Should Your Startup Give Performance-Based Warrants?

Posted on Mar 21, 2010 | 57 comments


carrotsThis is part of my ongoing series on Startup Advice

Large companies can be strange sometimes.  As startup entrepreneurs we all want to work with them because having their name as reference clients makes it so much easier for marketing, PR, selling to other customers, fund raising and even recruiting.  Plus, we’re all allured by the false sense that our contract with BigCo is going to “make us” because once they start using us it will spread like wildfire and the revenue will flow in.  Sometimes it actually does.  Usually it goes more slowly than we hope.

But I say they can be strange because of their behavior in working with startups.   I’ve observed the following scenario in both of my companies and in countless others I’ve advised or invested in:

- your company becomes moderately high profile in a few press articles

- BigCo calls you to review your product and decides they want to use you

- They negotiate a “master agreement” to work with your company with some maybe minimum guarantees in terms of revenue

- Somebody high up in the company reads the agreement and says, “if we’re going to work with these guys and make them successful then we better share in the upside.”

- What they mean specifically is ownership in your company.  I’ve heard the following so many times that it still makes me scratch my head, “if those guys are going to get rich off of our backs then we’re going to look like fools if we don’t have equity.”

Why I say this is strange is that with the exception of a few outliers (YouTube, Salesforce.com, etc.) the economic benefits to BigCo never warrant all of the time and effort they put into getting a stake in your company and trying to make that stake worth money.  For most BigCo’s I think they’d be better off just having a normal commercial relationship with you at an arm’s length transaction.  But I’m not going to change that, so if they want to share in your success how should you deal with it?

I’ve already made clear that I think raising equity from “strategic money” is an oxymoron.  If a company wants to invest in your company and you haven’t read that post please do.  I make exceptions for companies with proper venture capital funds that are mostly autonomous like Comcast, Disney (Steamboat) and Intel Capital – all of which are great funds.

So Plan B for many BigCo’s is to take “performance-based warrants.”  The following is a guide to what these are, whether to offer them and how to structure them.

What are Performance Based Warrants? A “warrant” is a right, but not an obligation for a company to buy stock in your company at a future date and at a pre-agreed price.  Think of it as similar to an employee stock option.  Simplistically, if your company is worth $5 million and you have 5 million shares worth $1 / share they might get a right to buy 250,000 shares (5%) at $1 / share with an expiration date of 4 years hence.

What is a “performance based” warrant?  It’s one in which the company must achieve a milestone in order to actually own the warrant.  Let’s say you give a warrant to a channel partner to sell your product.  In the above example you might say that the channel partner earns 25,000 shares for every $100,000 of your product that they sell in the next 12 months with up to a cap of 250,000 shares.  In this example if they sell only $10,000 in total in year one they own zero warrants the same way that an employee with options who quits after 6 months usually owns no options when they leave your company (due to the cliff period in most vesting programs).

Should You Offer Them? Often the reason that startups offer performance-based warrants (PBW) is because they’re asked to.  You should think of PBW’s in the same way as you think about employee options – they are an incentive for an important partner in your business to help you achieve success over time.

In the early days of your company they can be an important way to motivate your partner to achieve objectives that are jointly agreed.  If those objectives would make your company substantively more successful then you should be willing to allocate small amounts of warrants to your partners but they need to be based on achieving real results and they need to be for small amounts of ownership.  You obviously also need the consent of any investors you have.  Future investors aren’t likely to mind that you had a PBW program because the dilution will be taken before they invest.

How Should You Structure Them? So let’s think first about employee options and how they can be similar to company warrants.

Early in your company’s evolution, high-potential individuals take a bigger risk to join you so you’re more liberal with your allocations to them.  Having a few high-potential individuals determines your success trajectory more in the early stages.  Same with PBW’s.

The more senior the person is the more likely that they’ll have a substantive impact on your success so the more options they get (and if they’re senior the more options they’ll want in order to join).  Same with partners who are able to have a huge impact on your potential success.  The reason you have vesting is so if the employee leaves early and you didn’t get the full value you were expecting you didn’t have to part with all of the shares that you allocated to them.  Every share option you allocate to an employee is dilution both you and your investors face so they shouldn’t be allocated lightly.  This is why company warrants should be performance-based, too.  Like an employee if they provide value they get value.  If they don’t provide value, they shouldn’t walk away with value.

