BERT HENSLEY, CHIEF EXECUTIVE OF Beverly Hills executive search firm Morgan Samuels, had an Internet client planning an initial public offering. Since cash was a little short, the dot.com convinced him to accept 50% of his $200,000 fee in its stock. After all, he figured, the shares would return many times their value once the market gobbled them up. Didn't other search firms boast of making tens of millions on their equity kickers?

Alas, six months later, in mid-1999, Hensley's client was on the verge of collapse. Another company bought it at bargain-basement prices. Hensley, left out of the negotiations, could only watch helplessly. He got nothing for his shares.

Hopes of instant riches are spurring contractors, vendors and landlords to accept equity as payment from pre-offering Internet startups. "This is California's second gold rush and everybody wants a piece of the action," says one of them, Robert Sommers, a San Francisco tax attorney. But our modern-day prospectors are finding themselves loaded with a lot more risk than they bargained for.

Taxes on paper gains, for one thing. Take Anthony Saris, head of San Francisco financial consultancy CFO Land. In February 1999 Saris discounted his fees to his client, Docunet, by 50%, or $50,000, in exchange for 15,000 shares. Today Docunet is still a year from a stock offering, and Saris faces a hefty $20,000 tax bill on the value of his shares.
He now wishes he had accepted less of his payment as equity. "This is not free money and the pitfalls ought to scare most people," says Saris, who has been paid in stock by ten Net startups.
Of course, as preoffering stockholders, receivers of this New Economy scrip aren't home free once--and if--an offering finally happens. They still must deal with the lockup period. That makes them wait six months or so after the offering until they can sell their shares.
 

Ask Christine Hempel and Donna Sokolsky, partners in a Palo Alto, Calif. public relations agency called Spark PR. The stock options they took from client VA Linux were quickly in the money, and they exercised in November. But the lockup period will not have ended by Apr. 15, and they owe $100,000 in taxes.

So they are dipping into their savings to pay the Internal Revenue Service. And hoping that, when the lockup ends in June, VA Linux will still be a highflier, enabling them to sell and come out whole. But note that if the stock crashes to zero, they won't get a refund of the $100,000 tax bill. They will wind up with a capital-loss carryforward, which could take them years to absorb. "We try not to look at the market too often, it just makes us nervous," says Hempel.

They've got another problem. A lawyer warned them not to be shareholders in a firm they are publicizing, lest they be accused of hyping the stock. So Hempel and Sokolsky dropped VA Linux as a client.

Without wanting to throw too much cold water on these hot stocks, we'd offer the following advice to people contemplating payment in paper:

Stock is the best. Especially if you want to cash out soonest. With options, you have to hope that your stock exceeds the exercise price by the time the lockup expires.
Should you want to hold on for a while before selling, because the stock is headed for the stars, stock also is superior. Reason: You must wait a year to be eligible for lower (20%) capital gains treatment. With options, that year doesn't start ticking until you exercise.
 

Stock options: Get more. If you take options, says attorney Sommers, ask for two to three times the amount you would have taken in common stock.
Stock with restrictions: File quickly. Say you get chunks of common that don't vest until you meet performance objectives. Once you are awarded the restricted shares, file an 83(b) election with the IRS within 30 days. The then-value of your stock award will be taxable as ordinary income, but further gains qualify for the 20% capital gains rate if you hold for another year.
Don't be a second-class citizen. Make sure your shares have the same treatment as the startup's key officers'. If they get Class A shares, don't settle for Class B. Should you be sitting on the next Yahoo and want to stay, you will have a bigger voice in the company.
 

Source:  Josephine Lee, Forbes,  April 17, 2000