Buying services with equity - should there be a risk premium?

There should definitely be a risk premium. If you are taking equity from an entity with a little track record and does not have audited financials or at least financials reviewed by a third party, you are essentially accepting “Junk.”

In this respect I am referring to the Wall Street definition of junk. For example, the risk premium for junk bonds is essentially the difference between high-yield bonds and Treasury bonds, with similar maturities.

“If the startup has already established a valuation…” do not depend on it. Valuations are based on a point in time. The farther away you get from the valuation date, the less accurate the valuation will be.

I worked with a start-up early in my career. Day one we were well capitalized and ready to take on the world. There were six of us. Five were willing to accept equity payments only (slightly different than your scenario), but one would not. Instead he wanted a payment as an independent contractor. After the dust settled, I can say he was the only one that made money in the venture.

I'm going to throw in a counterpoint here, just to muddy the waters. A startup that is "going places" is a strange and difficult thing to negotiate with on an equity basis. Now I am not saying that what Regis says is wrong, because it's not - sometimes. From a CFOs perspective, and usually the CEO and board perspective, early valuations are there to keep the common stock price low so that they are attractive to early employees. That is, they are artificially low, and you want your 3rd party valuation to be low. Then you give that cheap equity to employees who work 80 hours/week and are thus giving you tremendous value.

When I or my CEOs have had consultants ask for some cash equivalent in equity, we always roll our eyes because that common stock valuation is intentionally hyper conservative in order to drive that low option strike price, but not, we believe, reflective of our actual valuation. Yes, most companies fail, so I guess that makes us delusional (although mine have done well, so not so delusional all the time).

So let's take the example above of $5K in exchange for, nominally, 1% of the company. Let's say we work with said consultant for 12 months, then that's 12% of the company. 12% of the company for half of a consultants time for one year (or less of their time if that $10K/month doesn't buy you full time work). A company in that stage might bring on a "real" CEO (not Jack Welch, but a "startup" CEO) for 12% equity that vests over 4 years. And that person will put in 80 hours a week for those 4 years (okay, maybe it's only 60 hours by year 4, everyone needs a break). Or, if we use a common but whispered valuation multiple of 10X, the company could raise ~$500K on a $5M pre-money valuation for that 12% (round numbers). Or, you could bring on 6 really great developers at 2% of the company each, vesting over 4 years (in fact, that's way high - you would only give that kind of equity to superstar early employees who are not senior execs, so your 12% likely gets you 10-25 early employees).

So as an exec at an early stage company, when I hear that the consultant wants 1% of my company plus $5K per month, I just roll my eyes. Most companies, unless they are truly desperate and are heading down the drain, would rather take that and put it towards cash or someone who will add lasting value to the enterprise. I will say it is rare (although i'm sure not impossible) for a consultant to add anywhere near that much impact to the LTV of a company, whether it fails or not. From my perspective, the consultant isn't putting in the same upside premium that all of the founders, investors and employees are putting in.

So, that's just another perspective, coming from the company as opposed to the consultant.

Good points but bear in mind:
Some companies may not have any or enough cash to consider an all cash option, and may not be successful in raising cash at this stage in their development pending achievement of certain development or sales milestones (regardless of whether they may be facilitated by the contractor). The issuance of stock can be an open ended source of 'funding" that will cause dilution, but may be worthwhile if it brings added value to the Company.
Generally most contractors will find $5000 in cash more valuable, useful and certain than $5,000 in stock so there would need to be some kind of discount.

There is also the problem that payment in stock creates the same tax liability to the receiving contractor but does not provide the cash to pay the taxes. Sometimes a company/ contractor may agree to pay in options rather than cash which defers any tax liability, and provides an equity investor with an opportunity for upside as part of his compensation, but this is also difficult to assess risk and value wise. Firstly the contractor will still have to pay to exercise his options, will still have the risks of (I) illiquidity in finding a market, (ii) qualifying time waiting to sell, and (iii) assuring that the sale value will be greater than his exercise price.

Then you have the issue of what is an unpaid option actually worth compared to the value of a fully-paid share or a cash alternative. Essentially, the option is a derivative instrument and, using a Black Scholes formula with all the wild assumptions that have to be made , typically end up with quite a low value per share which results in an unacceptably large number of options being required to justify the 'exchange" value required by the Contractor. Of course most Contractors don't subscribe to the Black Scholes story and hence the number of options required to satisfy a dollar liability becomes even harder to establish.

Thank you Mark, Simon, Regis! All very helpful insights.

The contractor I'm thinking of wants to take equity as part of their model (for alignment and return). Based on this discussion I'm leaning towards taking a share of payment in equity and applying a risk premium to that equity that correlates with our confidence in the latest valuation. I think options are the way to go with a nominal strike price.

Simon, not sure if I follow what you mean by "justifying the exchange value". Do you mean the options value should add up to the contractors rate? With an exercise price of $0, I would think about it as an effective exchange of services for equity. Thoughts?

When you state that the "client's valuation has been established as $500,000": how was that valuation established. Also, are you being paid in Preferred Shares or Restricted Common Stock? Are you familiar with 409A valuation reports? If that valuation is of the company's per share common stock price, and was based on a 409A valuation, then the risk premium, lack of control and other discounts have already been established. If, however, the valuation is the "pre-money" valuation that the client would use as a precursor to raising capital, then you are correct, some discount should be made to reach the value of the restricted stock you are receiving.