Guidelines:

1. Make the warrants tied to objective measures.  Best if it can be revenue goals but if not find another objective way of measuring

2. Make the warrants time based. It is usually best if they earn the warrants over time.  If you simply to a revenue number (say hitting $1 million in sales) and they hit it in year 1 then you’ve lost your carrot for year 2.  I know all the arguments for rewarding them hugely in year 1 one when it matters more like having an uncapped sales bonus, but I think it makes more sense to earn them over a 2-3 year period to keep them focused on milestones for a longer period of time.  While I’m a huge believer that sales bonuses should always be uncapped, I think capping PBW’s is a good idea.  Example: you allocate 4% in warrants to channel partner ABC.  They earn 1% in year one for hitting $200k in sales, 1% in year 2 for hitting $500k in sales and 1% in year three for hitting $1.5 million in sales.  You hold back 1% for the end of year 3 if they hit cumulatively $2.2 million in sales (e.g. a chance to earn back some warrants if they missed their year 1 or year 2 targets).  Numbers obviously have to be right sized for your company.

3. Make the numbers achievable.  If you bother having a PBW program assume that you’re going to give out the warrants in the same way that you assume it for employee stock options.  There is nothing worse than having a partner 6 months into the deal who realizes that the goals you set are not achievable so they stop trying.  If the goals are achievable but the partner isn’t performing you have a “carrot” to use in difficult conversations.  If the goals are unrealistic you’ll end up renegotiating them or they’ll have no meaning.

4. Have minimums but a sliding scale. Like sales programs I’m not a fan of an “all or nothing” figure.  If 1% of your stock for year one equals 50,000 shares then you might give 10,000 shares when they hit $50,000 in sales and a sliding scale between $50k-$200k.  You might allow them to “pre earn” some credits for year two but I still feel that it’s best not to let them earn the whole amount in year one.  My rationale is simple.  In a sales program you want your rep selling as much as possible as quickly as possible and any bonus payments will have a significant impact on that person’s earnings.  If it’s a big company earning a small stake in your business they shouldn’t feel too disappointed if they hit $400k in year one but only got 1% of your company (plus maybe 50% of those sales count as a credit on their year 2 target).

5. Have a regular meeting with a senior sponsor to go through objectives. The whole reason for PBW’s is to drive incentives of a partner or customer to help you succeed.  I strongly recommend you set up a quarterly meeting with a senior team of this partner to discuss how they’re doing against their targets.  It’s basically an excuse for you to have a regular meeting with your customer.  I see the PBW as a good excuse for them to want to have the meeting.  Your broader goal is about how to make the relationship work better.

6. Make the warrants for common stock and not preferred stock.  This is the same as with employee stock options.

Common Mistakes

1. Giving free warrants – There is not reason to give customers or partners free warrants.  If they value your product / service they’ll buy it.  If they don’t value your product / service they won’t.  You could use the same argument to say, “why give performance warrants then,” and to that I’d say, “I can’t argue with that logic.”  I think PBWs are stupid because they very seldom are worth much money for the company that gets them yet it makes them commit to more than they otherwise might without them.  As a result, with the right partner and right structure they can be effective.  Just don’t give them free.

2. Subjective warrants – I also see warrants given out without hard metrics.  Things like introducing us to clients, they help us close partnership deals where there is not revenue attached, etc.  I believe that PBW’s should have hard metrics.

3. Unrealistic warrants – Many entrepreneurs create complicated or unrealistic warrants structures.  Like unrealistic sales targets these can create more tension than no program at all.  If you set up a PBW program assume your partner will get most of what you allocate for them.  You want them to earn.  Don’t go in with the opposite mentality.

4. Too many warrants – I also see many entrepreneurs who are quick to hand out warrants to just about anybody that seems like they’re going to add value.  I recently saw a company that gave 4% options to their PR firm because “it was going to ‘make them’ early in a crowded market and this PR firm was ‘super connected.’ ”  The PR firm actually didn’t do badly but 4% was a lot of dilution.  The startup argues that they did free work so they saved cash.  I can’t argue with that, but just be careful.  This same company then looked to get a channel partner on board and that company wanted 5%.  You can see how stuff adds up quickly.  They’ll never really value the options enough to make it worth your taking huge dilution.

5. Strategic equity – Bad idea.  They seldom help as much as you want.  Already covered the topic here.

Anyone else have positive / negative experiences with performance-based warrants?  Anyone have structuring tips?

  • pablobrenner

    Hi Mark, I like the post and completely agree, anyhow I'd like to comment on “BigCo's behave strange”,

    Having worked for many startups selling/cooperating with BigCo, I totally agree with you (as one BigCo executive told me once: “common sense is not an employee in this company”), but the issue is to understand that Corporations dont take decisions, executives do, and they dont behave strangely, quite the opposite, they are highly predictable.

