Ask HN: Equity terms don't align; other compensation options? | Hacker News Reader

Ask HN: Equity terms don't align; other compensation options?

5 pointsdisposable_me10 comments

I'm a consultant. I've built software for 8 years. Approached ~2 months ago by a friend with a business idea for which he & partners need very complicated software. My quote landed at $200-250K.

Met with friend & majority partner (MP) today. MP asked for 50% rate in exchange for 5% equity. So, ~$20K per 1% equity. MP admitted not wanting to pay my quoted price. MP suggests it is an extremely overvalued stake. His version of failure here is 2,000 businesses paying $400/mo, totalling just under $10M in annual revenue (times whatever multiple he has in his head for selling at $XXX million).

I've learned there are 6-7 partners who already divided up equity. Friend has been promised 30% (divided 3 ways 12.5/12.5/5 among him, his wife, & a minor partner). MP splitting remaining 70% among 3 or 4 others, unknown distribution. No revenue, no software, etc. MP has ~30 years experience building/selling businesses, made millions. MP financing the endeavor. Others putting up $0 & time/experience in business, sales, marketing, strategy, etc. Entire strategy is build & sell in 3-5 years.

Based on 1% @ ~$20K, friend's portion is valued at $600K for giving up $0 & supplying marketing/strategy. Other 65% at ~$1.3M. Right? With the offered 5% for 100K, initial valuation of the company--with no clients, revenue, software, anything--to $2M total for 100%. Being soberly realistic, it's just an idea that could be wildly successful or mediocre at best. Only individuals discussing cash in the business right now are MP @ ~$100K (paid to me to develop the platform), & me @ $100K in the form of foregoing half my rate as a consultant. That means we should be starting at equal equity since we're the ones discussing real money, right?

Am I reading this all wrong? I've never taken equity, completely inexperienced in evaluating anything like this.

I would dive in deeper as to why MP wants to give away equity so easily especially if he has made millions. If he really believes the business can sell for 9 figures in a few years the extra 100k that he would pay you would be a steal. Maybe he is not as confident as he says he is.

Also, if you are considering this treat it like an investment. You are essentially investing $100k into the business. You have a right to know the full details. Ask for the distribution numbers and ask hard questions about his motivation and get references. Look into what he says to see if he's reliable. How well does your friend know him?

Have the 7 partners worked together before? Team dynamics are hugely important.

You will be partners for the next few years. Treat it as if you were getting married. Don't let yourself be rushed into making a decision.

Thanks for your reply.

I would dive in deeper as to why MP wants to give away equity so easily especially if he has made millions.

How would you go about this?

If he really believes the business can sell for 9 figures in a few years the extra 100k that he would pay you would be a steal.

I actually said this during our meeting yesterday (which lasted 5 hours with no conclusion). His response was that he simply did not want to pay my full rate and wasn't considering that as an option. It was a very weird moment.

How well does your friend know him? Have the 7 partners worked together before? Team dynamics are hugely important.

MP is my friend's client, so friend knows MP well as a businessman whom friend's company services. Friend & 2 partners are all partners in friend's company, so they work together and have good dynamics. MP and other 3 partners have all worked on businesses together for last couple of decades.

Your quote is a tool for screening sales leads.

Keep in mind that a majority partner can structure the sale of a company in such a way that places their interests beyond those of the other stockholders - e.g. a majority stockholder can sell the corporation or some or all of its assets at a discount to another company, including one in which they also hold a majority interest.

Your friend's partners have an idea that requires complex software and no way to execute it themselves. This is indicative of a perception that software development is just a line item expense.

Their objection to your fee is an indication that they perceive cutting software development costs as good business.

Empirically and despite past events not necessarily determining future events, the single data point upon which you must make predictions about their future behavior consists of trying to get you to take a financial hit.

I will add that if they cannot afford the $250,000 it will cost to execute the software portion of their idea, they are ipso facto undercapitalized. This may indicate that they are undercapitalized in other key areas.

To put it another way, would you ordinarily take a contract where $100,000 was not payable for three to five years and only payable if the company was still around?

My advice:

+ If you're a consultant, run a consulting business. I've never read anything on HN about a one-man band getting rich by taking equity in lieu of consulting fees. Not that I'm saying it hasn't happened, only that it doesn't appear to happen often.

+ If you're an entrepreneur, be an entrepreneur. Pick your co-founders carefully. Build a business you understand and control.

+ Don't confuse the two.

Basically the deal you are being offered is you pay $100,000 to someone who doesn't want to pay you now, on the expectation that at some nebulous time in the future they might want to pay you a big pile of money.

Thank you for your reply. You make many good points.

If you're a consultant ...

I like being a consultant. I don't particularly have any latent strong interest in being an entrepreneur. Do I sometimes think it'd be fun/cool to build something that winds up being worth millions? Sure, we all probably do. But it doesn't really drive me. I enjoy picking up projects, building new things, and then moving on.

To put it another way, would you ordinarily take a contract where $100,000 was not payable for three to five years and only payable if the company was still around?

Absolutely not.

Basically the deal you are being offered is you pay $100,000 to someone who doesn't want to pay you now, on the expectation that at some nebulous time in the future they might want to pay you a big pile of money.

That's how it feels, yes.

