Is equity without a valuation worthless?

Gregory Adams Tech & Marketing Consultant

October 30th, 2015

Quick background: my company is a small group of designers and developers.

When courting potential new business, I usually only accept physical payment for services. After seeing our price sheet, I'll often hear that some of these potential clients don't have enough funding to afford our services, and usually offer an equity play.

Additionally, they usually don't have a valuation or anything. My question is, are clients like this even worth entertaining? My intuition tells me that people without a budget or valuation aren't serious, and my chances of payout at some point are slim.

Is equity in a company that has no valuation (and isn't seeking external funding) worthless?

Mike Moyer

October 30th, 2015

Offering services for equity is the equivalent of angel investing. Expect most of your investments to fail, a few to break even and even fewer to payout a decent multiple.

Early-stage companies that are bootstrapping usually have no valuation so you have no idea what you're getting into. If you negotiate a % it's generally meaningless, there are all kinds of tricks to be played.

One option is to accept a convertible note instead of payment. A convertible note converts to equity at the time of the first major round of funding (often called Series A). The note converts under the same terms and has a few other benefits like a discount rate and a valuation cap (there are lots of articles online about how these work.)

Another option is to use a dynamic equity model. I developed a model, called Slicing Pie, for deals I wanted to do that included a mix of services and cash. If you contact me through SlicingPie.com I'll send you a copy of the book.

Dimitry Rotstein Founder at Miranor

October 30th, 2015

As has been said, most startups fail, so investing your resources in exchange for equity is a very risky business. I tried this myself at one point, but thankfully realized pretty quickly how risky it is and stopped.

I would even add that if the founding team can't develop the product themselves, then their chances of success are even lower than those of an average startup (which aren't high themselves, of course). One of the reason is that an outsourced team simply does what the founders tell them to do, while a real product should be developed in close interaction with actual customers, with no middlemen. Investors know this and are wary of investing in a startup that outsources the development, which decreases the chances of success even further. To top that, having to share equity with some external development company is just one more reason (and a pretty good one) for an investor to bail, so by taking equity from a startup you probably hurting it.

If you still want to pursue this venue, I would suggest taking deferred payment instead of equity, i.e. determine how much your work will cost, and agree that the customer will pay you in cash as soon as they can afford it (receive sufficient investment or revenues), but if they fail before receiving any cash, then you write that debt off.

I think it's a bit less risky because a company has a greater chance of having some money down the road than reaching an exit.

Neil Gordon Board Member, Corporate Finance Advisor and Strategy Consultant

October 31st, 2015

Think about a split fee arrangement, where you take a smaller fee up front and defer the balance. You can take equity, or you can craft a contractual formula that gets you paid at the time your client can afford to do so. (Build a premium in to compensate for your risk!)

Getting paid something puts some skin in the game, and can be a measure of whether the founders are serious about their venture.

Amir Yasin Developer, Architect

October 30th, 2015

Ask them if their stock is 2 or 3 ply. Almost all startups fail. Unless you really really believe in them (in which case you should Angel invest or become basically a founder as Mike Moyer stated), DO NOT take equity for contract work. Additionally if they don't have an investor putting in cash there is NO incentive not to dilute you to near worthless levels as well.

Anonymous

October 30th, 2015

yeah, convertible note is debt that will be converted into equity once there is a valuation, with a certain discount. https://www.quora.com/What-does-a-discount-mean-in-a-convertible-note You actually better make sure they will raise a round at some point.

Profit share might be another option, just comes with the pain that your client needs to disclose their profit.

TBH, being smart and just help them for the budget they have with their biggest pain point, get a loyal client and wait for them to have more money in the bank is probably more practical.

Manash Chaudhuri Entrepreneur, CRM Evangelist, Cloud Computing Architect, Product Management and Business Strategy Consultant

October 30th, 2015

Let's face it, opportunities like Snapchat or facebook come very rear and chances of having a startup fail in its first 18months is very high!

Gregory, I had gone through similar situation many times over. We have assisted a lot of pre-funded startups sharing their vision and invested in them with an expectation to earn equity and cash over the period of time. Invariably, unless there is a certain portion of cash exchange that happens at the onset of the project, chances of failure is just a matter of "when". As Mike suggested, if you are sharing the vision with a startup and offering services in exchange of equity; you are in a way an Angel investor.

For us what has worked in past few years is doing a mix:

- Get some cash portion in exchange. Let's say you believe the investment to participate in a given opportunity is $150K then get atleast 20% of it in cash paid as 50% of it as mobilization cost and balance in couple/few months once you hit certain milestones. Put some timeframe in mind when you expect full recovery of your deferred cash component.

- Whatever be the valuation suggested by the startup; consider 80% of it and based on your deferred cash component and the value that you bring to the team, calculate the equity component. Should the startup come even 80% close to what you suggested then I would say it is a fair deal.

- Always keep an exit strategy; in case the startup is not able to generate enough cash in a given time frame - either negotiate on higher equity stake or certain portion of cash component be paid with a proper payment schedule.

This will help you control your risk and yet participate properly in any startup opportunity. Just don't make a 100% equity participation.

Peter Kestenbaum Advisor, Investor, Mentor to Emerging firms

October 30th, 2015

Whether to accept cash or equity is of course not a cut and dry decision for a variety of reasons... first of course is whether you need the cash now even putting aside whether you think this is the next facebook or not... another is opportunity lost... meaning " is working on this project preventing you from working or doing something else more valuable with your time ". There are middle grounds...

Examples ... Accept cash but deferred payment .. ie pay me when you get some revenue... usually people do a cap meaning the firm does not pay until they clear x dollars and then a cap of 10% of revenue...

Another which I have used is allow your "phantom" cash invoice to be converted into their convertible note... ergo thats a way to sort of have a note but also an equity play... in other words if you invoiced say 25000 let that 25000 credit go into their note when they structure it... (assuming they have not done that yet ).

again though it really is a function of need and greed... and again there is no one size fits all

Scott McGregor Advisor, co-founder, consultant and part time executive to Tech Start-ups. Based in Silicon Valley.

October 30th, 2015

Equity without a valuation is not worthless, but it's value is unknown. It is like a house where the owner has not announced a price, and where you haven't gone inside to see how much square feet it is and its condition - probably not entirely worthless, but a lot. Companies that don't have a budget or valuation are very likely to fail. So the equity they offer you (typically common stock) is most likely going to go to zero, and in any case it will probably be years before it is liquid and you can sell it. However, every so often one of those company will become a unicorn, and your initial $1K-$50K note could grow to $1M - $50M. The chance that will happen is very low, but not zero. Startup companies that make it to break-even (even if they don't become unicorns) will start paying for services - if you have already worked with them, you'll probably be in a favored position. In this case you've done spent some marketing dollars to acquire a customer that will be worth something more later. If you have enough full cost clients to keep you busy, you probably don't want to deal with these people who have no money. But if you have otherwise idle resources that you are just wasting, you might as well run some of these experiments, as it keeps your designers and developers busy doing something, and they can keep their skills sharp or learn new ones.

Michael Barnathan

October 30th, 2015

As Mike says, you are essentially investing in them. If you want to be in that business, learn how to do due diligence on them and come up with your own valuation. If it were me in that situation, I'd probably only agree to do work for pre-valuation equity (and equity in many Series A companies, too) if (a) I strongly believed the company would do well, (b) the equity was significant enough given the company's stage, team, traction, and market size to make it worth my time, and (c) if there are plans to transition to cash once a funding round is raised.