The trend of software development companies taking an equity stake in their client’s business idea has been rapidly spreading throughout the industry. There are many benefits to partnering with an experienced CTO or development company, but there are also many pitfalls to look out for.
Benefits for the client include:
- A team that is more committed to see your idea succeed.
- Less financial risk to reach MVP.
Benefits to the developer include:
- A client more willing to understand the difficulties of development.
- Remuneration is based on the project success which can be much more lucrative.
Risks for the client include:
- Losing control of their business
- Loss of start up capital
Risks for the developer include:
- Loss of potential income.
The methods used to increase the success of a project will vary depending on the scenario.
Freelancer or company doing free work.
If the work is being done for free, the developer deserves a greater than 50% share in the company and decision-making control. It doesn’t matter how good the idea is, if you can’t scrape together a few thousand dollars through your social network, you shouldn’t expect a developer to risk working for nothing.
Freelancer or company working at highly discounted rates.
If you find a developer who believes in your business idea, discounts of up to 50% are possible. But the amount of discount vs equity is a difficult negotiation. Since the client is taking the main financial risk, they should maintain the controlling share of at least 51%. Paying a developer to take a controlling interest in your company just doesn’t make business sense. You should also ensure that all source code and intellectual property belongs to the company. There are other methods of negotiating such as preferred supplier agreements, revenue share agreements and profit share agreements that can help with negotiations so the client can maintain a bigger majority share.
Freelancer or company working at small discounted rates.
Smaller discounts for equity work more like a bonus for doing good work. It provides the developer an extra incentive, but both sides need to be careful that the added complexity is worth the benefits.
CTO as a business partner.
A CTO salary generally starts around the $100K per year, so a part time CTO working 1 day per week over a year on your start up is equivalent to approximately $20K. The key question in deciding how much equity to give to a part time CTO is based on the equivalent workload in cash. While a development company develops your product, a CTO looks after your company technology strategy as a whole and should understand supplier agreements, business strategy, internal technology requirements, product development requirements, project management, return on investment and much more. A CTO is not a developer, so to consider working with a CTO you still need to be able to fund your projects, but the CTO should be able to help you navigate the many pitfall and keep your business targets on track.
Before trying to enter into any type of equity agreement both sides should review exactly what they hope to achieve and what their expectations are. The following is a good checklist of things to go through before deciding on an equity agreement.
- As with any business agreement, is there a shareholder’s agreement in place?
- Would a simpler preferred supplier agreement, revenue share agreement or profit share agreement be more suitable?
- Is there a service level agreement that will guarantee both business development and product development expectations are going to be met?
- Have anti dilution clauses such as full ratchet, half ratchet or weighted average been discussed and understood by both parties?
- Are both parties ready to commit properly to the business and ensure due diligence is followed and the proper agreements and accounting structures are in place?
- Who will own the Source Code and IP rights to the product?