Tuesday, May 15, 2012

Lesson #115: When to Trade Equity for Services

Posted By: George Deeb - 5/15/2012


& Comment

Giving up equity in your business, as an alternative to paying cash, often sounds like a great idea to cash starved startups.  But, giving up equity in your business is often a very big decision, and can come at a long term price, both financially and operationally.  This lesson will help you figure out when it is appropriate to trade equity for services, and when you should avoid it.  As, well as certain potential pitfalls along the way.

To me, this decision often comes down to: (i) how easily can you source capital from professional investors to pay for the services; (ii) how big of a cash requirement is the project at hand; (iii) are services long term or short term in nature; (iv) how onerous are the terms; and (v) are there any other potential strings attached.  Let's tackle these points below.

When you can, raising capital from a professional third party investor is always preferred.  You always want to raise cash from equity investors with experience in building startup businesses, often with a rolodex of potential business contacts and lessons learned from their past investments.  Taking cash from a service provider is often just that . . . cash only.  But, if you have no other alternatives from professional investors, service providers can be a perfectly acceptable financing resource for you, if that is all you need and it is structured fairly.

I wouldn't be giving out equity to any and all service providers.  You should be holding your equity near and dear to your heart, and only giving it out when absolutely necessary.  The higher percentage of your company that you can retain over time, the higher your payday will be when you hit it big on the backend.  So, when considering trading equity for services, I would limit such to material projects of scale (e.g., financial benefit of in excess of $50,000 in savings).

And, on a similar note, I would limit equity conversations to service providers that are going to be long term in nature, helping you build your business over time.  For example, your tech development firm that is going to help you build your website and maintain it over time, is a much better equity partner than the firm that is going to design your logo in a quick one time project.

Now that we understand which service providers we are willing to have equity conversations with, next we have to understand how to structure these deals.  This typically comes down to the security, voting rights and valuation of the deal.  For the security, shoot for convertible note or common stock deals where you can, so no preferred stock requirements impede your ability to raise future capital.  For voting rights, it should be capped at their pro rata ownership in the company, and typically should not require any seats on your board of directors (allowing you to run the business as you see fit). 

For valuation, whatever cash savings you are realizing, should be invested at a reasonable company valuation.  For example, let's stay your startup is worth $1,000,000.  If you are getting $100,000 in cash savings from the service provider, they should get around 10% of the company.  So, make sure the percentage they are asking for is fair, in relation to your valuation.  And, always be sure the project is well-defined and the project size is capped, so project creep doesn't have you giving out twice as much equity as you originally planned.

Finally, make sure there are no strings attached and avoid other known potential pitfalls.  Things like: (i) it is difficult to keep a service provider managed on time and budget, when they are also an equity owner who needs to be treated with kids' gloves (so make sure both parties are clear their role as a service provider, meeting deadlines and budgets, will come first); (ii) make no promises about fund raising prospects, potential buyers or future valuation expectations (let them make their own assumptions, understanding they are investing in a very risky security where the future is unknown); and (iii) make sure there is a clear plan in case things are not going well together (e.g., a way to buy back the stock, keep a copy of tech code or trade out service providers, in all scenarios).

There are many other issues to consider here, but hopefully this is a good high level education to get you started.

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