    One important thing is to understand that the main decision driver for BigCo executives dealing with startups is fear, most of the time this is a huge problem, since in most of the BigCo's nobody gets a bonus for adopting a new technology from a great startup, but they can be punished if they fail.

    And in the case you mention, they may even get “in trouble” for “being used by a small startup to grow and BigCo not getting part of the pie”, so typically these kind of deals are more like “covering their behinds”

  • http://www.linkedin.com/in/scottjhoward ScottjHoward

    Mark great insight, here thank you. This is going into the archive. Helped a client implement a similar concept to much success. Sold product (with recurring revenues) at a discount and small non-dilutive equity in exchange for up front capital. Solved multiple issues for the client on the finance side, and created two 'strategic customers' that are engaged in the success of the client on two sides of the ledger. PBW's may be a better way to structure if done again in the future.

    What clarifications would you apply to an exchange of PBW's between partners at a similar business stage vs. growthco to bigco? I would see this as creating a shared risk/reward scenario vs. you are getting rich on our back.

    Looking forward to reading more. Cheers, Scott @HowieSJ

  • http://www.vcdeallawyer.com/ Chris McDemus

    Mark,

    Nice post. A few thoughts. I've taken the position in the past (http://www.vcdeallawyer.com/2010/01/14/if-you-p…) that if the service provided by the outside party is strategic enough and even possibly core to your business then the equity makes sense. Having been on both side of the fence on this issue, I would agree that the company asking for equity all too often does it out of fear that they'll “miss out and get blamed for not taking anything” versus having a real reason for wanting the equity. There's lots of variable that drive this issue.

    I agree with your views on strategic investors (http://www.vcdeallawyer.com/2009/10/27/should-y…) .

    Warrants are a great way to bridge the gap between no equity and having a service provider as a full-time stockholder. Most warrants don't get exercised until there is an imminent exit so you eliminate taking on an additional stockholder during that holding period. The downside is that companies sometimes go nuts with the warrants and their cap table looks amateurish.

    I really like the regular meeting with the sponsor idea. All too often, companies fail to pro-actively manage these relationships and they end up giving up real equity for a partner that doesn't deliver.

    Chris McDemus
    http://www.vcdeallawyer.com

  • http://www.vcdeallawyer.com/ Chris McDemus

    Mark,

    Nice post. A few thoughts. I've taken the position in the past (http://www.vcdeallawyer.com/2010/01/14/if-you-p…) that if the service provided by the outside party is strategic enough and even possibly core to your business then the equity makes sense. Having been on both side of the fence on this issue, I would agree that the company asking for equity all too often does it out of fear that they'll “miss out and get blamed for not taking anything” versus having a real reason for wanting the equity. There's lots of variable that drive this issue.

    I agree with your views on strategic investors (http://www.vcdeallawyer.com/2009/10/27/should-y…) .

    Warrants are a great way to bridge the gap between no equity and having a service provider as a full-time stockholder. Most warrants don't get exercised until there is an imminent exit so you eliminate taking on an additional stockholder during that holding period. The downside is that companies sometimes go nuts with the warrants and their cap table looks amateurish.

    I really like the regular meeting with the sponsor idea. All too often, companies fail to pro-actively manage these relationships and they end up giving up real equity for a partner that doesn't deliver.

    Chris McDemus
    http://www.vcdeallawyer.com

  • LondonChris

    Mark,

    I want to thank you for all the help and advice you offer through this blog. I have been an avid follower for about 6 months now and the information is truly priceless. Its even more interesting given you have lived in London – where I reside. I'm currently working with a New York based tech startup in the middle of the search for series A funding and your blog has been brilliant in keeping us on the right track and your wisom is much better shared!! Many sincere thanks and keep it up. And make sure you say when you are next on the way to London…

  • LondonChris

    Mark,

    I want to thank you for all the help and advice you offer through this blog. I have been an avid follower for about 6 months now and the information is truly priceless. Its even more interesting given you have lived in London – where I reside. I'm currently working with a New York based tech startup in the middle of the search for series A funding and your blog has been brilliant in keeping us on the right track and your wisom is much better shared!! Many sincere thanks and keep it up. And make sure you say when you are next on the way to London…

  • LondonChris

    Mark,

    I want to thank you for all the help and advice you offer through this blog. I have been an avid follower for about 6 months now and the information is truly priceless. Its even more interesting given you have lived in London – where I reside. I'm currently working with a New York based tech startup in the middle of the search for series A funding and your blog has been brilliant in keeping us on the right track and your wisom is much better shared!! Many sincere thanks and keep it up. And make sure you say when you are next on the way to London…