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?

  • http://www.jasonwolfe.co.uk/ Jason Wolfe

    Hi Mark, we're in the position of trying to bring our product to the US market from the UK. It's an enterprise product and we'll be dealing with large financial services companies and retailers in the first instance.

    We've been advised to build an “Advisory Board” in the US to help us achieve success. Does it make sense to bring people on from our customers (actual and target) to help in this process? And if so, should that be done in the same way that you've outlined above?

  • http://bothsidesofthetable.com msuster

    I covered the topic of advisory boards here: http://www.bothsidesofthetable.com/2009/10/12/s… – usually they don't deliver the value people hope / expect. Your best bet for success in the US is hiring the right team IMHO

  • http://www.linkedin.com/in/rajatsuri rajatsuri

    This is happening to us a lot! It feels like every customer wants to be an investor, with the exact statement “if we're going to help you out, it'd be nice to get a share of the upside “

    Thanks for the great tips – hadn't thought about this structure before

  • http://bothsidesofthetable.com msuster

    I should have written more about “how to avoid giving them” so hopefully people read the comments section. Everyone asks and then the CEO's come and ask me. I always tell them to say, “Unfortunately we have investors and a board who have made it clear that the really don't want to allocate shares to companies this way. If our relationship starts going really well then I will do my best to go and fight with them to get some sort of allocation.”

    This is important because then it puts the decision on somebody else so you can just focus on commercial use and benefits. I call this “appealing to a higher authority” and I plan to write a whole separate post just on this. See you on Tues!

  • http://www.assaydepot.com/ Christopher Petersen

    Great post, the second paragraph feels like it was taken verbatim from conversations we had with our first big potential partner! Instead of warrants they wanted us to refund some of their fees if they “made us” really successful. I was ok with this in principle (it does end up with us being really successful after all). However, it added so much complexity to the legal document that it never got signed. We've gotten to the point where we've basically scrapped that whole document and started over… sigh.

    I think PBWs would have greatly simplified our agreement/situation, but I agree never having to give anything like that is probably the best option (if possible). In our case, it seemed like it changed the tone of the relationship. It put a lot of emphasis what they were doing for us, instead of what our product was going to do for them. Our second partner didn't go this route, the deal got signed much quicker and the relationship feels healthier more clearly defined as a result.

    Either way, thanks for the advice. Great post.

  • daytulu

    This comment is not about a bigco situation. We had to give out some shares to a development firm. We put a trigger in the agreement saying that the warrant will be issued only if/when the company is valued by a professional investor during an investment and what we owe them will be paid in shares (lets say for every dollar we owe them they will get a share) at the closing. It was not a significant amount, but they understood that valuing the company at its inception did not make any sense. And there was no time and 'percentage' pressure on both parties.

  • http://bothsidesofthetable.com msuster

    re: “It put a lot of emphasis what they were doing for us, instead of what our product was going to do for them” … that's one of my fear's with PBW's. The convo can turn into how to maximize ownership in your company rather than how to make the implementation of your product successful. If they're not convinced of the value of your product, no amount of PBWs will make you successful in the end.

  • http://bothsidesofthetable.com msuster

    Yeah, warrants by suppliers are also common. As long as they're small I usually don't worry about them. Small as in very small. And best priced at a higher price as you indicated.

  • http://www.vumedi.com Roman Giverts

    I think having this type of relationship with a customer is in many cases a big mistake to begin with. A customer should be just that… a customer. The argument, “if we're going to make these guys successful, then we want to share in their success” is very weak. If BigCo tells you that, politely reply “thank you very much, but we're going to be successful on the basis of the quality of our product, not any single customer.”

    Most start ups do deals like this because at a very early stage they feel vulnerable and desperate, so they let BigCo push them around. I believe you have to have the mental strength to act like the market leader, even if deep down you know you haven't gotten there yet. If you have a great product that BigCo needs, you should have no fear turning down their desire to share in upside. They should be more than happy just being a customer and getting the huge value of using your product.

