Dave Neal – VC

Consultants and Revenue Deals – Waving a Red Flag

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.

Separating The Wheat From The Chaff – Getting The Most From Advisers

Start up companies get a lot interest from potential advisers that would like to be affiliated with an early stage company. Excellent advisers can make a lot of difference for your company, especially in the early stages. How then to figure out which advisers are likely to be most helpful to you and how you can use them?

This is an important task because a poor choice around advisers can cause many problems. It can be too easy to yield to more experienced counsel and spend a lot of time on courses of action that don’t move the ball forward. This is not a mistake that you want to make because at a precarious early stage you can suffer a lot of damage to the company.

Our experience at TSF says there are two things to focus on regarding advisers:

• Picking the right ones in the first place, and
• Deciding what to use from the advice you have received

Getting the right advisers involves getting the right expertise delivered with the right attitude and intentions. A good adviser will be very aware of the role that he/she should play in advising. At the end of the day it is your company. The choice of a course of action and the strategy used to reach your goals needs to lie with the founders. It’s important that your advisers recognize this.

It’s also important that your advisers have timely, relevant experience that is on point for you. The best fit is someone who has been in an operating role in your space or a similar one. Better yet is someone who has done that over the last 5-7 years. The methods of customer acquisition and developing “proof that you are onto something” have been revolutionized inside that time period. Direct experience on the path you are walking with a “lean startup” approach is likely to be the most helpful setup for you.

Invariably, the advice you receive will conflict. How do you (especially if you’re a less experienced entrepreneur) know which advice to follow? Part of the answer is experience. You will get a sense over the course of a few meetings/issues covered about the quality of one person’s advice compared to another. Don’t be afraid to make decisions about whose advice to follow; your instincts will give you a good place to start on this.

Finally, if you find yourself in perpetual conflict with your advisers one of two things is happening. Maybe you have all the wrong advisers. On the other hand, maybe you are committing the entrepreneurial sin of listening only to your favorite adviser – you!