Taking equity in startups as a consulting firm

I've been asked by a number of design agencies, development shops, and other consultants how they can work with startups. Part of this is understanding what types of services startups need and what their budget is. The other part is these firms thinking of themselves as investors, and wanting to have a piece of a product company that may pay off beyond just hourly consulting fees.

Much of the material is slanted towards design services, but is generally applicable to any service provider.

Early stage tech startups don't have a large budget for brand design, and since their customers and concept is in flux, a delivered "final" brand is not the right approach. I've heard some talk about lean branding and local agency Skyrocket talks about a "minimum viable brand".

Too often, people hear startup and think about it as a company that is just about to get a cheque from an investor for $1M – they have lots of money to spend! That's where I introduce my overview of early stage tech investing stages – most of that money goes directly to salaries, travel, and some paid marketing.

For very early stage startups, saving money on their design is of primary concern. I like to share this guide to budget design by Folyo to help service providers understand the types of dollars that companies are thinking about.

Below are questions that I was asked¹ that I thought it would be useful to answer publicly:

What are the creative/design/marketing services startups are most in need of or currently lacking?

Every new startup needs help with branding and identity. They at least need a placeholder or "starter" brand that they can evolve and grow with. This means a full basic brand package of logo, colour palette, style guide, business cards, etc. Often more valuable is the process of actually bringing together the story of the company.

Next up is a marketing website. This is the rarely edited but highly tracked marketing face of the company – perhaps 3 - 5 pages or one long single page design that works well on desktops and mobile. The site talks about the company, features, and pricing, but mainly it's there to drive towards a signup or further customer conversation.

I usually recommend that a blog is run separately, and is kept as simple as possible – e.g. Tumblr, SquareSpace, WordPress - and just lightly branded.

Unless one of the founders is a designer, UI/UX is the other area where startups could use more help, including the actual process of customer research and interviews.

Lastly, marketing. Yes, startups need help here. Hiring a junior marketing person at best gets them tactics, not strategy.

Design and UX are the areas that are most often outsourced at the beginning, since it typically happens before development and the (small) development team will be playing catchup on implementing features.

What are the typical metrics of success for an equity deal?

I think the main metric is did you make your investment back and what sort of return did you make, calculated over the years it took. Since that money could have been invested in something "safe" and earned perhaps 5% per year, you should think of your return as being how much you made above that.

You also need to think about portfolio theory: that you are making investments not just in one startup, but that you're investing in several over time to build out your portfolio. The general accepted minimum number of startup investments is somewhere around 10. Paul Singh's Moneyball Angel Investing presentation covers some of these concepts.

What percentage of startups are successful (very generally speaking)?

10% is a completely made up number that might be close to correct.

Technically, one of the only ways to get money out of an equity investment is for the startup to get acquired. Even then, acquisitions are often a mix of stock and cash, so it then depends on the stock of the acquiring company being able to be sold.

There are also multiple paths towards success. A company might pay dividends over time to shareholders, without being acquired.

What kind of timeframe (duration) would an equity deal be structured over?

Continuing on from talking about acquisition as one of the main ways to get money back out (the other being an IPO, which takes even longer), 5 years is an average time frame.

How much of a break on pricing might be expected to gain an equity share?

I don't recommend that people discount their pricing for equity or for other reasons. Rather, figure out what your investment is going to be.

I always recommend a mix of cash and equity. If a company has literally no cash to pay you, it means one of two things. Either they have hardly any money at all, in which case how are they going to stay alive. Or, they don't have a budget for design or whatever your services are: they don't value what you're selling.

What the balance is between cash and equity comes down to the service providers margins and business model. You might think about investing in a startup as a breakeven proposition, where the cash you charge covers your costs, and you invest your margin as equity.

To take an example, let's say you propose to do $150K worth of work. Your margin is 30%, so you propose $100K in cash, and the remaining $50K will be your investment.

(In reality, very early stage startups don't have that kind of cash, so either you're talking to a company that is farther along, or the numbers should be adjusted to be much smaller)

If you think the startup is going to do well, you might choose to actively invest in the company, and do 50/50 cash/equity, or even 30/70. I probably wouldn't go any lower than 30% cash compensation.

Now, having said all that, I actually think that a convertible debt investment mechanism is probably the best fit for protecting service providers and startups. Explaining the ins and outs of what convertible debt is and how to implement it is out of scope of this article, but it's something I want to cover in the event I'm planning.

Are there any unique aspects of IP that might be present in working with a startup?

Not really. Many web startups use open source tooling (e.g. the Bootstrap design framework, or Wordpress for their marketing website), but they actually do want to fully own their brand and identity or other services they are paying for.

If you are a development firm, a tech startup is going to likely understand the concept of paying you to build open source components. Something I've recommended in the past is to have the discussion up front if you, as the consultant, can retain the copyright on open source code you write. That can be another consideration in doing work at a discount, since you are investing in code you can use again.

Do there tend to be additional levels of approval and input with funders/investors/mentors being involved in the process? Basically – does there tend to be more stakeholders involved in decision making?

No, yes, and maybe :) In a healthy investor / founder relationship, the founding team might involve their investors in a branding or design exercise (since they know the story of the company well), but the founders are the owners and ones in control.

Event: How to structure part-equity consulting deals

Since these types of questions keep coming up, I put up a suggested meetup to see how many people are interested in talking more about this. As well as the questions and concepts above, this is what I wrote to set the stage for the event:

This will be an agency / consulting centric discussion on when, how, and why to enter into contracts with clients that involve equity.

As an agency that mainly charges hourly fees, is this a way for you to get a piece of potential upside?

When should you agree to an equity deal? How do you structure it? What kind of return can I expect from being an investor in a product company?

We'll start with a brief overview of early stage startup investing and some of the basic terminology, and then we'll get into the trickier questions of when it makes sense to do an equity deal.

Signup on the PixelCrafters meetup if you're interested in participating »