You're suggesting that the only things that will make the business a success are the financial and technology aspects. In my experience that's not the case at all. Money and tech are important, but the marketing and strategy are equally, if not more, important. You can build the best tech in the world, but without marketing and sales to get it to customers it's worth zero. Don't be so quick to discount your friend's marketing/strategy input.

As for the $100k you'd be losing, it's an opportunity cost of doing this startup. As far as the other people involved are concerned it's not relevant to them, so there's no reason why they should compensate you for it. After all, you might have an offer to work for the next year at $100,000,000 - would that mean they need to be offering you more equity because you'd be giving that up? No. The value you represent to the startup doesn't change. You alone have to work out whether or not the deal on the table is enough compensation for what you'll 'lose'. If it's not enough compared to what you could get elsewhere renegotiate or turn the deal down, but don't expect them to 'overpay' (in their mind) for what you'll bring to the table simply because of what you could earn somewhere else.

All that said though, it seems odd to me that the group have left so little equity for the technical founder. Do they actually understand what they're getting in to?

Thanks for your reply. It was difficult to limit explanation to 2000 chars, so a lot of my thinking/feeling was left out.

You're suggesting that the only things that will make the business a success are the financial and technology aspects. In my experience that's not the case at all. Money and tech are important, but the marketing and strategy are equally, if not more, important. You can build the best tech in the world, but without marketing and sales to get it to customers it's worth zero. Don't be so quick to discount your friend's marketing/strategy input.

I'm not at all suggesting, even to myself, the financial & tech aspects are the only things that will make it a success. I'm certainly not discounting my friend's marketing/strategy input. What his company, as the 30% holder, brings to the table is largely the deliverable of this endeavor--it just can't be brought profitably (in their minds) without the tech that automates as much as possible, which has turned into a lot of complexity. I was only trying to question if the tech input being valued at 5% was out of line (and included the 30% figure of my friend's pre-existing stake because it's the only number I know). At least, that's why I posted here, but I'll be sure to further check my assumptions to ensure I'm not mentally undervaluing others' contributions (I don't think I am, but it's difficult to express that within 2000 chars).

What I could not express in 2000 chars was that there appears to be a strong resistance, by MP, my friend, and the others who have already been established as partners to give up as little equity as possible (because they've already divided it up and are happy with their own numbers) while also wanting to drive down the cost of software as much as possible. It's difficult to express how that resistance is communicated, but I feel it rather strongly in conversation with both my friend and MP.

Anyway, thanks for taking the time to respond.

"Halve the offer and start negotiating under that number" is quite a common approach to transactions involving rarely traded items. Your counter party is signalling you that he never dealt with a software developer before. You are a rarely traded item to him and he's trying to twist your arm.

Working with people who don't know about software and appreciate the effort that goes into it is never a good idea.

Do you trust these people (and especially the MP)? I'm always suspicious when I hear about startups with many partners, none of them apparently doing anything. Who are those 6+ people and why are they on board? What value do they bring? I'm also suspicious when wives get shares.

That being said, you are using the wrong metrics: 1% @ $20K is not what you should focus on. Neither is your argument to split equally, your $100K discount is not real cash you are putting in.

What happens in a year when your software is not finished, do you continue to develop and improve it for free, or do you send a new quote? That will tell you whether you consider yourself a founder or a consultant. I'm guessing you feel like a consultant.

I trust my friend as a friend, but I've never done business with him. MP is, before this began, my friend's client. My friend trusts MP. Therefore, I'm extending a lot of trust for MP through my friend's professional relationship with him. I do not know MP well enough to have developed significant feeling of trust or mistrust on my own.

The pre-existing 6-7 partners is what has made me suspicious to begin with, which prompted my post here. But they aren't doing nothing per se.

- My friend and his company (3 partners), the 30% holders, are bringing content/marketing/strategy not just to the company, but also as a primary deliverable of the company to its potential clients. - The other 4 partners are apparently bringing their own combined years of experience building & scaling (non-technical) businesses. They are going to be focused on building & managing a human salesforce that will expand the reach of the business to get its services in as many business hands as possible. They comprise the other 70% equity holding at an unknown distribution.

That being said, you are using the wrong metrics

What are the right metrics? That's why I've posted the question. I'm not sure what the right metrics are. This is new territory for me. That said, I do disagree that the $100K discount is not real cash. MP has made it clear he does not want to pay my full rate, and wants me to exchange half that rate for a small equity stake. It strikes me as no different from being paid my full rate and turning around and handing half of it back to the company to purchase a stake. But I could be wrong in that assessment (which, again, is why I've posted the question to see things properly).

What happens in a year when your software is not finished, do you continue to develop and improve it for free, or do you send a new quote?

In a year, if there is more work to be done, I believe I'd be expected to do the work without a quote. They express wanting to have me feel committed/invested/responsible to the company & the tech.

$100k for 5% implies a valuation of $2M. Is the business (with no customers and no product) worth $2M RIGHT NOW?

But it isn't 5%. If it's typical 4 year vesting 1 year cliff, you can be fired after 11 months or 2 years.

You will be diluted when they raise money. As a minority shareholder, there are too many ways to be diluted. For example, your shares have no liquidation preference, but shares from investors usually have a liquidation preference. So you're in a worse spot than a typical angel investing $100k cash.

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