Revenue sharing · Equity

A potential enterprise customer who now wants to invest/get equity in our startup

Andrew Gee Real Estate Consultant & Broker

March 12th, 2014

Hi folks, our startup - a commercial real estate data startup has made a connection with what was initially thought to be a potential customer (a financial firm) that totally gets what we are building and sees value in bringing in finance referrals (commercial real estate loans) and potential deal flow (commercial transactions) to their business.  

In other words, I came away from the initial meetings with the message "we want you to build what you are building for us".

However the twist is that they are looking to share in the upside of this venture (equity).  I struggle with how to structure this kind of deal.  This is my take so far:

1. with a combination of sweat equity (we'll likely be meeting once per week at min to optimize our software for their biz) and I'm thinking to ask for a small investment (for skin in the game) in exchange for some % equity
2. as well as an agreed to % of the loans generated & $ amount of the deals that would go to us via any biz that we direct to that firm.
3. If certain milestones are hit - such as xxxxx in dollar amount of total loans/deals then we'd be open to more equity sharing.

I was curious if any FDers had experience/warnings/advice with this kind of arrangement.  Or perhaps a more tried and tested strategy?

Don Ross Managing Partner Digital Health at Life Science Angels

March 12th, 2014

The enterprise company would be a "strategic investor." This can be favorable and demonstrates industry/market support. Here are a few quick thoughts: 1. "Sweat equity" - Do I understand correctly that you propose to give them equity in exchange for their time in customizing the software for their use? If so, that makes no sense. 2. Lead generation can be a great business. It makes perfect sense to receive some sort of commission on deals you refer to them. 3. "If certain milestones are hit...." Personally, I would provide equity only for investment. If revenue milestones are hit, I would make financial adjustments to the commission structure. Cautions - What other "strings" are involved. Strategic investors often want a board seat to watch what is going on. Avoid this if possible. If you must grant a board seat, be certain to be explicit about the Strategic Investor recusing themselves from any discussions where there might be a conflict (e.g., another potential major customer that might be a competitor to the Strategic). - Get good legal advice on terms - you don't want to inadvertently "sell your company without selling your company." When it comes time to sell your company, you want multiple buyers competing with each other to acquire you. Terms such as "right of first refusal" can limit the number of buyers to one--your strategic--with a correspondingly lower acquisition price. Why raise only a small amount of money for "skin in the game?" You should do a good financial plan (get help, if needed. Many CFO-to-go firms are available for projects.) Then raise the amount of money that you'll need to drive success. Final thought--strategic investors typically invest at higher valuations than professional investors. Hope this helps, Don Don Ross HealthTech Capital, Managing Director and Founder

Daniel Eberhard CEO, Koho

March 12th, 2014

That's generally the structure. Couple thoughts, 

Understand your musts/wants/cant's going in. These relationships quickly get complex. 
Understand any conflicts of interest, especially with financial firms.  
Get a clear picture of the value they bring in the short/med/long term. Define roles/responsibilities clearly. 
Understand how their investment be perceived by other financial firms. Are financial firms your main market or secondary/tertiary ? Will their investment inhibit your ability to gain new customers?
Model out different scenarios and come up with 2 or 3 you can work with. It opens dialogue and you'll gain insight into their priorities/vision/risk tolerance etc. 
Unless you pair your milestone equity structure with rounds, you'll have to have a method of valuation between rounds or be comfortable selling shares at a discount (or just issue convertible note at pre-established discount)


Dave Lemley Consulting Technologist

March 12th, 2014

I agree with Don's position and would add:

*  if they (your early customer) are wanting something for the insight they provide as you develop the software, that is typically done as an early-adopter sweetheart deal; i.e. they get the product at some sort of advantaged pricing.  Equity is atypical unless they are super-close personal friends of you.

*  depending on how your company is structured (and where you want to go with it), having a bunch of early shareholders can be a problem, so generally keep your cap table tidy so save yourself headaches later.

*  Also I would suggest avoiding the term 'sweat equity' for qualifying this arrangement, because that term usually means 'in lieu of payment to an employee', and that is not what this is, since they are not an employee.  You are an employee, you are sweating.

