Tech startups often find themselves in a similar bind – they need to hire people to perform work to help grow their business, but they can’t afford the cost. There are a number of options for tech entrepreneurs looking for a way out of this predicament. The most common options are described below:
The most obvious solution to your cash shortage is to raise more money. The company could take advantage of various prospectus and dealer registration requirements and raise capital using one of a number of available exemptions, including issuing securities to family, close friends, business associates or those designated as accredited investors.
The advantage of raising capital is that you will likely end up with fewer investors, and you can be more selective about the people who will be your future shareholders.
This option provides the company the most flexibility as well – once the cash is in your hands it can be used in any number of ways, including paying for work done by employees or contractors.
Shares for Services
In this commonly-used option, an employee would perform the assigned work at an agreed-upon hourly rate, which the company would not pay and would instead accumulate a debt owing to the contractor. At the end of a set time period the company would enter into an agreement with each employee where both parties would agree that the amount owed to the employee will be satisfied by a grant of shares in the company with a total value equal to the amount of debt owed by the company to the contractor.
Stock Options or Performance Warrants
The company could also grant stock options or performance warrants to the employees. The options and warrants would work similarly: they would vest or become active once a specified milestone is achieved. Typically, these milestones would include the achievement of a specific event, or a revenue/sales target, etc.. It would also be possible to tie an individual’s warrants or options to an event specific to that individual (i.e. after performing 100 hours of documented work). Once the options have vested, the employee would have the option to buy shares in the company at an exercise price that is set when the options are granted. Similarly with warrants, once activated, the employee may purchase shares in the company at a pre-set price.
It would be best to have a number of milestones that you anticipate will be met over the course of a few years, rather than all at once. Also, milestones need to be realistic and objective so that they act as an incentive and both parties will know when they have been satisfied.
The benefits of granting options or warrants over a straight share grant are that the options and warrants may not be exercised (although you should assume, for planning purposes, that they will be), reducing the overall dilution of the company. As well, depending on the value of the exercise price, the exercise of the options or warrants will result in some additional cash flow to the company.
Promissory Note/ Convertible Note
A promissory note is evidence of indebtedness. The company could give employees a promissory note in lieu of payment for services rendered, and then the company can repay the note at a later date when additional funds are available. The company can also “pay” the employee with a convertible promissory note, which is similar evidence of indebtedness, except that it may be converted into shares of the company on a set date or upon the occurrence of an identified or specific event, and at a set conversion price per share. The employees would receive interest on the amount of debt owed (which interest may also be converted into shares on the occurrence of a specied date or time), or, payment of this interest owed may be postponed until the maturity date of the note. Typically, interest rates on a convertible note are higher, but this interest is usually added to the debt owing and converted into shares so it does not need to be paid directly.
Each of these options will result in the dilution of company stock and may result in unwelcome long-term consequences (i.e. if you were to have a falling out with one of the employees, he or she could create difficulties for your company as a shareholder). Also consider that, as a shareholder, the employee would have access to the company’s financial statements and other sensitive corporate information.
In the event that you are increasing the number of shareholders in the company, you may want to consider introducing (if you don’t already have one) a unanimous shareholders’ agreement that governs the rights and obligations of the shareholders and the company. There are numerous items a USA can address, including devolution of shares on the death of a shareholder, restrictions on share transfers and right to purchase another shareholder’s shares. For example, a USA could be drafted so that, in the event the majority of the shares of the company are acquired, the shareholders would be required to sell their shares to the acquirer. USAs are complex agreements that require due consideration of factors specific to the company and its potential plans, and legal guidance is strongly recommended.