    What type of warrants you should do is a moot point for me, because I think you shouldnt do them to begin with. Maybe I'm not very well read, but I can't think of any very successful companies that were built having relationships like these with their early customers.

  • http://bothsidesofthetable.com msuster

    Roman, I agree that it's nice to avoid PBW's if you can. But the reality is that there are circumstances where it can be helpful. You could take the same logic with employees, “I'm going to pay you a good salary and teach you a lot so you should work here without owning stock options.” I know it's extreme and not an apples-for-apples comparison, but there are similarities.

    Regarding “I can't think of any very successful companies that were built having relationships like these with their early customers” – not true. I think you'll find that they're very common. Just not usually disclosed.

  • http://www.vumedi.com Roman Giverts

    You're probably right, but I just hate feeling like a customer has you
    by the balls, and that's what “give us a PBW” kind of feels like. I
    suppose I can imagine a case where you're trying to build consensus
    within the company and someone insists on it, so you just do it to
    close the deal. Still leaves kind of a bad taste in my mouth.

    Would love to learn about some company's that had these types of
    relationships early on, and how and why they did it— if anyone has
    any stories…

    If we agree that they're nice to avoid, perhaps an interesting post
    would be when should you “concede” and do it, kind of like the idea of
    when to not over-negotiate a term sheet.

  • http://bothsidesofthetable.com msuster

    I think you concede if:
    - the company really does have the ability to “make” you
    - it's early in your company's lifecycle
    - the PBW is tied to hard results that would substantively change the value in your business
    - the amount is small enough (5% or less IMO)

    But no matter what you or I might think, the reality that companies sometimes demand PBW's is something entrepreneurs have to grapple with.

  • http://www.jasonwolfe.co.uk/ Jason Wolfe

    Hi Mark, we're in the position of trying to bring our product to the US market from the UK. It's an enterprise product and we'll be dealing with large financial services companies and retailers in the first instance.

    We've been advised to build an “Advisory Board” in the US to help us achieve success. Does it make sense to bring people on from our customers (actual and target) to help in this process? And if so, should that be done in the same way that you've outlined above?

  • http://bothsidesofthetable.com msuster

    I covered the topic of advisory boards here: http://www.bothsidesofthetable.com/2009/10/12/s… – usually they don't deliver the value people hope / expect. Your best bet for success in the US is hiring the right team IMHO

  • http://www.linkedin.com/in/rajatsuri rajatsuri

    This is happening to us a lot! It feels like every customer wants to be an investor, with the exact statement “if we're going to help you out, it'd be nice to get a share of the upside “

    Thanks for the great tips – hadn't thought about this structure before

  • http://bothsidesofthetable.com msuster

    I should have written more about “how to avoid giving them” so hopefully people read the comments section. Everyone asks and then the CEO's come and ask me. I always tell them to say, “Unfortunately we have investors and a board who have made it clear that the really don't want to allocate shares to companies this way. If our relationship starts going really well then I will do my best to go and fight with them to get some sort of allocation.”

    This is important because then it puts the decision on somebody else so you can just focus on commercial use and benefits. I call this “appealing to a higher authority” and I plan to write a whole separate post just on this. See you on Tues!

  • honam

    Performance based warrants are like strategic investments. In theory, it sounds like a good idea. In practice, it doesn't work. What I mean by that is that it does not change behavior of the strategic partner. The small amount of equity a partner gets is not enough to move the needle. But more importantly, it certainly won't change the way they do business. If it makes sense to partner – if they really need you – then they will work with you. If they don't need you, it doesn't matter if they own the entire company. The partnership will not work.

    Another very common problem is that the deal guy who is negotiates for the warrants (or investment) often has nothing to do with the people you need to work with day to day to make the partnership a success. At the end of the day, you have to make the operating guys responsible for your partnerships success look good. They could care less whether or not HQ makes money on the warrants.

