Acquisitions · Advisor Equity

Should I offer a reduced contract rate in exchange for equity?

Marcus Matos Software Development & Information Technology Professional

January 24th, 2015

Too Long, Didn't Read Version:

One of my clients is running out of money and will be struggling to pay me in the near future. Recent events have led me (a generally skeptical developer who refuses to work for equity/future pay) to strongly believe that with his industry contacts and my technical direction, we can release a product (already under development) that will be a massive success. I want to offer the client a reduced rate in exchange for ownership in the company. What could go wrong?

Wall of Text Version:

I have an interesting one for you guys. In general, I advise developers to NOT work for equity in lieu of income, especially if they are not familiar with the company/management/etc etc etc. In this case, I'm in kind of an inverse situation where I would like to offer my services in exchange for equity or ownership in an already established company. I will try to summarize as best as I can:

  • It is a small (about three years old, 2 employees, 5 outsourced developers) software development company with existing paying customers in a very specific industry with very little competition.
  • The owner has a history of building up multi-million dollar non-technical businesses, but is now running a technical business and struggling with it (hiring the cheapest developers he could find, taking on anything and everything customers throw at him, etc).
  • Due to those struggles, they brought me on as a process and software development consultant about a year ago, and I have made some significant changes to how they conduct their business. For example, prioritizing quality (of their product and the type of customers they take on) over quantity.
  • I am currently a contract consultant on retainer for 25 hours a week (although for the last 6 months have been putting in 40 to 50 hours a week).
  • 75% of the development work is flowing through my LLC and my own developers.
  • A few weeks ago I had the opportunity to visit an industry trade show and talk to hundreds of potential clients. During this show we had a booth where we demoed our product (currently under development) and were continually bombarded with questions like ("where have you been all my life?" and "how fast can you set us up?").
  • During this process I discovered some major pain points in the industry that nobody seems to be working on but everyone wants a solution for. We even had one of the biggest players (a $1B+ company that is already a customer of ours) in a private meeting ask us if we could help with their struggles. "We are not a software company and don't want to be."
  • Coincidentally, these pain points overlap with our product roadmap (but were not a priority). As a result, I have convinced the client that we really need to re-prioritize our development efforts and tap into this untouched stream.
The reasons for my question are:
  • Massive technical debt has started catching up and the client is starting to lose customers. This is not necessarily a bad thing because these are customers of a product that my client shouldn't have sold/supported to begin with.
  • However, with the loss of customers comes a loss of revenue, which means the client is going to struggle to pay me while we reboot, refocus, and build V1 of the solution that everyone is asking for.
  • I have many other clients and a successful LLC, and do not wish to become an employee of this company. (There are other legal reasons for this as well, including retaining copyright/IP for the work I do for myself.)
  • I strongly believe we have a massive, untapped opportunity and we already have the inside connections and customers necessary to make it happen.
  • I am the technical person with the knowledge and ability to make it happen. We both agree on this as a result of successes since I came on.
Given this situation:
  • Is it reasonable to approach the client and offer to reduce my rate and increase my hours in exchange for equity or ownership in the company?
  • If yes, what is a reasonable % or deal to ask for assuming that I am charging him 50% (or less) of my normal rates?
  • I believe I'd probably need to talk to a lawyer about this, but is this something I'd structure through my LLC or through myself personally? I feel like it'd be a conflict of interest to give an LLC ownership of a company that is also a client...but it's even more of a conflict for a part owner to contract out to that owner's company.
  • Assuming a deal is doable, is it reasonable to ask for access to the financials and have a say in how they're managed? (The client is already very open with me about revenue and operating expenses during our conversations.)
I appreciate any feedback or advice that you may have.

Dr. Jill S. Becker

January 24th, 2015

Go with your gut and go for it. Sounds like you know there is something there. But the timing is almost..they need $. Can you help them raise some or get someone too ASAP? Good luck. Always go with your gut. You know the right call. You already made up your mind. :)

Marcus Matos Software Development & Information Technology Professional

January 25th, 2015

Rob,

You brought up some very good points that I agree with, and at the risk of sounding like I already made up my mind...

His decision to use cheap, outsourced developers was out of ignorance and not necessarily intentional. Although this decision got him a good handful of well paying customers, it resulted in massive technical debt that he is just now coming to terms with. His core product was customized for each customer with undocumented changes - and almost impossible to roll out new features to without breaking the core product. Setting up a new customer took weeks of developer time. You know, the standard crap that happens when you have a non-technical person running the development team. It became unsupportable.

My efforts over the last year have been focused on converting this product to a supportable, multi-tenant solution with almost immediate setup and deployment (just a couple of hours per customer) - no development effort required.

