Convertible note · Founder equity

Vendor as an investor. What's the best way?

Lots2learn Entrepreneur

December 16th, 2019

I am an unusual position and would appreciate some guidance. I am a senior partner in a small software development and consulting firm. One of the things we do is a SAAS product geared towards corporate and retail barter operations. We typically sell a perpetual license and add a support contract to create a continuous revenue stream.

We were approached with an offer to become a "partner" vendor for a new startup that hasn't even been incorporated yet. We are offered equity in return for the license and 3 year support contract. The founder has interesting ideas, but he wants to get proof of concept working before raising capital, and our software would allow just that. So effectively we're at the very inception of the company with no valuation and little assurance. I am looking for the best way to structure that relationship in a balanced and transparent way.

Here's my current chain of thoughts:

  1. This is not a "cofounder" type of scenario as I wouldn't be personally employed by that company or involved in the operations outside of supporting our product; instead we should act as a "seed" investor,
  2. With no valuation on the table, we can use SAFE or convertible note to defer pricing to be determined later by professional investors but that leaves uncertainty if the owner never takes the company to Series A; perhaps the convertible note with a discount and a cap is a safer option as it would allow us to ask for cash if investment round doesn't happen in say 3 years,
  3. We should aim for a board seat and expect to participant 1-2 hours a week making sure our investment is safe and secure,
  4. Some sort of "vesting" would be logical to have to make sure we only get full equity when the company gets to the "proof of concept done" milestone; I don't think vesting is possible with a note, perhaps we can structure the total investment in annual stages as separate notes somehow.

I am interested in any critic and suggestions on how to structure this deal better. Thank you!

David Rueter Empowering businesses to improve and get lean through technology and best practices.

December 16th, 2019

I am the president of a SaaS company, and have also been a co-founder of a start-up. I've been involved in discussing these kind of deals from both ends: both as vendor, and as start-up.

My basic suggestion is to approach this as though it were a cash deal. That is, pretend that you had a different normal customer that would pay you 100% cash. Would you then be willing to invest that cash in this startup? If so, under what terms and conditions?

If you wouldn't invest cash in the startup, you probably don't want to invest your time / opportunity cost / software. And it goes without saying that you need to be sure that you can afford to loose 100% of your investment (and not have missed out on other bigger opportunities while you did so).

If on the other hand you think that this could be a worthwhile investment, and that there are also other intangible benefits, then perhaps it is worth pursuing.

A "barter" kind of deal like this is always more complicated and more risky for both parties than just a normal cash sale / cash there should be some kind of additional upside beyond cash ROI involved in order for the deal to make sense.

Next, you need to assess 1) Is your software of strategic importance to the core of the startup's business? Or are they just looking for a way to finance important but non-core business software? 2) If this deal is successful, do you get something more than just cash? (i.e. PR fame, access to an industry, co-marketing opportunity, access to new strategic partners? ) Or is success just cash return? 3) Do you have anything to offer this customer beyond just the software and services you normally sell to others? (advice, introductions, mentoring, access to customers, investors, etc.) Or would you be giving them only what you normally sell to others?

If the first of each of these is a "yes", then there could be a good deal to be made. But if the first is a "no", then be very skeptical...because you are really just making a cash investment with little "magic" involved.

If this still looks to be a good deal, then you need to think about things from the startup's perspective. Board positions, equity, etc. sound fun. But these make it harder for the startup to raise additional money. No one wants non-strategic shareholders around. Depending on the equity distribution, your position could deter an investor from coming in, or could prevent a round of funding from closing, or could require that a new investor buy your stake out prematurely. Likewise, board positions should be strategically beneficial for the startup. Maybe you provide strategic value...but maybe you do not.

And then...a board member has a fiduciary responsibility to the company. You as a vendor on the board would be inherently a conflict of interest. This is messy at best. Whose interests would you be promoting? There is opportunity for disagreement, problems, and litigation. But even in the best case, you wearing a "vendor" had on the board could weigh down the startup and hamper their ability to do what they need to do to be successful.

Finally, startups are risky, for lots of reasons. Beyond you perhaps failing to realize a return on your investment, you potentially could suffer a "boat anchor" effect of them dragging you down. If they went out of business (perhaps in an ugly fashion), could this reflect badly on you or give you a black eye?

As for being a "seed" investor...that is a whole can of worms for both parties too. For one thing, other cash investors will probably see your investment as inferior to their "skin in the game", and may be resentful. Also there are SEC considerations. And also a startup usually needs strategic value from a seed investor...not just cash.

In general, I guess I'm saying to be skeptical of deals like these: they rarely work out in a mutually-beneficial way.

