Entrepreneurs have long attempted to bootstrap a start-up by offering equity to developers and other key players instead of a steady pay-cheque. The start-up gets the expertise it needs even before it has investors or revenue, and employees get the chance to cash in, should that start-up become the next Amazon or Instagram.
That’s the ideal scenario, but the reality is seldom that simple.
About five years ago, Brian Geisel spent three to six months working on a project for another company in exchange for equity. “If it’s something you would have done for free, then stock can be a great motivator and could certainly pay off long term,” says the developer who is also CEO of Geisel Software, a web and mobile-development company.
Today, Geisel still holds that equity because the company has neither become publicly traded nor been acquired. Would he do it again? “Probably not,” he says. “It would have to be a really compelling case.”
Still, as a founder himself, Geisel can see the appeal of offering equity. “Getting development done without draining your cash reserves – if you even have any at that point – is definitely a great way to get started,” he says.
Not everyone can work for equity
Geisel says working for equity isn’t always a good idea. Though, as a founder himself, he notes the benefit of being able to offer equity in exchange for helping a company off its feet.
Just be careful what you wish for. A founder may be more than willing to go into debt and eat, sleep and breathe their start-up. But those earning equity may have other commitments and need other sources of income, too.
“It creates a strain when you have someone who has a family or has to do some consulting gigs on the side,” says Andre Gharakhanian, who advises tech start-ups as founder of law firm Silicon Legal Strategy.
“That’s where [it’s important to know] about your developer’s background and what their real needs are so you’re bringing on someone at the right stage of life.”
Related: Bootstrapping – The DIY Option
Don’t give away too much too soon
Founders also must avoid giving away too much equity too early, which could cause problems with potential investors or create dissension later among equity holders.
“Talk to your lawyers and advisors to figure out what’s standard,” Gharakhanian says. “Don’t grant weird percentages, and all of a sudden [find] you’ve given away 60% of the company.”
Using a vesting schedule where people earn shares over time (typically about four years) can help guard against this problem.
Here are some of the major pros and cons to consider before taking equity in lieu of pay:
Opportunity to cash in
The main reason people agree to work for equity is to try to become part of “the next big thing” before it strikes gold. Hernan Charry should know. As the marketing director for the software developer Split One Technologies, Charry has worked with several companies in exchange for equity.
“We have seen a number of clients become successful after having built their site for a few thousand rand,” says Charry. “With an equity share, we also can see a portion of [a client’s] profit.”
More often, though, a project doesn’t make it big, so, Charry says, it’s important to carefully assess each opportunity. “Evaluate the marketing team, evaluate the business plan, and be careful of getting into business with friends,” he cautions.
Potential for a full-time job
Geisel wound up working fulltime for the company where he’d started earning equity. That’s not uncommon, according to Gharakhanian. “A lot of people will try to build into their agreement that if the company does raise money, they would have an opportunity to earn an actual salary.”
He also has seen people who initially worked for equity in a startup later return to it and earn a paycheque as an employee.
Lack of money to pay the bills
Even if your equity pays off in the future – and there’s a reasonable chance it won’t – you clearly can’t pay bills with it now. Bootstrapping ‘treps sometimes cut costs by living together or in their parents’ basement, but they may still have expenses like student loans to cover.
While working in exchange for equity at a start-up, Geisel stayed afloat financially by spending half his time on consulting clients that paid him cash. For those with a mortgage or a family to support, working for equity may be an even bigger challenge.
Increasing work demands
When you’re willing to work for equity, time is a precious commodity.
“Entrepreneurs often think they have a partner who will work for free and constantly add to the scope of the work prior to even attempting to go to market or reach profitability,” says Charry.
Shrinking value of your equity
Future investors may reduce the value of your stake in the start-up. Setting a valuation before the company sees any revenue is a vague proposition at best. For purposes of paying in equity, the founders might set a R10 million valuation and create a million shares, each valued at R10.
But when an investor gets involved, he might disagree with that valuation and want to pay R2 million for a 25% stake. The founders just might agree to avoid losing his investment.
“Because investors have much better leverage than a single developer, they’re likely to push the valuation down which, of course, reduces the value of your shares,” Geisel says.
