in, the market value of the company is likely to fall, lowering the value of the stock for everyone.
- Complex to manage – Time is money when you’re committed to labor for a share of ownership. Before ever trying to bring their product to market or turn a profit, many entrepreneurs mistakenly believe they get a partner who will do everything for free and keep expanding the project’s scope. So defining the terms of work and management becomes increasingly complex.
Importance of 409A valuations when offering equity
According to Section 409A of the Internal Revenue Code (IRS), the fair market value (FMV) of common stock in a private firm is determined by an independent 409a valuation. Therefore, you can’t give away any kind of shares, including equity payout, to a consultant if you have no idea what they’re worth. A 409A valuation is required if you wish to issue shares of stock to anyone.
409a valuation to pay consultants with equity is crucial. IRS requires the strike price of the consultant’s equity payout to be commensurate with the fair market value (FMV) of the stock when you hire them. This cost basis for purchasing shares is determined by 409a valuation, subject to section 409A of the Internal Revenue Code (IRC).
The IRS may impose a 20% fine on the valuation of the company if a business offers equity payout without a 409a valuation and there if FMV and strike price are not determined. This penalty accounts for the gap between the strike price and the fair market value. Therefore, if you are thinking about an equity payout while you are engaging a consultant, a 409a valuation is a smart option to consider.
Setup and Manage Consultant’s Equity with Eqvista
Want to set up equity payout for consultants? Eqvista can help! Ensure a proper 409a valuation in compliance with IRS by working with expert providers. Eqvista is a worldwide acknowledged expert in producing defensible 409A valuations for enterprises of all sizes throughout every sector. NACVA recognizes us as a team of highly trained specialists with the appropriate qualifications, competence, and experience to offer you the finest service. Contact us today to learn how you can set up and manage equity payout for consultants on Eqvista today!