*  I personally out-of-box am averse to strategic investments.  My thinking is that it puts hair on the deal for later M&A by competitors.  That being said, my viewpoint could be different depending on particulars of the circumstance.  You'll have to figure out!  But otherwise, if nothing else, its flattering.  They like you!

Andrew, your statement 'ideas are ... worthless until you execute on them' is a mantra.  You are a wise man.  Your client could argue that you benefit by them helping you execute from their advice while you build the product, and they would be correct.  But I suspect your client is wanting double upside of reduced price (benefiting them), and equity (benefit to them).  But you can't fault them for asking for it!  Can't get anything if you don't ask, haha!

You'll have to figure out what makes sense.  I suspect that discounted price is fair.  If you really want to get good expertise, also throw in copious amounts of beer.  Folks will tell you everything that is important about your business in a social setting.  If you're old-school use golf; I use beer.  Be polite when delivering your 'no's, and be agile in your negotiation.  Always remember 'they' are trying to act in thier own best interest, and you cannot fault them for that.

But I wouldn't give equity unless they are also incurring business risk, and so far it sounds like it's all upside for them.

Andrew Gee Real Estate Consultant & Broker

March 12th, 2014

@ Don yes i guess i struggle the most with #1 as my perspective of the message i got from this firm was that, lets spend X days per week together "building this together", however I realize that it is really the software that we are building and the onus is on my startup to do that.  I believe the financial firm views themselves as "the idea people" and sees value in ideas (perhaps even has some different take on the UI/UX for example)....I tend to think ideas are generally worthless until you execute on them and show true value.... but in any case i should clarify with them the scope of the work and how the meetings will be run....

Mike Moyer

March 12th, 2014

Hi Andrew, This problem is easily solved using a dynamic equity fund that will properly allocate equity on a rolling basis based on the various contributions made by each party. I've attached a short guide I wrote on the subject. My model, called a Grunt Fund, is the best way to do this. -Mike

Andrew Gee Real Estate Consultant & Broker

March 12th, 2014

Thanks Dave super helpful.  I love both beer and golf, so love those suggestions as well

Rob G

March 13th, 2014

Andrew, all good feedback so far.  i would double Daniel's feedback - take your time, understand your prospect's needs/wants well first and don't give away the farm.  Deliver value and competitive advantage and charge for it.  i happen to believe that strategic money (customer funding) is the best kind.  No need to give up equity and i would personally suggest limiting if not eliminating that option, but i understand beggars can't be choosers.  If you take their investment for equity make sure they understand that you need to structure the deal such that their ownership does not come back to bite you later (i.e. scaring off future prospects who might be competitors of theirs). This prospect needs a solution and should be willing to pay for the solution.  take time to understand their position in their market, their wins, their competition, their weaknesses, etc.  Really do your homework.  A key win for them is first mover advantage - they get a head start on their competitors.  this is huge and is often worth to them several X the cash investment.  Another win is input/influence to the features/functions of the solution.   This is how the vast majority of large SW firms today started out: go back and take a look at the histories of SAP, Oracle, most IBM applications, ASK, BPCS, salesforce, etc.  They all started out with 1 customer willing to pay them to build software. That customer #1 got the super BFF pricing and a perpetual, NON exclusive license and they were not assigned the IP rights.  Help them understand that they don't want to be in the SW/SaaS business (i assume you are building a SaaS?) and they can't possibly build it and support it nearly as well as you can.  Also, most enterprise customers feel they are unique.  They are to an extent, but often they have unique needs/processes simply because they have always done it that way.  They will benefit indirectly from the input you receive from their competitors - is is ultimately a value to them that your company remain independent, but they will always get that 'first customer" support.  Sell value and competitive advantage and don't sell yourself short. let me know if/how i can help. 

Orion Parrott Founder and CEO, Lendsnap YC S16. We're hiring!

July 24th, 2015

13 months later... Andrew, do you have any updates for us? How did things turn out? Did the deal materialize?