Why Founder Shouldn’t Trade Equity for a Development
Startup culture promises freedom. Today, startups contribute to the GDPs across the world, and are influencing the way people do business worldwide.
While entrepreneurs run their business and make difficult decisions, their product is in safe hands of professionals. This is the most efficient way to take off your business.
But the tricky question here is how to pay your outsourcing team? Startups in their earliest stage may haven’t much money to pay for services. Until they found an investor.
And then there is a brilliant idea — why not pay by trading equity? Let me explain the disadvantages of this decision.
In this article, we will explain what is an equity offering and why it is not the best option. We will also look at various aspects of nurturing a successful startup.
Here is a list of important issues we will address:
- What factors are important to run a startup
- How outsourcing impacts the costs of running a startup
- The implications of trading equity instead of paying cash
- Reasons you should by all means resist trading your equity
- Alternatives to equity payment when you have tight budget
What is Important in Running a Startup?
Competition is common in today’s world. Thus, there are two critical elements for startup survival and success. They are speed and control.
Speed ensures your product reaches the market faster.
Control enables you to reap benefits from your success.
These elements are trade-offs. There are other responsibilities beyond building a product, such as managing, marketing, etc.
Outsourcing Contributes to Reduction of Startup Running Costs
A primary reason for outsourcing is to cut costs. At an early stage, startups do not operate with much money. They also need to settle down various decisions to attract investors.
There are many benefits of outsourcing product development. It can cut development costs down by up to 70%. This is more affordable than managing an in-house team over long period of time.
Outsourcing keeps overhead costs low, or at least reasonable, until you deliver a successful product.
What Does the Equity Option Mean for Startups?
Equity trade is a tempting option when a startup carries out a high-priced development. Especially if a founder has a tight budget.
Freelance contractors and organized outsourcing teams sometimes provide estimates. The estimates cover costs and offer a reduction in exchange for equity.
But, deferring “payment” raises the cost of equity against upfront fees. Yet, you have to get a full picture to notice it.
The question remains, should you give away an equity to build your product? Use equity to launch your product and get to revenue. Never use it for one-time expenses.
Use the equity in the business for talent, since the talent is rare. Use it when you want people to stay until you achieve your goals for the business. And only if they themselves want to fulfil their ambitions and use all their skills to make your company succeed.
You may also use equity to get funding for startup. You need money to pay for talent and company development.
Startup equity is not limitless. If you give away a part of it without due consideration, you’ll end up with little to nothing sooner than later. By then, you will give away everything and jeopardize the existence of your company.
Let’s remember the words of the legendary Felix Dennis. In his book How To Get Rich he advised that to become wealthy, you should never give away equity. It is more important down the road that you fight to keep every startup equity percentage you can now.
A payment happens once.
But if you sell equity in your company, this decision may influence every business decision after.
Every startup idea is in its own unique place. There are key factors that determine how to make decisions on equity and costs.
It is always better to resolve any issues related to payment before jumping into the working process. You negotiate the price, agree on it, but nothing will stop you from changing it by mutual agreement later.
There are expenses that don’t add value to your business (like rent or office furniture). But if they are necessary, pay for them in cash.
The Other Perspective – Questions to Ponder Equity Trading
Some questions are critical if you trade equity instead of paying for services.
These questions include but are not limited to:
- Are you, as a startup founder or appreneur, ready to be fully committed to your startup? Do you expect the contractors to take more responsibilities than they should?
- Are you capable of getting your startup off the ground?
- Do you have the requisite skills to run and grow a business for a period of at least 5 years?
- Will you be able to monetize your app idea?
- How can you guarantee profitability of your idea?
- Are you sure that your idea might be a matter of a fleeting interest?
The main takeaway is that someone else will try hard to develop your project. If they accept to work for equity, everything comes with a cost.
They will miss opportunities to work with others, who are ready to pay right away.
Top 5 Reasons You Should Pay Outsourcing Teams Instead of Giving Equity Away
1. An outsourcing team may perceive the value of the equity not as you expect
The first downside if offering equity to contractors is that they usually prefer cash payments. But this issue is more pressing that it may seem.
Usually, outsourcers or freelance contractors think that a 5% equity in a startup is too little. Thus, they aim for higher, let’s say, 10%. And even if they accept a 5% offer, they consider it to be a token amount.
But it may cause the situation when the contractors set priorities not in your favor and choose to work with someone, who offers cash right away.
Giving away 5% of your equity to a contractor might cost you 3 months of time to market. Meanwhile, you would have to always make the freelancer prioritize your business.
At the end of the day, if your product is successful, you would have to pay contractors an amount of money they never expected a 5% equity would ever cost.
Let’s say, your business is now worth $2 million. It means that the contractor will earn $100 000 for a web or mobile app development or design.
If you think that your business can cost more in the nearest future, you are right. But, paying in equity dilutes your business. It is more than about compensation for services startup needs.
