Windfall or Shortfall? Equity Compensation for Outside Service Providers

In a typical service provider-customer relationship, the provider delivers a service and the customer delivers cash. Upon delivery, both parties are happy and move along to the next transaction. However, a trend that gained popularity in the early 2000s adds an extra level of complexity to this seemingly simple business relationship – equity payments. Startup companies have long offered compensation to their employees in the form of “sweat equity.” For a cash-strapped startup, this form of payment preserves precious capital and incentivizes employees by making them partial investors in the business. Sweat equity allows companies to hire quality talent without draining cash on payroll. So why not apply the same thinking to other parties who provide their services?

Equity payments for outside service providers gained popularity in conjunction with the internet boom and continues within entrepreneurial spheres. Early stage companies are able to hire design, marketing, and consulting agencies of a caliber that would have been otherwise unaffordable. As investors in the company, service providers increase their potential upside from the transaction beyond fixed cash payments. An equity stake can also increase providers’ involvement and interest in the Company’s success.

While the combination of cheaper high-quality services for startups and potential for a valuable windfall to providers may sound idealistic, equity-based payments add an extra level of complexity for both sides. While startups may gain more personal and engaged service experiences, the expectation that they offer cash and equity for their needs can begin to bleed the company treasury dry or create a myriad of other pitfalls. On the other hand, traditional service firms take on additional risk as quasi-venture capitalists. Rather than accepting contracts from clients based on their ability to afford the service, firms must additionally vet potential projects through the forward-looking lens of longer-term investment quality. Accepting this kind of risk would suggest that an advertising agency should perform financial analysis and due diligence on a potential client before entering into a contract for an ad campaign.

For some service firms, the potential reward is worth the added risk of betting on the customer’s future performance. When design firm Ammunition Group began working with Beats Electronics, the company entered into a return on sales deal as part of the compensation structure. Ammunition dedicated nearly a quarter of its staff to the then-unproven products in which it had a stake. But with $14 million in revenue in 2012, Ammunition’s bet on the company seemed to pay off. Branding firm Red Antler is another service provider that regularly structures its compensation to include an equity stake, as described in a recent article in the Wall Street Journal.  For Red Antler, the most common contract structure – blended cash and equity payments – provides both a revenue cushion and the lure of a larger payout. One of the company’s recent investments, Casper Sleep, is estimated to be worth north of $550 million, based on its most recent capital raise. But whether or not Red Antler will see a large payout from the investment is still uncertain. After all, not all share classes are created equal and actual cash returns to different stakeholders can be very different from “headline” valuation figures.

While some of these investments pan out and provide a hefty windfall to investors, many do not. In individual cases, service firms have to rely on their own instinct and research. But many times market sentiment plays a role in companies’ willingness to make these investment decisions, parroting trends in the broader VC market. With venture capital funding – especially at the seed level – remaining low this year, many service providers have eased back on the proportion of non-cash compensation they are willing to accept. Whether the decline in acceptance of – or demand for – equity payment is a positive or negative trend for startup companies is not clear. But it certainly could change the mix of stakeholders to whom startups report and the nature of their relationships with their service providers.

Mercer Capital regularly assists start-up and mature companies with equity-based compensation valuation issues and we’re also experienced in the valuation of illiquid minority interests in companies across a variety of industries. Give us a call to discuss your needs in confidence.

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