    That said, if any of our companies were to do performance based warrants because someone at the potential partner really wants to make a name for himself and do such a deal to stick on his resume, then the advice is very good and I will refer our CEOs to this post. Thanks.

  • http://reidcurley.com Reid Curley

    Another nice post Mark. I have some observations and a few structuring points.

    First, these deals usually are worthless. The guys at BigCo who can really make a difference to your company typically don't get any benefit from the PBWs, so their incentive value is limited. It is critical that the PBWs be earned only if you get some real economic benefit. Otherwise you are throwing them away.

    Second, think carefully about the time frame for the deal. Just like with options plans, future investors will count all PBWs as outstanding stock. If your PBW deal is too big or goes on too long, this can screw up future financings.

    Third, think carefully about what happens in an exit. Trying to go public or sell your company when you have one of these deals in progress can be problematic. Ideally, you should have the ability to end the deal early if you sell.

    Fourth, think about what it will mean to have a customer as a shareholder assuming the deal works. You probably don't want them to have information rights, for example. Make sure that you are not structuring yourself into an awkward situation vis-a-vis your bylaws or investor rights agreement. It might be the case that PBWs should be exercisable for non-voting common stock.

    Finally, I highly recommend that you push BigCo to give you some cash up front. It doesn't have to be huge, but it should be meaningful in terms of the deal. For instance, if you structure it so that they have to hit $25,000 in revenue before they earn any PBWs, have it be part of the deal that they prepay the $25,000. Note that this is not the same as selling them the warrants. You book the $25.000 as a “prepaid revenue” liability and take it into revenue as you sell your product/perform your service for BigCo. Besides the obvious cash flow benefit, whether they are open to this will tell you a lot about whether they really plan on being a customer.

    Before it was merged into the NYSE, Archipelago Holdings (an electronic stock market) did a PBW consortium deal with large investment banks. The more business the banks routed to Archipelago, the more equity they earned. If PBW deals are hard, consortium deals are a nightmare. Nonetheless, the deal enabled Archipelago to build their volume and did contribute significantly to it becoming a successful company.

  • http://bothsidesofthetable.com msuster

    I agree with all your points and one thing that I missed in my post is that the person who negotiates the warrants is often not the person responsible for the success of your product. I also agree they should be avoided if possible. But having been in the CEO role when I was trying to land my first mega-deal it was very hard not to offer them. The customer knew how important they were to us. I was able to get a monthly meeting with the COO as a result of having them.

    They assigned an internal champion to work to help us succeed and he went on internal customer meetings with me to help with adoption. I still think it was strange behavior on their part, but it did help me greatly.

  • http://bothsidesofthetable.com msuster

    Reid, all very valuable points – I appreciate your taking the time to further the discussion.

    I agree with all points except I would make a slight adjustment to one point. You mentioned it might make future financings hard. If you do a small amount <5% in total, it is common stock and doesn't give rise to any voting rights then I don't think it will harm financing. Future investors will assume that all of warrants are going to be granted and will adjust their pricing on a fully diluted shareholding accordingly.

    Your point about M&A is good – you can simply have the warrants either lapse or have a certain percentage accelerate on a change of control (former obviously better, latter may be negotiated by customer) so that there is no overhang post deal.

  • http://stickyslides.blogspot.com Jan Schultink

    Thank you Mark, forwarding this to a client right now.

  • http://www.assaydepot.com/ Christopher Petersen

    Great post, the second paragraph feels like it was taken verbatim from conversations we had with our first big potential partner! Instead of warrants they wanted us to refund some of their fees if they “made us” really successful. I was ok with this in principle (it does end up with us being really successful after all). However, it added so much complexity to the legal document that it never got signed. We've gotten to the point where we've basically scrapped that whole document and started over… sigh.