You should also take into account that many freelancers survive on a short financial leash.
So, their attitude can be caused not by undervaluing your company’s equity. Those contractors, who make lots of money and set high prices, are usually not interested in being paid in equity.
But even if they agree, they are likely to take equity plus a reduced cash rate.
2. Equity brings contractors too close to your business. Make sure they are reliable long-term business partners
An outsourcing team can be a reliable and long-term business partner. But you need to be sure in your contractors before giving away equity to them.
Equity is not only about money. It is more about business plans, goals, and decisions. Would you want a designer to come into marketing or management decisions?
Thus, you need to understand the real value you’re giving away when you consider trading equity for services.
As a majority owner, you decide a lot, but you cannot keep minority owners passive. They have far more rights than you realize.
3. The impatience of (all) humans
People are mostly impatient. Founders are not exempt. Why is this so important?
Everyone wants to believe their equity shares in a startup will have even more value in 6 months or a year. But in reality, it takes around 3 years or even more until a company becomes appropriate for acquisition.
You don’t want to constantly deal with contractors, who are not ready to wait and want you to buy out their equity stake. This is the reason you need to find ways to make outright payments.
4. You communicate your perception of value to potential investors
Let’s say you choose a short-term convenience of offering equity for services.
Any founder can understand you, but in the eyes of investors, this decision defines your attitude. They consider sharing equity with minor characters shows that you don’t value your company enough.
Since you complicate your cap table with a few short-term assets, investors are likely to include uneven term sheet clauses with stronger than usual board representation. The reasons are obvious — they don’t think you are able to negotiate them out.
If the cap table is too complicated, any angel or VC investor won’t consider your offer for their investment. It might not be worth the trouble in their assessment.
5. Redefining the relationships
In the early stages, it may seem logical to give business equity to a developer or designer you’re working with. Your product will be constantly revised and need alterations to meet the users’ requirements. And you cannot do it alone.
By giving equity away you alter your relationships with the developers. It raises the expectations and changes the way you treat an outsourcing team.
Meanwhile, when you pay an outsourcing team in cash, the only thing you care about is the quality of the provided services.
But when you are giving away a part of your equity, you have to ask yourself whether you’re comfortable going into business with this particular person.
Because he or she will own a percentage of the company and gain a more active role in running your business.
Outsourcing teams are simple contractors. They don’t get tied into projects long-term and they don’t think about what happens a year from the time they create an MVP of an app. Simply put, they’re not your partners – they are just there to get work done and leave.
When you’re just starting out, it could be tempting to offer equity to an outsourcing development team instead of paying them in cash. However, this arrangement doesn’t benefit anyone. The outsourced team will take longer to get paid (if ever) and your product will suffer from poor quality because the developers will not be deeply invested in the long-term quality. Simply put, nobody wins in this arrangement.
Malte Scholz, a product manager and co-founder at Airfocus
Alternatives to Offering Equity to an Outsourcing Team
Startups in their early stages usually have a tight budget. So, what to do if your budget is limited? Well, instead of an equity option, you can offer deferred compensation. The issue is not whether you can pay cash, it is whether you can pay cash “right now.”
How does it work? You can offer cash payments that will be made at particular dates in the future. For example, it can be monthly- or quarterly-based payments. If they aren’t made, they can be converted to stock.
This method is preferable. If there is money available, it is better when startup pays any amount of it. Even if it lowers the stock payout a bit.
Development of a Minimum Viable Product
There are many founders, who believe that the product needs to be polished and have all the planned features to enter the market. This conviction often leads to trading startups equity for services.
But the concept of a minimum viable product can help with this. You need to define your business needs to get going and move to the next level.
Be sure you aren’t developing for development’s sake. You need to focus on acquiring the customers your business needs. And you don’t need too much design or development to start selling. It’s better to resist your desire to create a perfect product and save it for later.
Be Flexible with Agreements
Make your agreements terminable at will. This move gives you room to negotiate when you’re stuck. It sometimes happens that an outsourcing team fails to meet your expectations.
You can compensate them and save your equity.
A good example of a truly flexible agreement is being branded advocate. You can mention an outsourcing company in the footer of your website.
If your product makes big , their brand will also gain traction. Priceless!
Do Not Trade Equity Of Your Startup
In most cases, giving equity can lead to unpleasant consequences. It may work only if the partner is reliable and is ready for long-term involvement in your mutual venture.
If the contractor considers your equity as a lottery ticket, you should certainly refuse.
Cash payments for work almost always result in superior products and results. Any startup has little net worth at the beginning.
Without an adequate payment, an outsourcing team may jump ship if there is something more promising insight. Quite logically, that people work harder when they have a stake.
Giving away equity should be your last resort.
And it should be done only in case you trust your partners and are comfortable working with them.
Reserve your equity for employees, and as an incentive to grow your company in the coming years.