This week’s essay is a corollary to last week’s discussion about protecting founder equity. It is very tempting often to trade equity at a startup valuation for marketing, technical, business development, product design, office space and other services. Sometimes this is a wise decision, sometimes not. Let’s consider the issues.
There are many fine service providers that lead with that proposition and invest hard cash along with their labor. They are company creation vehicles for a team with a great concept and in need of all the resources to launch from a standing start. They are not typical incubators or accelerators. They become enmeshed in your venture and ride with you to the successful outcome. Whether you want it or not, you’ll always have “help” in the major decisions, but, if the overall package of services and investment greatly increases your odds of success, you as a founder may be getting a bargain. If you notch a win, you’ll have many more alternatives the next time around, should you choose to stay in the startup game. In the meantime, you just want to make sure the chemistry is good, your due diligence of your partner’s track record and references validate your decision, and you are comfortable being relatively locked in for the duration. As you can imagine, you can’t easily jump ship a year down the road if you decide you are being overcharged for services, or the quality is not there, or the combination impedes your ability to raise next rounds from other sources. As your lead investor, your partner/vendor will always have sway over your forward funding routes. However, you may well be a brilliant product conceiver who is better off “outsourcing” all the entrepreneurial business issues and focusing on what you are already great at doing. I have read many articles positing that there are more winning ideas and more investment dollars than there are leaders capable of taking those ideas through the total startup cycle from inception to exit. These full-service partners are built to address that very issue.
Then there are the opportunities to do one-off trades of equity for particular services. I’ve seen many of those in companies I’ve advised, and most often, once that habit is formed, no two arrangements are the same. If you are out proposing to trade shares for services, check with your lawyer to make sure you are not violating a securities rule and poisoning your ability to raise money from cash investors. More commonly, you will be reacting to a proposal from a vendor who wants a piece of the action. You’ll be offered a theoretical discount on services in return for some form of warrants, options, or grants. In turn you’ll hopefully tie some performance metrics to such a deal, have a vesting plan, and do your best to assure you get something tangible in return. That’s all well and good, but in my experience very few of these deals actually work out. If it’s sales help, and there are no sales, you risk being stuck with a shareholder who contributed nothing for shares for which your other investors have paid an assigned value. Nonetheless you’ll continue to get pressure to accept more sales help from that source, to pay commissions of some form, and not to hire a replacement rainmaker. After all, it’s your fault that the product wasn’t ready or the marketing materials weren’t up to par. You may have unwittingly made a friend for life that you wish not to have. Your confidential information, whether it’s customer lists or product strategies, is out there in the hands of a party who is no longer on the team. What if he or she shows up at a competitor while holding your shares? What if you are dealing with an entity where your primary trusted contact is dismissed, or becomes disabled, and your agreement hasn’t anticipated that possibility? I could go on; there are lots of ways to get in trouble in these situations. And, they all litter your cap table with deadwood that may adversely affect your valuation down the road.
Vesting plans are a highly important method of de-risking these trade-for-equity relationships. You most likely have a vesting schedule for any options you have granted to individuals. It not uncommon for venture investors to require even founders to put a significant portion of their shares back into the treasury and then reacquire them through tenure and performance. The primary concern is keeping a key founder from jumping ship early with all of his or her stock before the mission is completed. Without some vesting protection, finding a replacement necessitates issuing more shares and diluting everyone, and you have an outsider now holding a meaningful interest while delivering no more services. Such situations are always accompanied by hard feelings one way or the other and are symptoms of bigger problems in the management structure. The same factors apply if you have a service provider who either can’t deliver to your specifications or doesn’t want to and proceeds to bail on you. Arguments ensue. It’s not pleasant. Unless you have a tight string on the vesting schedule, you have no leverage and plenty of exposure. The worst of these circumstances seem to arise when equity has been traded for sales performance that doesn’t materialize. As mentioned earlier in this essay, blame for nonperformance gets passed in all directions, especially back at you.
Termination provisions are in every contract, but they get more complicated when you are trying to terminate a services deal through which you acquired a shareholder. Vesting, per the previous paragraph, is a minimum requirement. Paying careful attention to defining precisely the statement of work is a second vital requirement. You know that in software development things can easily run amuck. So can marketing. So can sales. All involve creative skills, and the correct courses of action are subject to debate. Even projects that go well can be claimed by multiple parties, especially in direct sales. No matter how close you are to a vendor and how much you have worked together, expend the energy up front to establish all the expectations and resist the temptation to say “just go figure it out.” The interpretation of “it” can lead to much heartache down the road. And, you can’t exactly fire shareholders and remove them from memory.
When you have a service provider shareholder, keep in mind that companies can change. They can be acquired and be managed very differently by a new regime. They can fall apart on their own, leaving you in the lurch. They they lose a chief rainmaker, a leader with key relationships you expected to access, or a superior design guru. Short of that, they just may become enamored of a new client that lures their focus and their best talent off your projects. The persons with whom you have key relationships may leave them for a competitor, or may have health problems, or may die, or may get shifted by management to different projects, or otherwise become no longer part of your servicing team. Your equity is owned by an entity, and you have no suasion over the individuals who work for that entity. You are at the mercy of whoever is on deck when a job is to be done or a critical decision is to be made. Tools like vesting and statements of works come in very handy in those situations. But, even with those protections, you may be irrevocably more joined at the hip than you imagined.
Even in light of all these potential problems, you may have great comfort with and trust in a particular vendor and come out much better by trading away some of your founders equity for their help. Let them play a key role in making your venture a raging success. Enjoy the results. Chances are that by implementing some of the guard rails mentioned above you’ll only make that relationship more productive. The fruits of good work will be well defined, as will the penalties for any deviations. The rules are clear.
I will continue to see cap tables with half a dozen sales channel failures still lingering in the mix. Don’t be one of those, please…