    I think PBWs would have greatly simplified our agreement/situation, but I agree never having to give anything like that is probably the best option (if possible). In our case, it seemed like it changed the tone of the relationship. It put a lot of emphasis what they were doing for us, instead of what our product was going to do for them. Our second partner didn't go this route, the deal got signed much quicker and the relationship feels healthier more clearly defined as a result.

    Either way, thanks for the advice. Great post.

  • daytulu

    This comment is not about a bigco situation. We had to give out some shares to a development firm. We put a trigger in the agreement saying that the warrant will be issued only if/when the company is valued by a professional investor during an investment and what we owe them will be paid in shares (lets say for every dollar we owe them they will get a share) at the closing. It was not a significant amount, but they understood that valuing the company at its inception did not make any sense. And there was no time and 'percentage' pressure on both parties.

  • http://bothsidesofthetable.com msuster

    re: “It put a lot of emphasis what they were doing for us, instead of what our product was going to do for them” … that's one of my fear's with PBW's. The convo can turn into how to maximize ownership in your company rather than how to make the implementation of your product successful. If they're not convinced of the value of your product, no amount of PBWs will make you successful in the end.

  • http://bothsidesofthetable.com msuster

    Yeah, warrants by suppliers are also common. As long as they're small I usually don't worry about them. Small as in very small. And best priced at a higher price as you indicated.

  • Roman Giverts

    I think having this type of relationship with a customer is in many cases a big mistake to begin with. A customer should be just that… a customer. The argument, “if we're going to make these guys successful, then we want to share in their success” is very weak. If BigCo tells you that, politely reply “thank you very much, but we're going to be successful on the basis of the quality of our product, not any single customer.”

    Most start ups do deals like this because at a very early stage they feel vulnerable and desperate, so they let BigCo push them around. I believe you have to have the mental strength to act like the market leader, even if deep down you know you haven't gotten there yet. If you have a great product that BigCo needs, you should have no fear turning down their desire to share in upside. They should be more than happy just being a customer and getting the huge value of using your product.

    What type of warrants you should do is a moot point for me, because I think you shouldnt do them to begin with. Maybe I'm not very well read, but I can't think of any very successful companies that were built having relationships like these with their early customers.

  • http://bothsidesofthetable.com msuster

    Roman, I agree that it's nice to avoid PBW's if you can. But the reality is that there are circumstances where it can be helpful. You could take the same logic with employees, “I'm going to pay you a good salary and teach you a lot so you should work here without owning stock options.” I know it's extreme and not an apples-for-apples comparison, but there are similarities.

    Regarding “I can't think of any very successful companies that were built having relationships like these with their early customers” – not true. I think you'll find that they're very common. Just not usually disclosed.

  • Roman Giverts

    You're probably right, but I just hate feeling like a customer has you
    by the balls, and that's what “give us a PBW” kind of feels like. I
    suppose I can imagine a case where you're trying to build consensus
    within the company and someone insists on it, so you just do it to
    close the deal. Still leaves kind of a bad taste in my mouth.

    Would love to learn about some company's that had these types of
    relationships early on, and how and why they did it— if anyone has
    any stories…

    If we agree that they're nice to avoid, perhaps an interesting post
    would be when should you “concede” and do it, kind of like the idea of
    when to not over-negotiate a term sheet.

  • http://bothsidesofthetable.com msuster

    I think you concede if:
    - the company really does have the ability to “make” you
    - it's early in your company's lifecycle
    - the PBW is tied to hard results that would substantively change the value in your business
    - the amount is small enough (5% or less IMO)

    But no matter what you or I might think, the reality that companies sometimes demand PBW's is something entrepreneurs have to grapple with.

  • honam

    Performance based warrants are like strategic investments. In theory, it sounds like a good idea. In practice, it doesn't work. What I mean by that is that it does not change behavior of the strategic partner. The small amount of equity a partner gets is not enough to move the needle. But more importantly, it certainly won't change the way they do business. If it makes sense to partner – if they really need you – then they will work with you. If they don't need you, it doesn't matter if they own the entire company. The partnership will not work.

