Is giving equity in your business a good idea?
By Cliff Ennico
“My wife and I have a small construction business.
We hired a consultant to help us with our business planning, but since we don’t have a lot of cash on hand, we offered to give him some equity in our business.
What he came back with looks a little weird. He says he’s willing to put $25,000 into our business, to be paid back over two years. He also wants a monthly payment of 15% of our net profits for the next five years, to be followed by royalty payments of 5% of our gross sales.
Doing the math, he’s likely to get over $300,000 on top of his initial investment over 5 years, which is an astronomical return. Is this legal?”
Your consultant may be an expert on business planning, but he has a little to learn about finance.
First of all, you didn’t ask him to invest in your business. Since he is (presumably) providing consulting services, he should be paid a fee, which can indeed be based on your revenues or profit. Because each payment is compensation for his services, it will be taxed at extremely-high “ordinary income” rates, and there’s a risk he will have to pay taxes on the full fair market value of each payment he receives.
It’s an educated guess, but I think he’s offering to invest in your business because he thinks he will somehow get a better tax treatment that way. I’m not sure he will.
Now let’s take a closer look at his investment proposal.
There are only two ways to make an investment in a small business. Either:
- You lend money to the company and take back a note with interest; or
- You make an equity investment in the company and receive a percentage of future profits and losses.
Because he wants to get his $25,000 back over two years, that looks a little bit like debt, but he didn’t specify an interest rate. Loans to a company must bear interest at least equal to the lowest legal rate allowed by the IRS (called the “applicable federal rate” or “AFR,” currently around 1.5% per annum), or the IRS will “impute” interest on the loan, usually at a much higher rate.
But then he wants a share of your profits and gross sales even after the loan has been paid off. That looks a lot like an equity stake, especially since the 3% royalty on gross sales would continue for as long as you are in business.
It is possible to make a loan to a company in exchange for interest plus an “equity kicker”, and perhaps this is what the consultant has in mind. Normally an “equity kicker” – a percentage either of the company’s gross sales or net income – terminates when the loan is paid off. Also, in some states, the “equity kicker” can’t exceed the maximum allowable rate of interest under the state’s usury laws (usually 15% to 20% per annum).
Keep in mind that if the consulting fee payment is based on your “net profits” or “net income,” your consultant will almost certainly want the right to audit your books and records to make sure the payments are calculated right.
Clearly your consultant needs to talk to his financial advisor or attorney to get a better understanding of how this all works. In the meantime, assuming you really believe this person will add value to your business, I would propose the following:
- You and the consultant would enter into a consulting agreement where he or she would provide specific services in exchange for 5% of your monthly gross sales or $1,000 per month, whichever is greater, only for as long as the agreement is in effect; and
- If you wish, you can also give the consultant a warrant to acquire up to a 15% nonvoting interest in your company, exercisable not earlier than two years into your relationship (so you can see how well he or she performs), at your company’s then current valuation.
That way the consultant will be required not only to prove his or her value to the company before you issue any equity, but he or she will be required to pay for the equity at fair market value, which makes a lot more sense than a loan you probably don’t need anyway ($25,000 is an extremely small amount of money for a construction company).
Note on the New Crowdfunding Regulations. The SEC’s new crowdfunding regulations – allowing small businesses to tap the Web and their social media networks to raise capital – went into effect on May 16, 2016. My new book, “The Crowdfunding Handbook” (www.amazon,com, search for “Cliff Ennico” or “The Crowdfunding Handbook”), tells you how to take advantage of this exciting new financing tool.
I also posted on YouTube this week a one-hour YouTube video on crowdfunding your business under the new rules, which can be viewed free at www.youtube.com/watch?v=VIVBXUzADPQ (audio only version available at http://westportlibrary.org/digital/podcasts/crowdfunding-right-your-business).
Cliff Ennico (cennico@legalcareer.com) is a syndicated columnist, author and host of the PBS television series ‘Money Hunt’. This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our Web page at www.creators.com. COPYRIGHT 2016 CLIFFORD R. ENNICO. DISTRIBUTED BY CREATORS SYNDICATE, INC. @CliffEnnico.
