Should you accept stock or equity in a client’s company as payment? To many consultants today, the obvious first answer is no. The issue is complicated by the fact that although many companies in the Internet industry have failed, the industry itself promises a business revolution. And stock options offer consultants an opportunity to get in on the ground floor.
But how do you decide whether or not to accept stock options or equity in any given company? Here’s some advice from people who have won—and lost—at the game of stock-option roulette.
Ask to see the business and revenue model
Across the board, consultants who have “been there, done that” with stock options recommend that the most important thing to do is evaluate the business model of the potential employer. Evaluating the business model is vital, since it can tell you whether the company has the expertise necessary to succeed in a rapidly evolving market. If the company has a sound business model, the chances are higher that the equity offered to you will actually be of some value.
Behave like a venture capitalist performing a due-diligence check. Learn as much as possible about the background of the company’s promoters. Have they succeeded in prior business ventures? Check the financial performance or projected performance of the company. Ask to see the previous year’s financial results, if they’re available. Does the company offer a product or a service that has the potential to appeal to a demanding consumer market? If so, the chances of the company’s stock trading above its initial price are a lot higher.
Evaluate the company’s plans to go public
Many companies offer hefty stock options to avoid paying the relatively high salaries that a technically qualified consultant commands. As many of us know, however, an offer of stock options may not be such a bad deal if the company has plans to go public in the near future. But the fact is that few companies actually do go public. According to David Root, president of Pittsburgh-based financial planning company D.B. Root & Co., Inc., only one in 10,000 companies go IPO. “If they do go public, 85 percent of all IPOs trade below their IPO price within 12 months,” Root said.
Check whether the company has actually filed for an IPO. If it has, ask who the underwriter for the IPO is. A known name is much more likely to lend credibility to the IPO—if the company’s IPO plan is being underwritten by a well-known company like PricewaterhouseCoopers, for example, you stand a much better opportunity of actually earning some revenue from your stock options if you decide to cash them in.
According to the High-Tech Equity Practices Survey recently conducted by iQuantic—a California-based compensation consulting firm—the percentage of high-tech workers receiving stock options is 30 to 50 percent higher than it was four years ago. The survey of more than 200 high-tech companies also reveals that the average option granted to a senior executive tripled from 1988 to 1998, and increased at least 30 percent in 1999 alone.
Further, the report says, “Despite the recent downturn in the Internet market, there has not been a stampede away from stock options in the marketplace. Options have become the centerpiece of pay in the new economy and will remain there.”
Go over the fine-print clauses
Make sure you understand all the terms attached to accepting stock or equity in the company. Many companies offer stock that has a lock-in period prior to encashment. Find out how long this period is and decide whether you consider it to be reasonable or not. Also take care to ensure that the stock or equity is transferable. In general, it does not make sense to accept stock that cannot be cashed in if the market shows an upward swing.
Also try and negotiate an antidilution clause into your package. Swapneel Kshetramade, a consultant at Ascent Computing Group, says that “If a company is offering options as part of the compensation package—as many dot coms do—try to negotiate an antidilution clause into the offer. Or try to negotiate for a percentage of the company instead of a fixed number of options. This way, if the company offers more options to other parties (venture capitalists, etc.), your shares are not diluted.”
Check out the stock-to-salary ratio
As a general rule of thumb, try to negotiate a package that comprises relatively less stock and more salary. Normally, the stock option should not comprise more than 15 percent of the total package. It’s a good idea, however, to try to negotiate for an even lower percentage, like 10 percent. This way, you’ll feel less of a financial pinch if the stock does underperform. Then, if the options prove to be lucrative, you can always purchase more at a preferential rate.
Consider the tax implications
According to financial planning advisor Mary Scherr, exercising your stock options could prove to be costly from a tax point of view. “If you’ve been offered nonqualified options, you can end up paying through your nose in taxes,” she said. “You will be taxed on the difference between your ‘strike’—or preferential—price and the market value of the stock. This tax is charged at the income-tax rate, not the capital-gains rate, which is lower. It’s always more advisable to go in for incentive stock options—that way, you won’t be liable to pay tax until you actually sell the shares.”
Is it a good idea to accept stock options in a client company as payment? Post a comment below or send us a note.