    Another very common problem is that the deal guy who is negotiates for the warrants (or investment) often has nothing to do with the people you need to work with day to day to make the partnership a success. At the end of the day, you have to make the operating guys responsible for your partnerships success look good. They could care less whether or not HQ makes money on the warrants.

    That said, if any of our companies were to do performance based warrants because someone at the potential partner really wants to make a name for himself and do such a deal to stick on his resume, then the advice is very good and I will refer our CEOs to this post. Thanks.

  • http://reidcurley.com Reid Curley

    Another nice post Mark. I have some observations and a few structuring points.

    First, these deals usually are worthless. The guys at BigCo who can really make a difference to your company typically don't get any benefit from the PBWs, so their incentive value is limited. It is critical that the PBWs be earned only if you get some real economic benefit. Otherwise you are throwing them away.

    Second, think carefully about the time frame for the deal. Just like with options plans, future investors will count all PBWs as outstanding stock. If your PBW deal is too big or goes on too long, this can screw up future financings.

    Third, think carefully about what happens in an exit. Trying to go public or sell your company when you have one of these deals in progress can be problematic. Ideally, you should have the ability to end the deal early if you sell.

    Fourth, think about what it will mean to have a customer as a shareholder assuming the deal works. You probably don't want them to have information rights, for example. Make sure that you are not structuring yourself into an awkward situation vis-a-vis your bylaws or investor rights agreement. It might be the case that PBWs should be exercisable for non-voting common stock.

    Finally, I highly recommend that you push BigCo to give you some cash up front. It doesn't have to be huge, but it should be meaningful in terms of the deal. For instance, if you structure it so that they have to hit $25,000 in revenue before they earn any PBWs, have it be part of the deal that they prepay the $25,000. Note that this is not the same as selling them the warrants. You book the $25.000 as a “prepaid revenue” liability and take it into revenue as you sell your product/perform your service for BigCo. Besides the obvious cash flow benefit, whether they are open to this will tell you a lot about whether they really plan on being a customer.

    Before it was merged into the NYSE, Archipelago Holdings (an electronic stock market) did a PBW consortium deal with large investment banks. The more business the banks routed to Archipelago, the more equity they earned. If PBW deals are hard, consortium deals are a nightmare. Nonetheless, the deal enabled Archipelago to build their volume and did contribute significantly to it becoming a successful company.

  • http://bothsidesofthetable.com msuster

    I agree with all your points and one thing that I missed in my post is that the person who negotiates the warrants is often not the person responsible for the success of your product. I also agree they should be avoided if possible. But having been in the CEO role when I was trying to land my first mega-deal it was very hard not to offer them. The customer knew how important they were to us. I was able to get a monthly meeting with the COO as a result of having them.

    They assigned an internal champion to work to help us succeed and he went on internal customer meetings with me to help with adoption. I still think it was strange behavior on their part, but it did help me greatly.

  • http://bothsidesofthetable.com msuster

    Reid, all very valuable points – I appreciate your taking the time to further the discussion.

    I agree with all points except I would make a slight adjustment to one point. You mentioned it might make future financings hard. If you do a small amount <5% in total, it is common stock and doesn't give rise to any voting rights then I don't think it will harm financing. Future investors will assume that all of warrants are going to be granted and will adjust their pricing on a fully diluted shareholding accordingly.

    Your point about M&A is good – you can simply have the warrants either lapse or have a certain percentage accelerate on a change of control (former obviously better, latter may be negotiated by customer) so that there is no overhang post deal.

  • http://stickyslides.blogspot.com Jan Schultink

    Thank you Mark, forwarding this to a client right now.

  • http://www.yourtour.com/ Bachir

    While i don't i have experience with companies wanting shares for helping us. I met with many bigCo where they instead wanted exclusivity.

    their argument was: “your product will give us a big boost against our competitors, but if you sell the same product to them we will loose that advantage”.

    it seems as the mentality of the early adopters, they did nor even try to negotiate the price, what matters for them was trying to get a technological advantage.

