With seeming legions of ordinary working stiffs jumping head-first into start-up ventures and striking gold with lucrative stock options, the lure of exchanging professional expertise for a piece of a dot-com or other technology company might seem like a good deal.
It could be. Law firms and other professional service providers have done it and continue to do so.
But before you assume you’re just giving your time to help a cash-strapped entrepreneur in exchange for some equity in the next Internet home run, think again. You might be getting more than you bargained for, and we’re not talking about equity.
David Wilke, owner of Wilke & Associates, a Pittsburgh accounting firm, learned that lesson the hard way. He once was approached by a couple of Internet entrepreneurs who were trying to get their start-up off the ground and looking for some business plan assistance. They suggested Wilke provide the work in exchange for equity in their company.
“It was a great idea,” Wilke says.
From an availability perspective, the start-up’s timing was good. It was off-season for tax work, and Wilke had just hired new employees, so he had expendable resources to devote to the venture.
But the company never went anywhere.
“They kept trying to hit home runs, and it just wasn’t happening,” Wilke says.
Are they committed?
Wilke didn’t get burned, but he did learn a few lessons. For one, it’s hard to gauge the commitment of the individuals you’re working with.
In Wilke’s case, the entrepreneurs kept promising they would quit their jobs and devote their full-time efforts to the business. They never did. Now, Wilke says, he would have to be “100 percent convinced” of the commitment of the individuals before getting into any such arrangements in the future.
In the case of an accounting firm, the choice can be especially difficult. If an accountant takes an interest in a company, the firm consequently can’t handle any of its public accounting needs. So the firm loses any potential fees it would derive from performing those functions.
The conflict factor
Charles Cohen, chairman and founder of Pittsburgh law firm Cohen & Grigsby, says lawyers and law firms are struggling with the issue of equity in exchange for all or part of their fees.
His firm is considering crafting a policy that will guide such transactions, mainly because of the avalanche of technology start-ups, many of which are looking for ways to stretch their cash. The profession’s rules don’t prohibit stock option deals, says Cohen, but he points to a number of key ethical considerations that lawyers must keep in mind.
“The rules don’t prohibit it, but the rules impose upon the lawyer the obligation to be scrupulously careful that the transaction between the lawyer and the client are both well-understood by the client and that the terms of the relationship will be well-understood,” Cohen says.
Lawyers are burdened by the requirement that they must be sure, for instance, that when they exchange services for equity, such a deal won’t be construed as too good. In most other business transactions, the two parties have the option of either renegotiating a deal which they judge as not good enough or taking advantage of one even if they believe they’re getting a much better shake than the other party.
But when lawyers are presented with an offer of an equity-for-services swap, they are compelled to tell the business owner that they should have another lawyer review the fee arrangement. Ironically, business owners offer the swap because they need to conserve cash. Now, they have their prospective lawyer advising them to pay another lawyer to look over their deal.
Even if a lawyer can work out an acceptable arrangement, Cohen says other potential problems exist.
Let’s say an owner gets an offer to sell, but the lawyer realizes it’s not in the owner’s best interest to sell under the terms offered. The deal would benefit the lawyer, however. In these cases, Cohen says, he’s not sure that all lawyers could separate their obligation to the client from their own interests.
Taxable consequences
Legal and accounting professionals are constrained by legal and ethical considerations — including tax considerations — when it comes to taking equity in client companies.
Any equity partner, faces tax consequences. Stock received in exchange for services is taxable during the year in which it is received. For a company with employees and other overhead to cover, a reduction in cash flow and a concurrent drain on company resources in delivering services to the client may bring a cash crunch.
Cohen points out an intergenerational problem that is starkly apparent in law firms but could apply to other kinds of businesses, as well. If there is a wide age range among shareholders, a stock deal that won’t pay off for several years may seem attractive to younger people but not benefit older shareholders.
Due diligence
Strategic planning and education consultant Lance Kurke recently got a call from an entrepreneur who was producing computer hardware and software for a hand-held device. The company was short on cash, so the entrepreneur asked Kurke, president of Kurke & Associates Inc., if he would be willing to take equity in the company in exchange for his services.
Before Kurke accepted, he says he did some due diligence and concluded that the market the entrepreneur was trying to penetrate was quite crowded, with more than 20 companies vying for a piece of it. Consequently, he backed away from a straight swap of services for stock, but is considering a half cash, half stock arrangement.
Kurke is quick to warn against trying to use the “home run” strategy, an assumption that that one big hit will make up for a lot of strikeouts, in considering an equity deal.
Says Kurke: “If you’re rolling the dice 10 times and betting your fee and hitting one time out of 20, you’re a fool.” How to reach: Wilke & Associates, www.npimall.com/wilke; Cohen & Grigsby, www.cohenlaw.com; Kurke & Associates, (412) 281-4227
Ray Marano ([email protected]) is associate editor of SBN Pittsburgh.
