Updated June 28, 2020:

Consulting for equity agreement is a popular avenue taken by companies in their early stages. It allows them to minimize the cash they have to outlay when there isn't a lot of cash to go around.

When Facebook went public in 2012, over 1,000 of its employees became millionaires. Those employees had accepted equity as their form of compensation, in lieu of cash. In this example and many others, an equity compensation agreement may allow its recipients to flourish if the company goes on to become majorly successful.

Equity Compensation Agreements

An equity compensation agreement will require a written document to explain the program's operation in detail. When companies decide to pay an employee or a consultant with equity, they usually use both cash and equity. An agreement offering 100 percent equity is uncommon because there's the risk the provider won't receive adequate compensation.

Calculating the Delta

One of the ways to estimate how much equity to offer an employee is to figure out the value the employee will offer the company. This is known as calculating the delta.

Let's say it's determined that an employee will increase a company's value by 15 percent. In that case, the delta will be 115 percent minus 100 percent. You'll want to take that number and divide it by 115 percent, bringing us to a total of 13 percent.

If that employee is going to receive an annual salary of $100,000, you'll want to calculate the employee's expense as 150 percent of the salary, including the margin and the overhead. Now, $100,000 really equals $150,000.

Finally, let's say the company has an estimated worth of $4 million. This makes $150,000 3.75 percent of the $4 million. The difference between 13 percent and 3.75 percent is 9.25 percent. There you have your equity offer.

Performance Standards

In an equity agreement, it's important to be clear in your definition of the work the recipient will be expected to perform, as well as the performance standards that must be met in order for the equity to be received.

Equity payments should line up with the employee's performance standards. The agreement should also specify when equity payments will be made, as well as the consequences for not fully meeting the performance standards. That is why the performance standards must be specific, attainable, and measurable.

Forms of Equity

Equity compensation can come in many forms. Three of the most popular forms are:

  • Stock options
  • Grants
  • Warrants

In the agreement, it should clearly state which type of equity will be provided, as well as the methods for valuing the equity.

If you're considering stock grants, the agreement will need to identify voting rights, as well as the class of the stock. It should also state whether any of the grants will vest with time. Additional performance standards that could have an impact on vesting will also need to be outlined.

If you're considering stock options, the written agreement will need to outline the strike price, exercise rules, and waiting period. Any rules concerning the ability to transfer the stock should also be included, as well as any information pertaining to tax withholding.

Benefits and Risks of Consulting for Equity

Taking equity is a complicated matter. It's wise to hire a seasoned lawyer and a sensible accountant. First, ask your lawyer if you're able to take equity. Also, know that some states impose securities regulation exemptions. However, most states also have exemptions for companies offering less than 25 people an equity agreement.

One of the misconceptions pertaining to equity agreements is that there's no cost when taking equity. This is untrue because when someone is issued shares in a company, they'll have to declare its value and pay taxes on it. When a company is in its early stages, the value should be nominal. However, once the company starts generating revenue, the value could be more than anticipated.

Also, both parties are going to incur additional fees as they relate to legal and accounting. If your equity begins to vest over time, ask your accountant about filing an 83(b). When someone files an 83(b) within 30 days of receiving equity, it allows them to pay taxes on the upfront amount, rather than its vested amount.

If you need help with consulting for equity agreement, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.