    Since exclusivity will harm us, we tried to instead to negotiate/finding a way to share the upside, but they were simply not interested.

  • alexanderrink

    Thanks, Mark, for another valuable and insightful post.

    First of all, I agree with pretty much most of your points here. A few additional points:

    1. Back in the dotcom era, I recall a large, well-known company that tried to negotiate equity/options in our company in return for issuing a press release (!). That's right, not a commercial agreement with real money and product/service changing hands, but merely a press release stating that we had created a marketing relationship. Worse, it was one of those Friday 5 PM type of calls, with all the hallmarks of putting pressure on us before an upcoming milestone. It made me wonder whether they had actually trained this individual to seek out these types of situations. We tried hard to get them to commit to a commercial agreement, but there seemed to be no appetite on their part to do so. Naturally, I declined to enter into a relationship lacking any substance.

    2. I find PBWs to be a good idea for advisers. It is often difficult to accurately predict which advisers will create the greatest value for your company. As such, we created a structure whereby there was a small base allocation for agreeing to become an adviser, and a variable equity allocation based on sales generated from that adviser's introductions.

    3. An even less useful version of the PBW-based agreement is the customer option agreement. This is the situation where the customer gets what amounts to be an option to use your product/service at defined terms for a prescribed period of time, but with no hard commitment. We signed such an agreement with our single biggest target a number of years ago, and it never amounted to anything. When dealing with large companies, we always need to keep in mind that the person you signed the agreement with will likely not be in that role in a year or two, and even the best of intentions may not get fulfilled.

    I think the overriding lesson is common sense: an agreement is only worth entering into if it comes with firm commitment from both sides, and an equitable exchange of value.

  • http://bothsidesofthetable.com msuster

    I actually loved when they wanted exclusivity. Here's why:
    - often I could get a larger payment
    - I would offer a set of exclusive “features” – only those that we would develop at their request and with their $
    - I would limit the exclusivity period to 3-6 months

    Therefore they ended up paying for part of my R&D roadmap. They get the time advantage they wanted. It was win-win.

  • honam

    Agreed. Strategic partners can behave irrationally – sometimes to your benefit. Entrepreneurs should take advantage in such situations. I just have a jaded view. I should try to offer more healthy skepticism. Each situation is different.

  • http://www.yourtour.com/ Bachir

    i more had cases where companies wanted 3-4 year exclusivity. which if the relationship did not work it will be a huge risl.

  • http://www.yourtour.com/ Bachir

    While i don't i have experience with companies wanting shares for helping us. I met with many bigCo where they instead wanted exclusivity.

    their argument was: “your product will give us a big boost against our competitors, but if you sell the same product to them we will loose that advantage”.

    it seems as the mentality of the early adopters, they did nor even try to negotiate the price, what matters for them was trying to get a technological advantage.

    Since exclusivity will harm us, we tried to instead to negotiate/finding a way to share the upside, but they were simply not interested.

  • http://how2startup.com/ Roy Rodenstein

    We had some of these conversations at Going and were able to avoid them (eg per your “make your board the bad cop” tip below), we did have a strategic investor which I'll break down in a later post.

    One small question, you say “Future investors aren’t likely to mind that you had a PBW program because the dilution will be taken before they invest.” Doesn't that depend a bit on a) whether, and when, the PBWs end up vesting and are exercised? and b) current pool and shares outstanding etc.?

  • alexanderrink

    Thanks, Mark, for another valuable and insightful post.