If we went back 8 months, I would 100% agree with you. The client balked at my estimates. He disagreed with my efforts. He resisted every "burn it to the ground and start over" conversation we had. But in the end, I won those fights and after our successes he now looks to me for those decisions. I have gone from "I can't wait to fire this customer" to "holy crap, this is really working" over the last couple of months.

So yes, in the past, he did not value great people, prioritized cost over quality, and is now paying for it dearly. If the story ended there, I wouldn't have posted.

It's my conversations with existing and potential clients in the industry that got me thinking about this. There are no serious competitors (yet), and as far as I can tell, there is nobody out there working on the solution either. The biggest players in the industry tell us that there's a huge gap that needs filling. It's tough to not get excited about this!

In the interest of motivational transparency, I'd like to share what my plan for 2015 was toward the end of 2014: wrap up projects with most of my clients and focus on building out a couple of my own projects. I have a track record of architecting and building other people's ideas, but not my own.

In thinking through the risks, I believe that working full time on my own projects (with no existing customers, funding, etc, yet) is a bit riskier than buying in to a company that already has paying customers, contacts, etc. I guess what I'm saying is - should I put myself on the line for my own projects, starting from scratch? Or should I put myself on the line for another company that already has some successes and that I'm already a year into? With the latter, I'm not taking on 100% of the risk, and I believe the chances for my own success are much greater due to the fact that I work best in tandem with a business partner.

This post has gotten a lot more personal than I would have expected, but I guess it's good to get it all out.

I do sound like I've made up my mind. I may need to sit on this for a few weeks.

I will definitely post updates in the future as I'm sure there are others who could benefit from my experience through this venture.

Steve Owens

January 25th, 2015

@Rob - you could fix number #1 (valuation) by simply taking warrants that are priced when there is an arms length transaction. So called "Unpriced Warrants". Also, I do not agree that outsourcing = bad management. We have several customers who outsource, although strategically, work and are very successful. I do agree that hiring low performing employees or outsourcing to the low cost providers is bad move, especially with technical work - but when you do not know how to judge talent, that is the only criteria you have to go on. The key if, after being educated, does he continue that practice. If he is listening now, I would not worry about it. Regards, Steve Owens - Finish Line PDS A Better Way for Small Companies to Develop Products e | Steve.Owens@FinishLinePDS.com p | 603 880 8484 w | www.FinishLinePDS.com 94 River Rd | Hudson, NH | 03051 Click for Product Development White Papers ---- On Sun, 25 Jan 2015 11:44:39 -0500 Rob Roj <reply+dsc+2103@founderdating.com> wrote ---- FD:Discuss New Comment on Should I offer a reduced contract rate in exchange for equity? Commented on by Rob Roj Sales Engineer, Jumio Inc. and Alumni Executive Board Member, Johns Hopkins University. Don't do it. The CEO clearly does not value the technical side of the business. The warning signs are already there: He's coming from a non-tech industry He chose to use outsourced developers He chose the cheapest developers he could get It's pretty clear you've decided that you're going to do it. Allow me to predict what is going to happen. He's going to value is company ridiculously high and even if the company does succeed, you would be better off working for another start-up. You are going to work more than you currently are for less pay and as soon as you are replaceable, you will be replaced. He's not going to learn the value of an excellent technical co-founder until it's too late. Simply put, even if you can turn around the company, growth is going to be an issue because the CEO does not value GREAT people. In other industries such as manufacturing and distribution, you can get away with hiring "good enough" people and do ok. In tech, where it's chaotic, with rapid development cycles, and speed, time and quality are EXTREMELY important, this company will get crushed by the competition. My question to you is, "What is this company's moat?" How will this company defend itself from competitors and for how long? And no, IP is not a defense. IP is a battle that ends AFTER the market has decided. Just look at Samsung vs Apple, by the time Apple won a $1B suit (still under appeal), Samsung had already dominated the mobile market. Your moat, 3 years with 5 outsource developers, is generously 3-6 months. Here's a better explanation from HBR (It's a bit dated but still true). https://hbr.org/2011/06/why-zuckerberg-is-almost-right.html I'm curious to see how it goes. Please keep us informed. Upvote | Downvote Read 10 more >> PARTICIPATE IN DISCUSSION or Reply Directly to this email to participate in the discussion Manage your email notifications

