1) Is this legal? 2) Is this a stupid option as a developer?
2) Yes - you are effectively being strong armed into becoming an investor.
Would you invest $[your salary / year] into a company that is running out of money and not paying employees? I sure wouldn't.
Without knowing the situation, the likely truth is that the VC's passed, the angel investors passed, so now you and your coworkers are being turned into the unwilling bottom-of-the-barrel investors.
But probably not.
Unless the founders are offering the employees more than 50% of the company in aggregate, people who will ask others to work for no pay and with any future reward solely at their discretion are still in control.
It will most likely go bust. 10% of 0 is zero. Leave.
Run.
2) Well, if you're no longer getting paid a salary, as far as I'm concerned its no longer a job. Its now akin to your own personal project. Most of us not born to money aren't in a position where we can quit our jobs and decide to work on our own personal projects. So really, the decision is somewhat analogous. Is it a personal project that you think it makes sense to be working on despite not getting paid? If you can't survive without getting paid, well, time to look for your new job. (in all seriousness, without knowing anything else about it, run is probably the correct option :P).
If founders are unwilling to accept new money because of greed, valuation too low, contingencies, etc... then yes maybe it is a fair gamble to work for equity... Like if you knew your startup had 99% chance of being acquired in 3 month at 5x over today's valuation, then equity pay makes sense.
However, it does not seem like the case here. Highly likely that all VC/angels had passed,.. hence, follow the money and look for an exit.
To make it easier to decide: ask founders to explain why they cannot raise money. If they bring low valuation as an excuse, ask to show termsheets and make judgement upon that. If they cannot provide this proof - run.
Yes it is legal if the agreement is made mutually.
However! If one of them wants to leave and go somewhere else, they still own that part of the company. This dead weight is not good in the eyes of future investors.