How To BootStrap Your Business With Funding From Your Shareholders
Fund your business: Bootstrapping with loans from shareholders.
In the early stages of a business there is often little or no revenue – so where does cash come from to keep the lights on? In our previous article, we discussed raising funds by bringing on new shareholders.
Now we are discussing the opposite scenario – where you support the business with your personal funds rather than bringing on new shareholders. Ultimately, this is what start ups mean by bootstrapping: You, as the shareholder, get your business through a tough patch or an early stage growth phase with your own funds.
Three reasons to consider bootstrapping
Bootstrapping is a very powerful way to grow one’s business for a number of reasons. The first reason is that by having fewer shareholders, you will have fewer partners to share the profits or future value with.
But there are other more complex reasons to bootstrap. You keep control over your business, taking strategic decisions independently without consulting a large board of directors or shareholders.
Often, in the early stages of a business, this kind of nimbleness is essential for maximising the impact of the founder’s creative ideas. You can rapidly deploy ideas, learn from them, improve them and deploy again – ultimately, that is the beauty of a lean start up as opposed to an established company.
Understand the risks
So why doesn’t everyone do it? Well, aside from the obvious point that not everyone has the cash to invest, there is another more subtle point: Risk.
With a limited liability company, you only lose what you put in (see our previous article describing this here). So, if you have personal savings, a bond, etc. you won’t put those on the line unless you decisively invest those funds into the company.
Raising funds from other people spreads the risk around – if you put all your cash into the company, you take all the risk.
So, what to do if you fund the company with a shareholder loan? The critical thing is to record it! If you don’t’ record it, your accountant can’t track it, and there is a good chance that the cash will remain untraced and never repaid.
A simple one page document recording how much was loaned, and a simple liability entry into your financial statements, can mean the difference between getting that money back (with interest) or not.
Treat the funds as loan capital
Then, what about the terms on which the cash is loaned? Many founders regard this as an equity investment, in terms of which the money is “invested” into the business, hopefully repaid, but not with interest. That is wrong.
No matter the scenario, you need to ensure that the funds are treated as loan capital, with a clear understanding that a market-related interest rate applies to it.
Why? Well, aside from complex tax implications otherwise, the question is actually whether or not you are a prudent investor? The reality is that these are your funds and prudent commercial practice means that you should weigh up your options.
For example: do you pay back your debt (saving you interest payments), do you invest it in your pension (earning you returns), or do you invest it in your business. Surely if you invest it in your business, you would only do that the investment has a comparable return – otherwise it is nonsensical.
An interest free loan earns you nothing, in fact, it simply depreciates your investment by the amount of inflation on a daily basis.
Having said that, although interest will accrue on a shareholder loan, it will typically not be repayable until the company actually has the funds to pay. This also applies to the principal amount (i.e. the upfront cash amount loaned to the company).
For that reason, although shareholder loans are regarded as debt, they are treated as “junior” debt – i.e. they are repaid last, only repaid after normal (arms length) creditors have received back their cash.
This is where your shareholders agreement is so useful (once again!) – one of the things which a shareholders agreement does is to lay out the general terms on which shareholders give loans, including interest rates and repayment terms.
Then, as and when loans are made in the future, you don’t need additional or lengthy loan agreements, you just need to confirm receipt, and record the loans in your financials.
Good luck bootstrapping!
Ever Heard Of The SAFE Funding Agreement?
A new way to raise capital? It provides an interesting new way to raise capital for your business.
Everything in Silicon Valley moves to keep pace with the speed at which business and entrepreneurship evolves and adapts. As a result, the legal and transactions infrastructure is forced to match this development by using increasingly innovative transaction documents.
An example of this is the SAFE agreement. Pioneered and made popular by the famous Y Combinator, the SAFE Agreement — an acronym for Simple Agreement for Future Equity — represents the evolution of the much-favoured convertible note.
The South African entrepreneurial ecosystem, whilst a bit behind the pace of San Francisco, has a habit of adopting these trends and applying them, right here in Mzansi. The SAFE agreement is no exception.
However, a word of caution — simply adopting a US template and applying it to your company can create some undesirable consequences.
To keep pace with innovative financing mechanisms, it’s important to be familiar with the salient features of a SAFE agreement.
