"When a business needs financing, X for Equity can be a very practical solution, but you need to avoid some big risks to keep things from going completely wrong!"
Background
In the fast-paced world of digital and tech-based startups, securing the right funding can be a make-or-break moment, especially in an early stage. Traditionally, financing options have ranged from bootstrapping, business angels, early stage venture capital, grants and subsidies, and loans, but there's another intriguing avenue: "X for Equity."
Understanding "X for Equity"
"X for Equity" is like a special deal where startups trade a piece of their company for services "X" they need, like software development, design, marketing, sales support or even advice. Instead of handing over money, they give away company shares.
Here's how it works:
Imagine a startup wants to develop a mobile app, and they need 100K EUR to do it. Instead of asking an investor for cash, a software company offers to build the app in exchange for 10% of the startup's company (Development for Equity).
In another case, a startup in an very early stage needs a logo and a website design, but they can't pay the 10K EUR fee. So, they make a deal with a designer who takes 3% of their company as payment (Design for Equity).
A different startup has a great product but can't afford TV ads. Instead of getting money from an investor, a TV station agrees to give them some TV ad space in exchange for a chunk of the startup's company (Media for Equity).
Another startup with a ready-made B2B product but no money for a full-time salesperson partners with a sales freelancer who takes 5% of their company as payment (Sales for Equity).
Lastly, a startup urgently needs continuous advice regarding the business model, overall strategy, financial planning, investor readiness, execution and how to scale the business. They install an advisory board with experienced experts for x% of the company (Advisory Board for Equity).
Why X for Equity can be tricky
These examples make a lot of sense at first glance, as they avoid the detour via money and as a startup you get the services you need directly. The service providers even take the risk, because if the venture doesn't work out, or if there is never an exit or payout, then everyone involved comes away empty-handed.
Nevertheless, startups have to be very careful in practice, because X for Equity has some stumbling blocks, so that it does not pay off in some cases. To start with: there are cases where X for Equity makes a lot of sense and it also goes very well for all parties involved, but unfortunately there are other cases where X for Equity created a lot of problems. Here are the most important reasons why and issues to consider:
1. Share Commitment: Once you have agreed, you cannot change your mind and you may end up giving away more of your company than you intended. Once you have gone to the notary, the shares are gone and there is only 100% of the company and no more.
2. Quality Issues: Since you're not paying cash, it can be difficult to ensure that the work is top-notch. It can be a challenge to hold the service provider accountable. Especially if the provider doesn't deliver, the quality is worse than expected, or there are long delays in delivery, there's not much you can do about it in many cases.
3. Changing Priorities: Your partner might be busy with other projects, which could slow down your work. Partners need to take care of their employees first, and when it becomes necessary, they need to focus on well-paying client projects instead of working on your project. In these cases, you may experience long delays and / or poor quality.
4. Losing Faith: If things take longer than expected, your partner might stop believing in the success of your startup. They need to take care of their employees and shift focus. They often don't know or expect that it can take years for a startup to succeed, and even longer for an exit scenario to occur.
5. Outdated Work: Technology changes quickly, and your first website or app could become obsolete sooner than you think, making your business less valuable to you. That means you got something temporarily, but the company shares are definitely gone.
6. Dead Shares and Need to Clean Up the Cap Table: As your startup grows, dealing with these equity arrangements can get complicated, especially if you want to bring new investors on board. They don't like so-called "dead shares". Dead shares are owned by people who will no longer contribute to the company's success in the future. Typically, investors will ask you to clean up the shareholder list / cap table to get rid of all dead shares. This can become a problem if the owners of the dead shares do not cooperate.
How to Navigate "X for Equity" Safely
So, how do you avoid these problems while still using "X for Equity" to your advantage? Here are some simple tips:
Choose Trustworthy Partners: Only enter "X for Equity" agreements with partners who have a proven track record or with whom you have personal experience working together. Trust is your foundation.
Prioritize Continuous Cooperation: Instead of sporadic or one-time interactions, aim for ongoing collaboration. Consistency helps maintain alignment and commitment.
Clear Buyout Terms: Contractually establish a fair buyout mechanism that both parties agree on. This ensures that if circumstances change, there's a way out that doesn't hurt either side.
Implement Vesting: Vesting is critical. It means that your partner's equity stake doesn't fully kick in immediately but instead vests over time or as milestones are met. This aligns incentives and discourages quick exits.
Solid Contracts: Ensure your agreements are well-drafted and legally sound. Consult experts to create contracts that protect your interests and clearly outline responsibilities, timelines, and exit strategies.
Consider Alternatives: If the potential pitfalls of "X for Equity" financing seem too daunting (especially for one-time topics like the design of a website), consider other funding options. Sometimes, avoiding "X for Equity" altogether is the wisest choice.
By following these guidelines, you can significantly reduce the risks associated with "X for Equity" arrangements, making them a safer and more beneficial way to grow your startup. Again, "X for Equity" makes a lot of sense in some cases, e.g. if you have the right (!) advisory board members on board to continuously support your successful growth and they need to be committed and perform to get their shares step by step (vesting!). But with the wrong partners, especially if the collaboration is one-time and not continuous, the risk of dead shares is high and there is a lot of trouble. Similarly, with larger Development for Equity projects, the focus and quality of the partner can change quickly, so you can't get anywhere.
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