New Start-Ups Should Consider Collaboration Agreement as Alternative to Equity Agreement
Given my Silicon Valley location, I often receive calls from start-ups who want to “give equity” to a developer that they’ve just started working with. When I receive these calls, I inevitably have a talk with the client or prospective client urging them to consider an alternative: entering into a collaboration agreement with the developer rather than actually giving the developer equity.
You might ask: why do I discourage start-ups for granting equity to a developer? Well, nine times out of ten the start-up has never worked with the developer before when they call me. They are generally proposing equity because they do not have the money to pay for the developer’s services, and the developer usually wants a large percentage of the company. Also, I know from experience that most clients terminate their relationships with their first developer within the first year of starting their business, so the odds are high those same clients will be coming to me within a year asking how they should go about kicking the developer out of their company.
Going into business with anyone is a huge commitment, and it despite the fact entrepreneurs are accustomed to granting equity in lieu of paying cash for services, doing it immediately with someone you have never worked with is a tremendous risk.
So, what do I recommend instead?
I recommend that start-ups in the position of requiring development work and not having the cash to do it should consider drafting a collaboration agreement.
Why use a collaboration agreement structure instead? Well, you can still share the profits arising from the development work with the developer; however, you can do it in such a way that if the relationship does not work out on a long-term basis, you can get out of it by ceasing use of the work that was developed. In the alternative, if the developer proves to be an integral member of your team, you can always provide equity down the road after the developer has proven his or her worth to the business.
In case you are not familiar with the collaboration model, this model is one that is routinely used in the Silicon Valley to describe an arrangement between two individuals or companies who have decided to pursue some sort of business opportunity together but have elected not to set up a separate business entity or to provide equity in an existing company to do it. The agreement provides a framework by which the parties can work together, defining how expenses will be shared, how profits will be shared, and what services each party will perform within the framework. It also defines how disputes between the parties will be resolved, in order to prevent a breakdown of the collaboration when there is disagreement.
All in all, I think it is the perfect model for many cash-strapped entrepreneurs to consider when they want to hire a particular developer but lack the cash to pay the developer for the services. It certainly is much less risky than taking a leap of faith and granting a large amount of equity in a company to a developer they have never worked with, and it really accomplishes the same purpose if the relationship works out, which is to share the profits made from using the work that is developed.