Funding a Startup without Giving Up Equity
Q: What are the different ways a startup business can fund its operations without giving up equity?
A: In most cases, the issue of funding operations in the early days is the cost of attracting the talent you need to build out your MVP and get launched. A creative way of funding employee compensation expense is with sweat equity.
There are various forms of sweat equity, but since you are sensitive to doling out equity, I’d recommend using Royalty Agreements for compensation as sweat equity.
Issuing royalties in exchange for sweat equity can serve to benefit both the Company and Consultant (the person contributing effort in exchange for sweat equity) in several ways.
Royalties Defined: The Consultant receives compensation by receiving a royalty position in a particular asset (intellectual property, a completed project or case, etc.) rather than ownership in the company as a whole.
Why Royalties are Popular: A royalty agreement provides a unique benefit to a Company in that it can be used to compensate for sweat equity based on all of the company’s net revenue or for only the net revenue of specific products or services. For example, if a consultant is contracted to develop a specific offering, the company may want to consider only compensating the consultant with a royalty on the sales of the particular offering, rather than other offerings that the consultant was not part of developing under a Statement of Work.
What sets royalties apart from any other form of sweat equity is that the Consultant is receiving immediate payment whenever the offering is sold to a customer. Additionally, the Consultant gets compensated along the way without having to wait for a liquidity event.
Benefits for Companies When Using Royalty Agreements:
Compensates the Consultant only for their completed work. The company has the ability to pay royalties based solely on the sales of a particular project that the Consultant worked on, rather than all of the Company revenue generated from other products.
Consultants are incentivized to work harder. Consultants have the incentive to work hard to create the best possible product or service since their work has a more direct and more immediate impact on their potential compensation, rather than a far-into-the-future potential exit event.
Potential tax deduction. Royalty payments are typically tax deductible.
No obligations at the conclusion of the agreement. At the termination of the royalty agreement, the issuing company has no equity dilution and no debt to pay off.
Downsides for Companies When Using Royalty Agreements:
They must be paid regardless of the circumstances. The Royalties are paid on revenue and therefore the Company is obligated to pay whether the Company is profitable or not.
Mandatory cash expense. Royalties require a cash expense along the way as the Company grows, rather than back-end equity-based proceeds at an exit as would be the case if the Consultant was paid for their sweat equity in some form of equity. You will want to set aside sufficient cash for the anticipated royalty expense and manage investor expectations in your financial model on the earnings impact of the royalty expense.
The Consultant knows the company’s revenues. Since a royalty is based on revenue, the Consultant will know the Company’s revenue, which may be a sensitive issue. However, if you are following a best-practice process, the Consultant has performed the work under a Proprietary Information Agreement, so you would have the expectation of confidentiality.
Benefits for Consultants When Using Royalty Agreements:
Excellent alignment. Consultants are rewarded based upon the success of the product they helped produce.
More predictable than equity. A royalty agreement will usually produce some income for the Consultant since many startups will experience revenue, while most will fail to ever have a successful exit.
Possible loss decreases with each received payment. Royalties are paid as the Company receives revenue. Therefore, with each additional payment, the Consultant’s possibility of the loss of the value of their time investment decreases.
Downsides for Consultants When Using Royalty Agreements:
Personal income tax rates. Royalty payments are taxed at personal rates, rather than the potential for Capital Gains tax as may be the case if the Consultant was compensated with an equity-based incentive.
Capped Upside. Royalty agreements usually have a capped upside, such as 2x or 3x the Consultant’s time for the risk premium, whereas an equity incentive is uncapped. In the cases of a very successful startup, an equity incentive would offer an unlimited upside for more overall potential.
The Bottom Line: When a Royalty-Based Sweat Equity Agreement Should be Considered:
When the sweat equity contribution is smaller in scope and tied to the development of a specific product or service
When the Company and the Consultant want to more closely correlate the variable upside for the Consultant to the success of their contribution in the market
When the Consultant needs/wants payouts over time rather than waiting for a liquidity event for an eventual payout
When the Consultant understands that the tradeoff is to pay higher personal income tax rates on a more predictable royalty payment rather than pay lower capital gains tax rates on the less certain gain in equity value
See our Sweat Equity Download Kit for more details or to use our super-simple, low-cost app to quickly negotiate and document a sweat equity-based royalty agreement.
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