Every so often I get asked a question along these lines:

I’m short of cash but a business consultant/web designer/marketing expert has offered to help me out in return for equity. Should I accept his offer?

No you shouldn’t. Never and I mean NEVER pay for any business expense with equity. To explain why lets look at what that equity will really cost you.

What equity really costs you

As a small business:

Lets say your small business hires a consultant for what would have been a £5,000 consultancy project, but instead of paying them the £5,000 you offer them a 10% stake in your business. You then work hard on your business and generate profits of £30,000 and £50,000 in your first two years. As you’ve taken tax advice from your accountant you’re taking a small salary out of the business and relying on dividends to top up your earnings. After two years you sell the business for £40,000, which reflects the profit levels minus the equivalent of your salary.

In this case you’ve actually ended up paying the business consultant: dividends of £3,000 in your first year, £5,000 in your second year and £4,000 from the proceeds of the sale of the business. In total that’s £12,000, or £7,000 more than you would have paid in cash.

Had you paid for the advice, but borrowed the money:

• on a credit card at 30% interest it would only have cost you (assuming you made no interim repayments) a maximum of £8,450;
• from a bank at 12% interest it would only have cost you (assuming you made no interim repayments) a maximum of £6,272.

In other words paying in equity has been the equivalent of borrowing the £5,000 at an extortionate 55% interest per year.

As a high growth startup:

Let’s assume you hired a consultant to do some work that, had you paid cash would have cost you £12,000.

If you offer them 10% equity, it costs you no cash now, but you’ve given away 10% of the business. As the business is a high growth, cash hungry business the profits are re-invested and no dividend payments are made. But as a result your business is successful and you sell in three years time for £1M. You’ll only see 90% of that and you’ll have paid the consultant £100,000 for £12,000 worth of work.

Conversely if you’d borrowed that £12,000:

• At 30% interest and not paid a penny of it back until you sold the business, it would have cost you £26,364 for the same advice.
• At 12% from a bank, again not paying a penny back until the business was sold, it would have cost you £16,859.

In effect by using equity you would have paid 103% interest per year.

It doesn’t stop there however, because, in both cases, as well as the financial cost you’ve also given away some control of the business (I am assuming of course that they’ve insisted on a suitable shareholder agreement to protect their share) and made it harder to seek external investment in the future (because there are more parties that need to agree a valuation and dilution of their share).

In short, don’t ever pay with equity. If you really need the product or service, find the cash another way, and preferably not by using credit cards!

But what about the risk?

Now I’m sure someone will argue that by paying with equity, rather than taking on debt or using their own capital the entrepreneur has minimised their risk. Which they have, but it’s a very, very expensive way of minimising the risk. I’d also argue that there are better ways to address the risk.

Addressing consultancy project risk:

• Precisely specify the problem to be address, the deliverables resulting from the project and how success will be measured.
• Ask for and check references. Make sure the references relate to projects like yours, not unrelated projects.
• Ask the consultant to guarantee their work against the specification you have provided.
• Tie part or all of the fee to the achievement of agreed performance milestones.

Addressing investment project risk:

• Test the idea before investing.  See How To Start A New Business for more on testing business ideas before implementation.
• Precisely specify the project, the deliverables resulting from the project and how project acceptance will be managed.
• Tie the majority of the payment to satisfactory acceptance of the project.

Finally don’t forget that paying with equity introduces the risk that the supplier is offered another project halfway through yours, that pays cash. If they decide that the cash is more attractive, you’ll be left in the lurch.

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