    First of all, I agree with pretty much most of your points here. A few additional points:

    1. Back in the dotcom era, I recall a large, well-known company that tried to negotiate equity/options in our company in return for issuing a press release (!). That's right, not a commercial agreement with real money and product/service changing hands, but merely a press release stating that we had created a marketing relationship. Worse, it was one of those Friday 5 PM type of calls, with all the hallmarks of putting pressure on us before an upcoming milestone. It made me wonder whether they had actually trained this individual to seek out these types of situations. We tried hard to get them to commit to a commercial agreement, but there seemed to be no appetite on their part to do so. Naturally, I declined to enter into a relationship lacking any substance.

    2. I find PBWs to be a good idea for advisers. It is often difficult to accurately predict which advisers will create the greatest value for your company. As such, we created a structure whereby there was a small base allocation for agreeing to become an adviser, and a variable equity allocation based on sales generated from that adviser's introductions.

    3. An even less useful version of the PBW-based agreement is the customer option agreement. This is the situation where the customer gets what amounts to be an option to use your product/service at defined terms for a prescribed period of time, but with no hard commitment. We signed such an agreement with our single biggest target a number of years ago, and it never amounted to anything. When dealing with large companies, we always need to keep in mind that the person you signed the agreement with will likely not be in that role in a year or two, and even the best of intentions may not get fulfilled.

    I think the overriding lesson is common sense: an agreement is only worth entering into if it comes with firm commitment from both sides, and an equitable exchange of value.

  • http://bothsidesofthetable.com msuster

    I actually loved when they wanted exclusivity. Here's why:
    - often I could get a larger payment
    - I would offer a set of exclusive “features” – only those that we would develop at their request and with their $
    - I would limit the exclusivity period to 3-6 months

    Therefore they ended up paying for part of my R&D roadmap. They get the time advantage they wanted. It was win-win.

  • honam

    Agreed. Strategic partners can behave irrationally – sometimes to your benefit. Entrepreneurs should take advantage in such situations. I just have a jaded view. I should try to offer more healthy skepticism. Each situation is different.

  • http://www.yourtour.com/ Bachir

    i more had cases where companies wanted 3-4 year exclusivity. which if the relationship did not work it will be a huge risl.

  • http://how2startup.com/ Roy Rodenstein

    We had some of these conversations at Going and were able to avoid them (eg per your “make your board the bad cop” tip below), we did have a strategic investor which I'll break down in a later post.

    One small question, you say “Future investors aren’t likely to mind that you had a PBW program because the dilution will be taken before they invest.” Doesn't that depend a bit on a) whether, and when, the PBWs end up vesting and are exercised? and b) current pool and shares outstanding etc.?

  • http://reidcurley.com Reid Curley

    Future investors will just assume that all of the warrants that COULD be issued WILL be issued. This will result in a lower price per share at any given valuation. As Mark indicated in a reply to my earlier comment, as long as the PBW deal is small, this won't kill a future financing. Keep in mind though, that the dilution cost in this case to the existing shareholders is very real regardless of whether BigCo is performing, so the economics of the PBW deal had better compensate for this. Further, if you have several of these deals, the fully diluted share count can start to increase rapidly. Worst case is that you think you are going to do an up round based on absolute valuation but it is actually a down round on a per share basis, thereby triggering anti-dilution protections, etc. This raises another point. In most cases, it will only make sense to do one or two of these deals. Make sure that you are doing them with the best partners available.

  • http://reidcurley.com Reid Curley

    Future investors will just assume that all of the warrants that COULD be issued WILL be issued. This will result in a lower price per share at any given valuation. As Mark indicated in a reply to my earlier comment, as long as the PBW deal is small, this won't kill a future financing. Keep in mind though, that the dilution cost in this case to the existing shareholders is very real regardless of whether BigCo is performing, so the economics of the PBW deal had better compensate for this. Further, if you have several of these deals, the fully diluted share count can start to increase rapidly. Worst case is that you think you are going to do an up round based on absolute valuation but it is actually a down round on a per share basis, thereby triggering anti-dilution protections, etc. This raises another point. In most cases, it will only make sense to do one or two of these deals. Make sure that you are doing them with the best partners available.

  • 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