At first, this seems like a win / win situation. If a startup is able to find a service provider that believes in them, the service provider takes equity, and they will be more incentivized to do a good job with development because they now own part of the company. The startup can conserve cash this way and focus on building product instead of raising money. This seems like a good idea but in our experience, this is rarely how things work out and this ends up being a lose / lose situation for both the service provider and the startup.
This, like most problem scenarios, comes down to misalignment of incentives. A service provider typically has not raised money and their biggest concern and cost is employee payroll. In most cases, it takes successful startups multiple years before the investment becomes liquid, so the service provider is never able to look at the investment as something that will address their greatest concern.
The startup is also not forced to go out and raise money from professional investors, whose job is to identify good startups and to help them. The fundraising process helps startups figure out what their core competency and idea really is. They instead raise money from a service provider who has little to no experience identifying which startups will be successful and which won’t be able to provide good startup advice or intro them into the connections they need to raise their next round. We’ve also found that if you aren’t paying cash for something it’s really hard to understand the value of that. There’s no product focus and lean disciplines are thrown out the window when design and development costs are free.
Why do service providers sometimes take on equity for development deals then?
Here are some reasons why and the reasons why it never works out:
1. The service provider has a lull in work and since their employees have nothing to do right now might as well get some equity. This never works because as soon as paying clients sign up then the startup work becomes the lowest priority. If they never get work, then they are probably going out of business.
2. The service provider’s costs are extremely low and they take on part equity and “discount” their development. This is a service provider marketing scheme to try and win a deal. They make the startup founder feel really good by convincing them that they “believe in” their company. In reality, they are paying some developer $10/hour and discounting their rates from $150 to $80 and still making 8x margin. This is problematic for several reasons. Good developers are paid for a reason. Development is typically extremely low quality, and there’s typically no overhead that’s managing those developers. The reality is they do this with every startup to give them self confidence, they don’t really believe in your business.
3. The service provider has some cash saved up and therefore risk appetite is higher. This at some point doesn’t work as well, for the same reasons as number 1. Even if things are going well now, at some point they don’t go well and that service provider needs to start making money. In this case the startup again becomes the lowest priority.
What should you do then as a startup?
1. Raise money from investors that specialize in investing in startups: accelerators, incubators, angels, pre seed venture investors, seed venture investors, etc. (if you are having problem raising that money, then it honestly means you need to go back to the drawing board on how you are presenting your idea / startup) or try raising money on a crowdfunding platform, or try to start a company that doesn’t require a lot of cash up front.
2. Use that money to hire full time engineers or designers. If you need supplemental help, then hire an agency or development firm to help with development, design, and marketing. Full time employees are always going to be cheaper because they don’t have overhead but it depends on what you priorities are. If you don’t have time to hire and manage right now, there’s a temporary need (or you are unsure of whether the need is long term yet), or your needs are constantly changing that’s when you pay someone like us.
This isn’t to say if you are a startup we don’t want to hear from you. We’d love to introduce you to an investor, help advise you on how to raise money, and give you major red flags that we’ve seen. We also work selectively with funded startups as their design or development firm. Our commitment in all cases is to be transparent and give you the facts.