Inc. has an article on service firms waiving their fees and instead taking equity in their clients. As the article points out, this approach was common during the 90's Interent boom. Interest in this waned when the Internet bust resulted in most tech start-up equity becoming worthless, but it seems to be coming back.
Part of my business is working with tech start-ups as an advisor/consultant. I often take stock in lieu of cash. I've been doing this for almost 10 years and overall this approach has worked out positively for me. However, I've learned four lessons the hard way:
1. Most tech start-ups fail. I have a file drawer full of worthless stock certificates and I continue to add to it. Even the best venture capital firms have a lot of failures and few successes. Before you agree to take equity in lieu of cash, you need to understand that any individual early stage start-up company equity is most likely going to be worthless.
2. Not all start-up stock is created equally. I won't bother going into details on start-up financing terms (see this post for an overview of typical VC terms) except to say if you don't know and understand:
- the firm's cap table and valuation
- what kind of stock you are getting
- where your stock sits in the liquidity preference stack
- what rights and preferences the founders and the other investors have
- what your rights are
there is a real good chance your stock is not going to be worth much.
3. Luck plays a role in high tech start-up success. I've had the good fortune to both work for and invest in successful tech start-ups. I've also invested in a number of start-up failures.
The best start-up I ever invested in went bankrupt in 2001. They had a great managment team, A list VCs, great technology, excellent sales traction and market leadership in a very exciting space. They looked like a sure winner. But for a mix of reasons mostly beyond the control of the company, they went under.
At the same time I had equity in a company that was in horrible shape with no hope of survival. For reasons I still don't understand, more or less out of the blue a large corporation acquired them for a substanial amount of money. The company and its investors were very lucky, and all had a very merry Christmas.
The bottom line is luck - good and bad - plays a role in tech start-up success and failure. Also, no matter how good a start-up looks there are many reasons it can fail.
4. I am very picky about the companies I am willing to take equity from. Before taking equity in a company I go through a VC-like investment and due diligence process. I've found this greatly increases the chances I see a positive return.
While I've made at least my share of mistakes taking equity in lieu of pay, I continue to see this as a key part of my business model. Simply put, it provides me with substantial financial upside with limited risk. Also, because I have equity in multiple tech start-ups I gain portfolio diversification benefits (meaning I'm more likely to get lucky).
As long as you fully understand the risks and can easily absorb the inevitable losses, trading cash for equity can be a very good idea. Just make sure you can absorb the losses.