I’ve seen several situations in the last year where an early stage company engages a development or marketing partner and agrees to pay a percentage of revenues as compensation. The last time was just this month, so it’s time to write about it. The implications for these key issues affect your company’s future in ways that you should consider carefully.
Giving up a share of revenues is one such issue. It’s great to get a quality provider to do something for you for less than full cash price, but there are ways to do that without impairing your business’s ability to raise capital or reach profitability down the line. When a provider agrees to help you in this way, it’s fair to provide them upside as compensation for the risk they are taking, but the form of that upside is very important.
A claim on revenues has to be carefully tailored to avoid creating problems. What is the definition of “revenue”? How much upside is enough? What percentage can you agree to before you cause continuing harm to your business?
Revenue can be defined as initial software revenue on the product created, but that’s one among many definitions. You don’t want to allow a claim on other revenues, especially those that have less gross margin. An example would be software support revenues in out years, when you have no certainty that you can make your numbers. Those may be more costly for you, and giving a claim to revenue is harder to justify to later investors who are banking on your venture’s future liquidity.
Creating a fair upside requires some thought. In these type of deals the consultant is usually sacrificing a portion of their normal hourly rate in order to receive an equity kicker. I’d like to know what the average rate they actually charge and collect is. This opacity raises concerns that consultants are estimating their amount sacrificed compared to a published rate that they are seldom able to charge. I recommend that you, as the entrepreneur, do your best to determine the rate that the consultant actually bills. Once you’ve established the consultant’s actual average rate and you know how many hours the project will require, you are in a position to calculate how much the consultant is sacrificing in cash terms.
What’s a fair return on that risk and sacrifice? In my mind, the amount returned to the consultant from an incentive should be at least twice the dollar amount sacrificed. That’s the bottom end of the range where the risk/return trade off seems balanced justifiable range. Beyond that range, it’s a matter of negotiation between the parties. In any event, I think a cap on any such revenue share is necessary. It’s very difficult to justify an unlimited claim on revenues. Depending on how quickly the revenues grow and are shared with a consultant, they will enjoy venture type returns at somewhere between 2-3x of the amount of dollars foregone in the original contract.
Just as important is the fact that if you grant a revenue share the consultant will be receiving a return on a preferred basis. Preferred stock, debt, and revenue share agreements are paid before common stock holders see any cash. In other words, they get theirs before you (as Founders) get yours. This fact supports the argument that the consultant is taking less risk and should therefore be willing to reap more modest rewards.
If you have no option and need to offer a percentage of revenues you should limit the percentage as much as possible. Even a single digit percentage of revenue can wreak havoc with your level of your profitability, or your ability to be profitable at all. If you plan to raise capital, it’s likely that future investors will have concerns. Those concerns will be magnified by the percentage claim on revenues.
Granting a small equity percentage has several advantages. It puts the founders and the consultant at the same place in line with regard to getting a return. Both parties win when a liquidity event occurs. More importantly, a small, single digit equity stake is less likely to cause concern for investors who don’t like to see large equity positions in the hands of people who aren’t currently working in the business every day.