That said, they "can" work out: I have one right now that is going kind of OK. This one though is a percentage of gross revenue (not equity), with monthly minimums kind of like a retainer. Revenue is trailing projections, and my labor exceeded estimates...but things seem to be moving in the right direction. No huge equity opportunity / exit in the future, but it's a good mutually-beneficial relationship.

I probably have more to say...but have gone on long enough. Let me know if you have any questions. All the best!

Clay Nichols Helping other startups grow after launching 2 successful startups.

December 20th, 2019

Do you mean that you provide their company with a License (and maintenance) to YOUR software in exchange for equity in THEIR company?

Dane Madsen Organizational and Operational Strategy Consultant

December 17th, 2019

I assume the proposer believes using your platform would accelerate the launch and have a halo effect in the target market. I also assume that, being unlikely you will license technology they then use to compete with you, it is a target space you do not intend to directly exploit. Finally, I assume they would want some assurances you would not license to a competitor of theirs in the future.

If that is accurate, I would structure this where your company owns a significant amount of the equity, and I personally would insist on preference shares or, at the minimum, the highest class of shares and rights afforded to any shareholder (such as dual class common). Waiving fees for the license and agreeing to ongoing support is real capital to you. It has real value to them.

You need to first quantify the amount of value you would bring by waiving this and then apply a multiplier to the significant reduction in time they would enjoy using your platform instead of having to create their own. The rule of thumb in acquisitions is that, for each 6 month period a project or product can be accelerated, the value is 3 x the raw cost. If your platform costs $100 K for a license, and the annual support is another $15 k each year, then you are contributing $145K at the outset. Assume they get to market immediately instead of 18 months, then you have contributed about $435 K in value.

I would also get a deal expert with experience in this type of transaction to advise you because the pitfalls of this could be significant. E.G. you license the technology, they bring it up and get traction, then they build a similar system and stop the use of yours, then transfer ownership to a new entity that you have no ownership. I would also restrict any transfer of the technology to any entity without your express consent, protect yourself from them reverse-engineering the technology, and contemplate the costs for customization they will likely require.

You should have Board representation pro rata to the value agreement and be allocated representation until your stake has been diluted (via new investment or sale) to some hurdle.

I would not use a SAFE or similar in this. You take real risk and cut their launch time and risk significantly. Your work should be afforded that credit.

Hope this helps.

Lots2learn Entrepreneur

December 17th, 2019

Big thank you to David for the reminder of inherent conflict of interest and potential downside to the startup, and to Dane for the great rule of thumb!

Lots2learn Entrepreneur

December 18th, 2019

Hi Dane, thank you for a rule of thumb. I am loosing track following the math thought. If it is 3x for each 6 months, should it be 9x $145K for 18 months then?

The rule of thumb in acquisitions is that, for each 6 month period a project or product can be accelerated, the value is 3 x the raw cost. If your platform costs $100 K for a license, and the annual support is another $15 k each year, then you are contributing $145K at the outset. Assume they get to market immediately instead of 18 months, then you have contributed about $435 K in value

Sheeba Pathak Solopreneur

December 19th, 2019

As rightly pointed before, barter deals with no money involved is a rarity to work out however there are cases in which it can; especially if in perpetuity. You can offer the usage of your SaaS for a short time period and assess the firm's progress. However, the firm must not entirely depend on your service to garner a projected target market. Instead you could here, itself evaluate the value you bring to the table and seek a commission out of each touchpoint (say x%), each lead (say (x+y)%) and so on. It serves two purposes: your software is giving you a live demonstration on how it is reaching the targetted set as well as generating revenue for the new start-up; so your sweat equity isn't left at that; it's monetised.

You could carry this arrangement on till the breakeven or till you start earning from the commission model as much as you would if you would have sold the software to another paying customer (you can work this timeline and the Math out and toggle with any fluctuations in a best case and worse case scenario and take a call accordingly)

Yes, the chance of never reaching a Series a round is possible if the firm starts paying by itself and is rather boot-strapped or even if there are minimal to no out of pocket expenses (this could arise because of the very commission based model too); so to failsafe this in case it's a really long tenure; you must take an amount of equity that you and the firm agree to the fact that you would either sell in case monetarily it isn't working out.

Additionally, you could have a loaned model. Loan out the software service for a short time span within which the firm must have the proof of concept. After which they would have to ensure to pay back the service utility fee as you would to a paying client along with a certain interest rate. This could be paid to you by the targetted client as well directly. (Something that the firm offering you this 'partnership' should be smart enough to work out; so practically he uses your service for almost free)

A completely different model is for the proof of concept stage to materialise and then you could look at acquiring this firm if it is in your line of interest and business alignment. Essentially, you turn the table and move from a 50-50 partnership to an ownership for the incubation and seed non-monetary support