image courtesy of flickr
As a dev shop, you’re going to be approached by startups who need help building their MVP (minimum viable product). Often, they’re strapped for cash. The solution: offer equity instead of a large cash payment. It’s a risky, but enticing proposal. It’s the stuff of lore, getting in early with a startup that could take off and be the next Snapchat. But is it the right decision for your dev shop?
That’s the idealized story most startup founders will sell, and the one most of us want to believe in return. The reality — it’s never that simple. We all want a piece of the ‘next big thing’, but the chances of a startup going public or getting acquired are fairly slim. Nine out of ten startups fail, so the odds are definitely stacked against you.
Equity as payment isn’t black and white; there are many different factors you must weigh before making any decisions. Here’s a checklist of things you should consider when deciding if you should take equity in a client.
The Scope of Work
The MVP is the first version of the new product which will allow the team to test its hypothesis with with customers. Don’t be fooled by the definition though. Building an MVP is hard. It’s just the first point in a product’s journey.
The driving force behind creating an MVP is to do market testing with a minimal product, getting more accurate information about customer needs. But what happens after the client launches the MVP? The idea of building in small iterations enables the ‘fail fast’ and ‘pivot’ purported by agile methodology. But if you don’t have a developer on hand to build out these features (and fast), then who will? Is part of your equity deal building follow-on features? Is that done for “sweat equity” as well? Like any other client, it’s important to outline the scope of work beforehand.
If your dev shop is the one building an MVP for the startup, it’s sort of a crapshoot to try and predict how users will take to the product. Good ideas often fail and the crazy ideas turn out to be billion dollar ideas. True, you’re responsible for creating a great product, but you probably had no part in testing the initial idea. You could very well end up building an entire MVP only to find out that people aren’t loving the idea.
In addition to the failing product, working with the founder adds another layer of complexity to the building process. Your agency has to keep the ‘customer’ happy while simultaneously building a product people love. If not, the relationship will sour and your investment (time) goes down the drain.
The Details of Taking Equity
The basic agreement with equity is this: the startup offers the agency a certain amount of equity or stock, meaning that your agency will own/have stake in part of the business. The amount of equity will vary, but it’s important to accept an amount of equity that would significantly exceed the ‘waived’ fees for your services.
At the time of the agreement, the startup is a privately held company. The payoff from equity would only come when the startup goes public, or is acquired by another company. The average time frame for return on investment is 5-7 years. It’s important to keep that in mind when deciding whether you can accept an equity deal or not.
The reality is, your dev shop has to evaluate the potential client like an investor would. First, what do you think of the entrepreneur? Do you believe she can go the distance and build a successful company? If you’re on the fence, you’re out. Second, what do you think of the idea/market? Is it a transformative idea? Is the market large enough? Lastly, can you afford to make this decision financially? You’ll be putting significant time/resources into this decision.
Advantages of Equity
Are you salivating at the idea of picking up millions of dollars on your time investment? Okay, so the company may never be valued at a cool billion, but it could still be valuable. The idea is that it would be more profitable for your agency in the long run than charging your normal fees would.
Money aside, taking equity in another company could be an opportunity to further your agency. You are building a partnership with another company, and your business may grow in turn. Owning part of the business means that you have some say in their strategy, which could be a great opportunity to learn.
Employees (hopefully) will want to work very hard to build an awesome MVP if they have some stake. If developers’ hearts are in it, they’ll take initiative, work nights and weekends, and treat it like their own.
If the startup sinks, so do you. Taking equity is a huge risk, only 10% of startups end up going public. Even if the startup does well, but doesn’t get acquired, your investment is worthless — unless you’ve set up some separate agreement for that scenario.
As mentioned before, it’s difficult to tell how sound the investment will be without a product built. It makes analyzing the investment trickier than if the company was up and running. And if they have no or little money to pay you, how sound is their business plan, and how much do they value your services?
If you wanted to get involved, is that something you would have time for? Going back to your scope of work, what is your commitment after the MVP is built. It could be a real headache in the end and suck up all your resources towards paying clients. A startup might play the “you’re invested in this business” card and ask you to work out of scope and after hours. If you don’t, you’ll likely lose your investment.
Overall, you have to ask yourself how much your time is worth, what you’re willing to risk, and how accurately you are able to judge the company’s merit. If you will struggle in the slightest with overhead by taking on a temporarily ‘free’ project, forget it. The only time to take a risk like this is when your company is already doing very well, and you can afford some level of risk.
Generally, the risk is not worth the reward. Startups rarely go public, and the headache of legal agreements and involvement in the midst is annoying at best. If you are really gung-ho on a company you believe in, a better option might be to take some equity in combination with payment. A possible solution could be 50% payment and the rest of your fee becomes convertible debt. The allure of startup equity payoffs are tantalizing, but the startup gets the better end of the bargain. Do what’s right for your company. More times than not, it’s going to be passing and taking a cash client.