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Use Equity to Get Aligned with Service Providers

October 30, 2006
URL: http://www.entrepreneur.com/article/169836

Editor's note: This article was excerpted from Financing Your Business Made Easy.

Instead of being paid in cash for services they provided to entrepreneurs, some professionals are sometimes willing to take some of their fees in the form of equity. Lawyers, accountants, marketing and public relations professionals, and management consultants are the most likely to agree to an equity stake. But even landlords have been known to take equity.

Some professional service providers are willing to take equity because they feel an equity stake will some day be worth more than the cash they could take today. They work on the notion that $1 in income today is only $1 of sales and far less than $1 in profit, but $1 taken as an equity stake in a company can some day be worth $5, $10 or more, with everything above the first $1 being pure profit.

Others take an equity stake because they have excess capacity in their businesses--more supply than demand--and prefer to gamble on getting some return from a deal rather than wait for cash-paying business to come through the door.

Most of those willing to take equity don't take their entire fee that way. They usually take enough in cash to cover their costs and then take the portion of their fee that would be their profit in the form of equity, gambling that their stake will increase in value over time. And they don't take an equity stake in any business, only in those they feel have a real potential for serious payback.

Service-providing professionals are usually in a position to do due diligence about a business while doing their work. Accountants and lawyers are privy to a company's intimate financial details. Management and operations consultants understand how the company actually does its business. Marketing and public relations consultants are able to see how the company is viewed by customers, suppliers, competitors and other important outside groups. They all can develop some "gut feeling" about whether the business will flourish or flounder in the long run. If a service provider is willing to discuss taking a portion of fees in equity that is a vote of confidence you should cherish.

Finders and Brokers
Finders and brokers who raise investment capital often like to take a portion of their compensation in equity in states where they are allowed to do so. Most insist that the retainer portion of their fee and their expenses be paid in cash, but some are willing to take part or all of their "success fee" in the form of equity.

One formula that is often used in calculating success fees is 5 percent of the first $1 million raised, 4 percent for the next $1 million, 3 percent for the next $1 million, 2 percent for the next $1 million, and 1 percent for anything over $4 million. Thus, a broker or finder who raises $5 million would be due $150,000. If he or she were willing to take this in the form of equity, you would have enough cash to hire more employees.

Incubators and Accelerators
Incubators and accelerators are also often willing--or even request--to receive some of their fees in equity. What's the difference between an incubator and an accelerator? Incubators nurture new companies over time, while accelerators act to supercharge new companies.

Incubators are essentially real estate that's loaded with extra services. They have always worked well for life science companies, which would have to invest heavily to build or retrofit space into laboratories.

A small company, instead of simply renting space, fitting it out as a lab and hiring its own service providers and staff, can take space in an incubator that includes lab and office space, shared services such as marketing and accounting, and common spaces such as conference rooms, auditoriums, and a cafeteria or on-site restaurant.

During the dotcom frenzy, companies such as Idealab and CMGI sprouted and called themselves "incubators." They were essentially holding companies funded by VC money that invested in equity stakes in small dotcom businesses. To achieve their funders' goals, they were driven to try to help companies move from concept to initial public offering (IPO) in less than one year. However, most of the small companies and the incubators failed with the dotcom meltdown in 2000 and 2001.

Corporate incubators have been more successful than dotcom incubators. Paul Weaver, the former chairman of the global technology program at PricewaterhouseCoopers consulting, which has since become part of IBM technical services, argued a few years ago that there was more money being spent on incubating new ideas in large companies than in independent incubators. Today, incubators are even more out of fashion and large companies are setting up more elaborate mechanisms for partnering with and investing in startup technology companies.

Corporate incubators work with outside entrepreneurs who have technology or products that dovetail with their own. Such companies as AT&T, Dow Chemical and Sony have active incubator programs.

Corporate incubators have an advantage over independent incubators, Weaver believes, because corporations are inherently strategic in their thinking, incubating efforts that relate to their core businesses. The independents' business model is purely financial, essentially venture capital with added services.

Accelerators
Incubators have been around longer than accelerators. Accelerators were spawned by the same need for speed as touted by the for-profit incubators. With so many ideas--especially Internet-related ones--chasing venture capital and angel money, only those that got there early got funded.

Some accelerators are individuals; others are groups of independent professional service providers who team up to offer "one-stop shopping" for entrepreneurs in need of services. Some larger management consulting companies have also formed accelerator-type organizations to work with smaller, entrepreneurial companies.

An accelerator can add value in many ways. In addition to rounding up financing, accelerators can find real estate, provide legal and accounting assistance, and even mentor young entrepreneurs in the rudiments of running a business.

Some angels act as accelerators. These "value-added" angels often take an active role in a company's day-to-day management and put their network of contacts to work for the entrepreneurial company.

Equity for Service Providers
You should probably think of service providers as participants in earlier rounds of financing, either with family members and friends or with angels. This is important when determining how much equity to sacrifice. You always need to leave enough equity to attract enough funding for future rounds of financing.

If you find discrete service providers who will take some equity in the early stages of your business, don't let go of more than a total of 10 or 12 percent to them and the family and friends combined.

You probably don't have to throw around large amounts of equity to satisfy professional services providers. At this point, they know they are taking a big risk.

If you find an angel who is also acting as an accelerator, you need to factor that in when determining how much equity the angel will receive for his or her investment. Remember: the angel's investment of time may not be as valuable as his or her investment in capital.

For instance, suppose an angel wants to take 25 percent of the equity for a $500,000 investment and will provide personal services worth another $100,000 over the next year. A 25 percent stake for $500,000 assumes that the company's value is $2 million. Therefore, another $100,000 in professional services should be worth another 5 percent.

But you are taking a salary of $60,000 a year for a position that would pay $150,000 at an established company. You are assuming that your low pay will be compensated on the back end through additional value in your equity position when your company is bought or goes public.

In this case, you could ask the angel to consider taking 40 cents on the dollar in equity for his or her professional services, so another 2 percent, not 5, for $100,000 in services.

For more information on ways to raise money for your new or established business, read Financing Your Business Made Easy from Entrepreneur Press.