You Give Me Service I Give You Equity - Where is the Money?
Raaj Nemani and a pal were making plans to start their own business, an online retailer of limited-edition sneakers. But they couldn't afford the $100,000 for high-end website design.
Then, they learned of an alternative.
Alana Prant
Raaj Nemani and Aaron Firestein of Chicago paid for website development primarily using equity in their firm, BucketFeet Inc.
By joining forces with a Chicago website-design and professional-services firm, the pair of first-time entrepreneurs were able to get the work they needed by paying primarily with equity, instead of cash.
The swapping of equity for services is exploding, as a range of professional services providers—including website designers, attorneys, ad agencies and business consultants—seek to profit directly from the growing demand for their services on the part of U.S. start-ups.
Because starting a company is less expensive than ever before, thanks to lower-cost technologies, there's been a surge in new ventures that are very small and lean on resources. There were 758,000 new U.S. businesses launched in 2011, up from 742,000 in 2010 and 700,000 in 2009, according to government data.
Equity-based compensation for professional services was popular—and hotly debated—during the late '90s dot-com bubble. Back then, some law firms that took equity stakes in lieu of hourly billing made extraordinary profits after some of the companies went public in IPOs.
But such investments fell out of favor after 2001, when many Internet ventures and Web companies went belly up. Some professional-service providers were left with no equity, no fees.
What's driving the resurgence now is an understanding among today's cash-strapped entrepreneurs that access to services such as website development may make a critical difference in their chances of survival. On average, 20% of start-ups fail within their first year, according to the Ewing Marion Kauffman Foundation, an entrepreneurship-research organization in Kansas City, Mo.
Since January, Debbie Madden, an executive vice president at Cyrus Innovation LLC, a software-development firm in New York, has been fielding multiple requests daily from entrepreneurs looking to trade equity for the firm's services, which include providing pairs or teams of developers to work side-by-side with a start-up's staff. Entrepreneurs have been "begging me to do this—it's unbelievable," she says.
She's wary, she says, because her firm already has gotten burned once by such arrangements. It provided $50,000 worth of work over the course of two months last year to a bootstrapped entrepreneur looking to build an online subscription service in exchange for a 10% equity stake in the venture. The subscription service still hasn't launched. Ms. Madden doesn't it expect it to ever get off the ground. "I'm not waiting for my paycheck," she adds.
Paying for Services With Equity, Instead of Cash
Pros
The service provider has a vested interest in your success.
You can spend your cash on developing or improving your product.
You may be able to grow faster than if you had to wait until you raised outside capital.
Cons
The service provider may give its paying clients greater priority.
You dilute your ownership stake, which can hurt your motivation to succeed.
Professional investors may be turned off if you give away too much of your business.
Source: The Wall Street Journal
Critics say these arrangements are often a bad idea, particularly for service providers that don't have experience evaluating start-ups. The entrepreneurs best positioned to succeed, they argue, rarely need to give up equity for services, because they are funded by venture capitalists or other investors and thus, can afford to pay the fees.
Yoichiro Taku, a partner at the Palo Alto, Calif., law firm Wilson Sonsini Goodrich & Rosati PC, says with more start-ups coming through the door this year, he's approached nearly every week by entrepreneurs who can't afford to pay for legal services.
His firm charges about $5,000 to do the necessary paperwork to incorporate a new business—one of its most common services. For cash-strapped entrepreneurs who can't pay, the firm will take up to a 2% stake in their business, while deferring its fees until the start-up receives a round of financing, is acquired or goes public.
"It's always been in the playbook," he says of the firm's willingness to accept equity stakes for legal advice. Several of those stakes have ended up being worth more than $100,000, far more than the original legal fees, he adds.
David Vogin
Wilson Sonsini made out handsomely in the last dot-com bubble. Its investment fund held stock in 35 companies that the firm shepherded through their IPOs in 1999—and three of those were collectively valued at $82.5 million, based on closing prices of those IPOs on their initial trading days, according to figures cited in a legal trade journal in 2000.
Accountants are prohibited by professional rules from investing in client companies, if they are auditing a company's financial statements. It is generally considered okay for accountants to take an equity stake, in exchange for, say, tax-filing or bookkeeping work, however.
For lawyers, the rules are less clear. The American Bar Association's model rules of professional conduct caution against taking interests that might be adverse to a client. But the rules don't prohibit a lawyer from doing business with a client. They merely specify that the deal be "fair and reasonable" and that the client has an opportunity to seek the advice of an independent lawyer.
One major downside to giving up a significant equity stake in a start-up is that it can hurt founders' chances of securing additional capital down the road.
That hasn't deterred Per Lofving, the 52-year-old founder of New York-based B2BAnywhere Inc., a provider of custom and generic tablet apps for businesses. Six months ago, he turned to Resolute Digital, a digital marketing firm in New York, for app design and development help.
Now, while Mr. Lofving's two-person start-up focuses on sales and marketing, it leaves the apps to Resolute Digital, which has a 51% equity stake.
Resolute Digital, a 40-employee business that services major companies like Samsung Electronics Co. and Meredith Corp., currently has ownership stakes in three young companies. It provided Mr. Lofving's firm with $25,000 in seed capital as part of the arrangement, as well as office space.
Dashfire LLC, a two-year-old Chicago services firm, provides start-ups with website-design, recruiting, fund-raising and strategic-planning services in exchange for heavily discounted fees and equity stakes of less than 10%.
One of its earliest clients was Mr. Nemani's year-old online sneaker business BucketFeet Inc. "We didn't have to spend money we didn't have, and additionally, got a partner that was really incentivized to see us succeed," says Mr. Nemani, who is 30 years old.
