The Folly of Swapping Equity for Services

Emily Maltby and Sarah E. Needleman wrote an interesting piece in the WSJ last week capturing a worrying trend – the swapping of a start-up’s equity for services. For example I need legal services, web design services, accounting services but I don’t have any money. But I do have lots of shares in my company. So I give you 10% of my company and you give me $5000 worth of legal services. Fantastic. I don’t think so and here is why:

The Start Up Perspective

1. You are clearly starting your business with very little working capital. This is the beginning of a bad habit. The business is clearly on a weak financial footing. Do a detailed cash flow analysis to work out your first year of existence based on zero sales but building in the essential costs to get you operational. Launch the business when you have that cash in a bank account. Build this analysis around realistic costs for everything. Only the essential items. That’s why it’s called zero-based budgeting.
2. No matter how small or how big your private company becomes, there will only ever be 100% of the equity. It can never be 110%! So keep that equity close to your chest. Don’t give it up easily. The opportunity cost to you of giving up 10% could be $1m, $10m, who knows, but it’s very precious.
3. The expectations of an external shareholder can be very difficult to manage. Before you know  it, you have a collection of shareholders who each own 5% and they all want a say in your strategy, your decisions and who you hire.
4. By giving up equity for a service you are effectively raising a tiny sum of money by making a massive compromise.

The Service Provider Perspective

1. In effect by taking equity you have invested a pile of cash in a small private company with little due diligence (let’s face it, what due diligence can you do). This is what we call a punt.
2.  You have diversified your area of activity from legal services, web services whatever your core is into the world of angel investing. Diversification is a graveyard of good intentions……..and diversifying into venture capital/angel investing!
3. The relationship of supplier and customer has now changed. Your are now a shareholder. What happens if your next quote doesn’t cut it?The customer moves on and selects another supplier perhaps when they have cash in the bank. You now hold 5% in an illiquid asset and you have no relationship with the company.