What Is An Earn-In In M&A?

By Sebastian Amieva

An Earn-In strategy is basically getting equity-shares in exchange for your services.

Equity vs. options

One possible way to avoid initial upfront taxes is by receiving warrants or options. By setting the strike price of the warrant equal to today’s market value, the warrant essentially has no value today. Only when the option is exercised (and the value of the underlying equity is greater than the strike price) do you earn and pay taxes on the difference. The downside is that you will have to pay a full tax rate on your profits when you exercise the option (as opposed to a much lower capital gains rate if you had taken equity).

How much equity should you receive?

This is always a tough question. You don’t want to take so much so that you are limiting the companies ability to raise money or attract future employees. If you are not a full-time hire, don’t expect to get more than a percentage point or two (and typically much less). Try to value your services as a cash rate and compare that to the value of equity you are negotiating. Make sure to discount the value you assign to the equity in this calculation to account for the many years it will likely take to become liquid and the very high risk that it never will.

How do you earn money on your equity?

The most common cases will be when a company has an IPO, is acquired, or raises a round of financing where the founders take money off the table (sell their equity).

If the company is an LLC, then typically any cash the founders take out needs to be distributed equally among its members (i.e. you would earn a percentage of the distributions). LLCs can be really flexible though and it is possible for the majority owners to change this. Be aware that if you are a member in an LLC, you will have a tax obligation on the profits/losses they record (they need to issue you a K-1 at the end of the year that breaks down your share of their profit or loss) so at bare minimum you should ask that the company covers, via cash distributions, your tax obligations on profits recorded.

Most companies provide specific language in the company shareholder or operating agreement limiting your ability to sell or transfer your interest. However, most often, you can ask for tag along rights (if the company sells shares, you can opt-in to selling the same percentage of yours) and they will request drag along rights (you can be forced to sell when the founders do). As a minority holder, it is unlikely you will receive any preference or other rights, and this is probably best for both you and the company. You should read and understand the shareholder or operating agreement of the company to understand your rights.

Dilution

Expect to be diluted alongside the founders in any fund raising round. If you own 1% and the company issues a 20% stake to a group of investors in a funding round, your stake will be diluted to 0.8%. Most tech companies raise multiple rounds of financing with a 20-30% dilution each time: earlier rounds being typically more dilutive, and later rounds being less so. Also expect investors to get anti-dilution protection and liquidation preferences. The former could end up massively diluting your stake in the event of a “down” round, and the latter could prevent your stake from having much or any value in a distressed exit or “soft landing” scenario.

Is it worth it?

The harsh reality is that most startups fail and it is unlikely that your equity will be worth something. If you really believe in the team and opportunity, then go for it, but don’t expect to see a huge windfall.

Reference: https://www.wework.com/ideas/professional-development/benefits-risks-consulting-equity

Disclaimer: This is not meant to be a comprehensive post just some things to consider. Always consult a lawyer and accountant before making decisions related to equity. Don’t take our advice, we’re developers not lawyers.

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Sebastian Amieva

M&A Expert

www.sebastianamieva.com