Steve Owens

January 26th, 2015

@Aldo Lets say you have $100 of unpriced warrants today. 5 years from now, you decide you want to exercise these options. In this 5 year period, the company did 3 deals: A, B, C. Series A was at $1 per share, Series B was at $5 per share, and Series C was at $10 per share. You get to buy 100 shares at $1 per share since that was the best deal. If the Serres C was a down round, say $0.5, then you would get 200 shares @ $0.5 per share. The idea is to avoid pricing the shares - let someone with a lot of money, experience and no emotional attachment to the business decide the price. Steve Owens - Finish Line PDS A Better Way for Small Companies to Develop Products e | Steve.Owens@FinishLinePDS.com p | 603 880 8484 w | www.FinishLinePDS.com 94 River Rd | Hudson, NH | 03051 Click for Product Development White Papers ---- On Mon, 26 Jan 2015 03:39:16 -0500 Aldo Pahor<reply+dsc+2103@founderdating.com> wrote ---- FD:Discuss New Comment on Should I offer a reduced contract rate in exchange for equity? Commented on by Aldo Pahor Previously C# Developer, Paddy's Power Pty Limited. Previously .NET/SQL Developer, Barclays Capital. @Steve Owens can you give a numeric example of "Unpriced Warrants" and of the following: "You get warrants equal to the peak value of the outstanding balance - The warrant price would be at any price the company sells for in the future - that is, best of the A, B or C round. - Get a security interest in the IP But always talk to a lawyer" Upvote | Downvote Read 14 more >> PARTICIPATE IN DISCUSSION or Reply Directly to this email to participate in the discussion Manage your email notifications

Tim MBA CEO, Healthcare Forward

January 27th, 2015

Marcus-
I recently did some research on a similar situation I am facing- working for equity in lieu of my market rate compensation.  I am including a link to what I think are three very good articles on the topic.  The bottom line is that working for equity should be treated more or less as an Angel investment, since you are trading a quantifiable amount of time/ opportunity cost- which can be converted to a monetary figure- into a reasonable amount of equity. The logic goes that you should be treated contractually as if you are an Angel investor, and there is plenty of guidance on that regarding convertible notes, exchangeable shares, etc.  Of the articles, I really like the one by MIchelle Wetzler because she used three different methods to arrive at a proposal, including a formula I also reference by Paul Graham of Y Combinator.

http://paulgraham.com/equity.html

http://blog.asmartbear.com/cash-equity-compensation.html 

Even though this is a logical discussion, I get the comments by people about "go with your gut", because the bottom line is there are unquantifiable components to the decision, and at the end of the day, you'll need to live with the decision, right or wrong. 

Good luck!

-Tim

Anonymous

January 24th, 2015

tl;dr but if he has a history of multi-million dollar businesses, why won't he fund it or have the connections to provide the funding? Sent from my iPhone

Michael Brill Technology startup exec focused on AI-driven products

January 24th, 2015

I'm with Francis on the question of why he isn't able to raise money... and why you think there'd ultimately be liquidity.

Having said that, you are already working for 50% discount by virtue of putting in 50 hours for 25 hour pay. So getting something extra doesn't seem like a bad idea. If you go forward, there are a couple of issues:
1. The client is going to view his company being worth *way* more than you think it is. As things get more dire, this difference narrows... and if you're doing most of the product work then you may need to play a timing game to get what you think you deserve.
2. There are huge tax implications of being paid in straight equity, so be very careful how you structure a deal.



Anonymous

January 24th, 2015

I will be blunt: Reading your last response makes me question some things you said. A. Your confident the product can be so amazing why are you even asking? B. Do you know the CEO as well as you think? Stretched thin is bad for everyone. C. You won't share details but are asking for support. That's almost like asking a psychiatrist to help you but you won't tell them your issues D. Can you even help the company succeed more than just developing a product? If you believe in the product and the team, follow your heart. Don't go by others because ultimately you need to sleep with your decisions. The community can only guide so far but every situation is different. Sent from my iPhone

John Shiple

January 24th, 2015

I would like to speak with you. I am in a similar but less impactful situation. Also, I talk to and advise CTOs and technical co-founders all the time and can likely provide you with some insight or relative "case studies" related to your situation. +=John

Marcus Matos Software Development & Information Technology Professional

January 24th, 2015

Regarding the funding, I don't feel comfortable discussing the specifics publicly but I am aware that the founder did make some prior personal and business decisions that ultimately did not work out. That said, he did come back from it in a new industry which leads me to believe in his ability to recover from adversity.

As to his ability to raise funding, I don't know, but I can tell you that between managing developers, hustling for sales, and existing customer management, he's spread incredibly thin (this being a reason to bring me on).

Please don't take my response as cheerleading. We've had major disagreements and there have been days that I've wanted to fire the client. However, it's the trade show experience that has opened my eyes and based on our discussions the last couple of weeks, I feel we're on the same page and have the same vision.

It's really a situation I didn't expect to find myself in hence the post here.