Last month I was sitting down for coffee with the CTO of one of the most successful app development shops in Boston. He confirmed what I had suspected –his firm, like many of his largest competitors in the space, resisted the temptation of taking equity in their clients in lieu of service fees. Unlike venture backed product based companies, for app dev shops and other service based companies, leveraging investor capital to grow your company is much more rare, and rather, your fee compensation is the lifeline of your business. But for you founders of newly formed app dev shops, agreeing to take all or a portion of your fees in the form of equity, if you can stomach the risk, might end up being the difference maker in winning your next job from an early stage start-up that is preserving burn at all costs. Here are a few alternative forms of consideration you might contemplate taking from your potential clients, and the upside and downside of each:
If the start-up you are contracting with has an open bridge round whereby the company is taking investment in exchange for the issuance of convertible notes, you might consider exchanging services for principal in a note issued in the round.
Upside: Convertible notes have the benefit of running interest (typically at a rate of 3-8%) and, at conversion, noteholders enjoy a steep discount to the price paid by new investors for the security into which the noteholders debt converts in the next equity round.
Downside: There are plenty of start-ups that are successful raising an initial friends and family bridge note round but aren’t able to build a business which attracts enough interest from institutional investors to successfully close an equity round.
Regardless of whether your potential client has an open bridge round, the YCombinator SAFE security is flexible to allow for a single SAFE to be issued to an investor, or in this case, a service provider, without the need for your potential client to open a broader round of financing.
Upside: Although there is no interest running on the note, SAFE holders, similar to noteholders, enjoy the same steep discount to the price paid by new investors for the security into which the SAFE holder’s purchase amount converts in the next equity round.
Downside: Similar to the risks of a noteholder, there is a chance the SAFE never converts and you are left holding an illiquid, equity security (junior in payment to debt) in a failing company.
If the potential client prefers not to issue their service providers an investment instrument in exchange for services, an alternative form of compensation can come by way of a warrant. A warrant is a security which gives a holder the right to purchase a certain number of shares (common or preferred), within a defined period, at a set price equal to the fair market value of the underlying security on the date of grant of the warrant. The idea, similar to a stock option held by an employee, is that as the value of the underlying security increases, the warrant holder will enjoy the delta over that set price stated in the warrant and the ultimate value (most likely at a sale of the company).
Upside: The issuance of a warrant is not contingent on the company having an open bridge round and the warrant security will provide for a cashless mechanism whereby the warrant holder will never have to actually come out of pocket to enjoy the increase in value of the warrant.
Downside: The term of a warrant is typically 10 years and, even if the potential client is able to sell their company within that time frame, there is always the risk that the valuation of the company in such sale may not be high enough for the warrant to be in the money.