Then, they learned of an alternative.
Alana Prant
Raaj Nemani and Aaron Firestein of Chicago paid for website development primarily using equity in their firm, BucketFeet Inc.
By joining forces with a Chicago website-design and professional-services firm, the pair of first-time entrepreneurs were able to get the work they needed by paying primarily with equity, instead of cash.
The swapping of equity for services is exploding, as a range of professional services providers—including website designers, attorneys, ad agencies and business consultants—seek to profit directly from the growing demand for their services on the part of U.S. start-ups.
Because starting a company is less expensive than ever before, thanks to lower-cost technologies, there's been a surge in new ventures that are very small and lean on resources. There were 758,000 new U.S. businesses launched in 2011, up from 742,000 in 2010 and 700,000 in 2009, according to government data.
Equity-based compensation for professional services was popular—and hotly debated—during the late '90s dot-com bubble. Back then, some law firms that took equity stakes in lieu of hourly billing made extraordinary profits after some of the companies went public in IPOs.
But such investments fell out of favor after 2001, when many Internet ventures and Web companies went belly up. Some professional-service providers were left with no equity, no fees.
What's driving the resurgence now is an understanding among today's cash-strapped entrepreneurs that access to services such as website development may make a critical difference in their chances of survival. On average, 20% of start-ups fail within their first year, according to the Ewing Marion Kauffman Foundation, an entrepreneurship-research organization in Kansas City, Mo.
Since January, Debbie Madden, an executive vice president at Cyrus Innovation LLC, a software-development firm in New York, has been fielding multiple requests daily from entrepreneurs looking to trade equity for the firm's services, which include providing pairs or teams of developers to work side-by-side with a start-up's staff. Entrepreneurs have been "begging me to do this—it's unbelievable," she says.
She's wary, she says, because her firm already has gotten burned once by such arrangements. It provided $50,000 worth of work over the course of two months last year to a bootstrapped entrepreneur looking to build an online subscription service in exchange for a 10% equity stake in the venture. The subscription service still hasn't launched. Ms. Madden doesn't it expect it to ever get off the ground. "I'm not waiting for my paycheck," she adds.
Paying for Services With Equity, Instead of Cash
Pros
The service provider has a vested interest in your success.
You can spend your cash on developing or improving your product.
You may be able to grow faster than if you had to wait until you raised outside capital.
Cons
The service provider may give its paying clients greater priority.
You dilute your ownership stake, which can hurt your motivation to succeed.
Professional investors may be turned off if you give away too much of your business.
Source: The Wall Street Journal
Critics say these arrangements are often a bad idea, particularly for service providers that don't have experience evaluating start-ups. The entrepreneurs best positioned to succeed, they argue, rarely need to give up equity for services, because they are funded by venture capitalists or other investors and thus, can afford to pay the fees.
Yoichiro Taku, a partner at the Palo Alto, Calif., law firm Wilson Sonsini Goodrich & Rosati PC, says with more start-ups coming through the door this year, he's approached nearly every week by entrepreneurs who can't afford to pay for legal services.
His firm charges about $5,000 to do the necessary paperwork to incorporate a new business—one of its most common services. For cash-strapped entrepreneurs who can't pay, the firm will take up to a 2% stake in their business, while deferring its fees until the start-up receives a round of financing, is acquired or goes public.
"It's always been in the playbook," he says of the firm's willingness to accept equity stakes for legal advice. Several of those stakes have ended up being worth more than $100,000, far more than the original legal fees, he adds.
David Vogin
Wilson Sonsini made out handsomely in the last dot-com bubble. Its investment fund held stock in 35 companies that the firm shepherded through their IPOs in 1999—and three of those were collectively valued at $82.5 million, based on closing prices of those IPOs on their initial trading days, according to figures cited in a legal trade journal in 2000.
Accountants are prohibited by professional rules from investing in client companies, if they are auditing a company's financial statements. It is generally considered okay for accountants to take an equity stake, in exchange for, say, tax-filing or bookkeeping work, however.
For lawyers, the rules are less clear. The American Bar Association's model rules of professional conduct caution against taking interests that might be adverse to a client. But the rules don't prohibit a lawyer from doing business with a client. They merely specify that the deal be "fair and reasonable" and that the client has an opportunity to seek the advice of an independent lawyer.
One major downside to giving up a significant equity stake in a start-up is that it can hurt founders' chances of securing additional capital down the road.
That hasn't deterred Per Lofving, the 52-year-old founder of New York-based B2BAnywhere Inc., a provider of custom and generic tablet apps for businesses. Six months ago, he turned to Resolute Digital, a digital marketing firm in New York, for app design and development help.
Now, while Mr. Lofving's two-person start-up focuses on sales and marketing, it leaves the apps to Resolute Digital, which has a 51% equity stake.
Resolute Digital, a 40-employee business that services major companies like Samsung Electronics Co. and Meredith Corp., currently has ownership stakes in three young companies. It provided Mr. Lofving's firm with $25,000 in seed capital as part of the arrangement, as well as office space.
Dashfire LLC, a two-year-old Chicago services firm, provides start-ups with website-design, recruiting, fund-raising and strategic-planning services in exchange for heavily discounted fees and equity stakes of less than 10%.
One of its earliest clients was Mr. Nemani's year-old online sneaker business BucketFeet Inc. "We didn't have to spend money we didn't have, and additionally, got a partner that was really incentivized to see us succeed," says Mr. Nemani, who is 30 years old.
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