By Nyall Jacobs, Partner at chartered accountancy firm Carter Backer Winter
It would be great if your suppliers were to supply a service to you for free. Well it is not as improbable as you might think! It is becoming more common for startup companies to ask their key suppliers to accept payment in shares. This would allow the start up to reduce its liabilities at a shot and raise Investment funds with the minimum of effort. A great idea… or is it??
This is often referred to as “sweat equity”. Sweat equity is a clever method used to exchange your shares in the company to pay for products, services or expertise from suppliers, key employees and contractors. It kills two birds with one stone: by paying for services in sweat equity the company has raised investment from its suppliers, and the supplier liability is fully satisfied by a payment in shares. It feels entrepreneurial and collaborative, so what’s is the catch?
The first concern that must be addressed is what value do you attach to the shares that you use to pay the supplier? The value of the shares is calculated by multiplying the price of the shares by the number of shares - that’s the easy part. The hard part is determining what price the shares should be valued at and the good news is that there are definite rules that come into play here to assist you.
The golden rule is that you must value the shares with reference to the latest market value. This can be, for example, based on the price that you last sold some shares - provided that it wasn’t too long ago! Ideally you need to have sold shares within three months of the invoice date. However if there were no transactions, then you will have to justify the valuation using say, profit forecasts., But you must be careful to ensure that any shares sold later on are valued with relevance to the share price you valued this transaction. Valuation can become complex if there are no recent transactions to refer to and this is where you may need to bring in your accountant.
Like everything in life there are commercial risks that need to be taken into account:
• You have now made your supplier a shareholder in your business, so he has the right to act like a shareholder and he can ask to see your accounts which may make it difficult to agree a future discount with him if he sees you had earned large profits.
• If you don’t ask the supplier to sign up to a shareholder agreement, you could find that the shares get sold on by the supplier without you knowing who they got sold to until it’s too late. Therefore the shares could fall into the wrong hands, such as your competitors.
• Make sure that the agreement to issue equity includes the VAT as this still needs to be paid by the supplier for the service which they may not realise.
• If the service performed by the supplier is poor, it can be more difficult to resolve if the supplier is also a shareholder as well as your key supplier.
• The £10,000 you may have agreed to pay for the service may end up costing you £100,000 as the shares you sold cheaply to the supplier may have increased 10 times in value by the time you sell the company. So if you had valued them better, you would have only sold 1,000 shares at £10 each instead of 10,000 shares at £1!
• Don’t forget about including these shares in your books and registering them at Companies House as this is often overlooked.
In conclusion, our message to you is that it may not be advisable to enter into a sweat equity arrangement as the value of the equity you are agreeing to exchange may be more expensive than you think and will probably cost you more if you are the majority shareholder, so get proper advice. And remember make sure that the supplier performs in accordance with his contract and don’t assume that the supplier will do more for you just because he is now a shareholder!