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How startups should prepare for service-for-equity investments.

Did you know that the value of sweat equity in the USA equals 1.2 times their GDP, which is over 20 trillion USD1? I was stunned when I read that. Now the market for service-for-equity is probably not so big (yet). But it is definitely a serious option to get the resources you need to build a business. It is much more direct than fundraising and finding investors because here you can take the direct route. You can read a lot about fundraising and find programs that guide you through it. But what about service-for-equity and finding the right service investor? Not much on that. So keep on reading if you consider this option to build your startup.

 

Here are six steps that you should consider for every service-for-equity deal.

 

  1. Make sure you are at the right stage.

Have a look at the KAPSLY Matrix and click through the different fields. Ideally you have completed the idea and concept phase and validated your business model with first (pilot) users. It is important to know what exactly you need from service providers and what kind of output it can generate. If you are uncertain you might end up with the wrong partners, or after some time you have to pivot and the service provider is not of much value anymore.

 

  1. Set the terms for the investment.

At a normal fundraising round, you would propose a valuation to investors. So, you should do the same here. In our case you would propose the terms for the convertible service agreement. Those include a valuation cap, a discount and an interest rate or a markup to account for the risk the service providers have. For example, if the market value of the services is 100´000, with a markup of 20% it would be valued at 120´000 when it converts to equity. We recommend to start with a convertible note always. Equity is like marriage, and you don’t make wedding proposals on a first date. Additionally, we advise to use virtual shares (also called phantom stock) to incentivize the service providers. That way the service providers are not on your cap table and the contracts are much easier to set up (we actually do that for you).

 

  1. Quantify the market value of the services.

Define the project requirements and desired outcomes. Make sure that external and new people comprehend what needs to be done and communicate it with potential service investors. Ask the service providers what they would charge if you would pay them normally. The specifications will help you to get comparable proposals.

 

  1. Be prepared for due diligence.

You will treat the service investor like you would treat any other investors. They will want to get to know you and the founding team, see your pitchdeck and financial forecast. Have articles of incorporation and your bylaws ready to share. If you have any traction, you might be able to provide some customer contracts, LOI’s, or subscriptions data. All this information should be organized in a shared folder, such as Google Drive. Before we launch your campaign on the KAPSLY marketplace we will go through those documents, so that we can help you finding the right service partners.

 

  1. Start dating.

Once you have all this and received some offers, you should start to get to know your business partner better. The convertible service agreement defines the duration of your “dating period”, usually 6 months. After that time, you should have quite a good understanding if this collaboration has the potential to turn into a long-term partnership, otherwise you can pay at this time if you have the money.

 

  1. Release virtual shares on a regular basis.

After the initial dating period you might change the terms of the collaboration a bit. Often startups have better liquidity and start paying a higher portion of the services. If you continue to consume services for equity you should incentivize the service provider regularly. However, make sure that you only compensate for completed work. Therefore, there is no vesting period for the service providers because the value was already created.

 

The key takeaway is that also for service investments you must come prepared and know what you want. If this sparked your interest, reach out to me at vincent@kapsly.com.

 

 

Sources:

  1. Federal Reserve Bank of Minneapolis, https://www.minneapolisfed.org/research/staff-reports/sweat-equity-in-us-private-business

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