Briefly, these are:
- Unlike a convertible note, the SAFE is not a debt instrument and so, it wouldn’t traditionally attract interest
- It seeks to mitigate the risk of insolvency for the Investee and does not have a maturity date
- It’s intended to be a simple, standardised document to cut down on transaction costs, negotiation time and provide an easier way for businesses and investors to agree on a neutral document to regulate the advancement of funds.
Typically, an investor would advance funding, in exchange for a future, contingent right to acquire equity in the business, upon the happening of pre-agreed ‘trigger events’, such as:
- Equity Financing: For example, where the Investee company raises capital in exchange for equity
- Liquidity Event: May occur upon a change of control or an IPO
- Dissolution Event: When the company voluntarily ceases to trade and/or is liquidated. One would have to regulate whether business rescue proceedings constitute a dissolution event in SA.
When one of these trigger events occurred, the investor would acquire the right to purchase shares in the company at a pre-agreed ‘valuation cap’ or a discounted valuation to the actual value of the company.
The valuation cap attributes a pre-agreed, but notional, value to the company that will be used in the calculation of how many shares the investor will purchase. For example:
Investor A invests R1 million into Investee Company B at a valuation cap of R10 million. At the Trigger event, the actual valuation is calculated to be R20 million. Accordingly, Investor A will purchase shares equivalent to a R1 million equity purchase in a R10 million company, despite the value of the company actually being R20 million.
This translates into relatively more shares in Company B, than if purchased at the actual valuation — a win for the investor and just reward for taking a bet on a speculative business.
An alternative is the ‘discounted valuation’ method, which arises where the investor agrees with the investee company to discount the real value of the company at the trigger event, by a pre-agreed percentage.
In the example above, where Investor A agrees with Investee Company B to invest R1 million at ‘valuation less 20%’, he would get more preference shares than if he had invested R1 million at the actual valuation.
A further alternative is a hybrid of both the discounted valuation and the valuation cap, where the investor is able to choose either scenario, depending on which would yield the greater number of shares.
It is worth remembering this about SAFE agreements:
- The business is free to issue as many SAFE agreements as it pleases, unless this is specifically regulated
- There is no uniformity on the treatment of the SAFE as a non-debt instrument and has not, to the best of my knowledge, been tested by International Financial Reporting Standards
- The SAFE provides for the subscription of shares on a substantially similar basis to that of other shareholders, but the investor has no way of knowing those terms, unless specifically regulated in the document
- There is no maturity date, so the investor could wait indefinitely for the trigger event to occur.
6 Tips For Bootstrapping
Not all start-ups have the luxury or know-how to gain financial investment at the outset. Most often, newbie entrepreneurs will need to fund the business from their own pockets and resources — this is called bootstrapping.
Bootstrapping a business is a lesson in hard work and flexibility, but ultimately it can help accelerate a company’s success.
Here are my survival tips for entrepreneurs
1. Pick your business partners carefully
When you are bootstrapping, most of the work will have to be done internally; you need to have a partner who shares your vision and is able to bring a skill-set that you don’t necessarily possess.
If you are good at different things, chances are that you can get more done and keep expenses and outsourcing to a minimum.
2. Generate cash flow fast
The most successful bootstrapped companies today share this common trait: They generate cash flow almost straight from the word go.
Without cash flow you will burn any initial investment you have made in the company and you will definitely not be able to show investors any traction.
3. Get good at accounting
If you’re not a numbers person, get one. Track what is coming into the business and what is going out. If more money is leaving than coming in, we have a problem. Look at free budget tracking apps online, such as GoodBudget and You Need A Budget.
4. Don’t be lazy
Don’t outsource work that you can do yourself. Yes, there may be people out there who can do certain tasks better than you can, but in a bootstrapped environment, you will have to learn to wear many different hats.
5. Don’t try to be fancy in the beginning
Posh offices, embossed business cards and fancy tech are all unnecessary items for the bootstrapped entrepreneur.
Use freeware, print your own business cards and use social media instead of expensive websites to promote your business.
6. Don’t take no for an answer
Perseverance is everything. Network, build relationships, be seen, use social media to your advantage. Bootstrapping is ultimately an investment in yourself that will yield results in the long run.
Read next: Essential Tips for Bootstrapping
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