Follow me

Should You Co-Found Your Company With a Software Development Shop (2 of 2)?

Partner (manga)

You’ve got a great idea and domain expertise, but limited money and insufficient technology resources.  Should you co-found your company with a software development shop?  I wrote a summary of my thoughts in Part 1 of this series; I’ve written below in more detail what some industry players think.

I’ve seen a range of options for supporting entrepreneurs, which I can rank from least to most involvement in companies by investors:

  1. financier VCs, e.g., Correlation Ventures
  2. mentor VCs, e.g., most VCs
  3. accelerators, e.g., Dreamit, ER Accelerator, Techstars, Y Combinator
  4. incubators, e.g., the many options in New York
  5. portfolio operator VCs, e.g., Andreessen Horowitz, ff Venture Capital, First Round Capital, Google Ventures
  6. foundries/studios, e.g., BetaWorks, Idealab, Accretive LLC, Lux Capital; see detailed list here
  7. intrapreneurs, e.g., the employee of GE who is tasked with launching a new business

Not surprisingly, the list above also is ranked from least to most equity stake in an investment for the investor, relative to the cash they invest. An intrapreneur is the extreme; usually an intrapreneur’s employer owns 100% of the new business that she creates.

I’ve talked with a number of software development shops who are eager to get into the business of cofounding companies, i.e., getting product revenue and equity instead of just consulting revenue. They’re typically pursuing a foundry/studio model. I agree with VC Mark Suster that we’ll see a boom in this “foundry” or “studio” model over the next few years, if the macro environment continues to provide liquidity for the innovation economy.

Design, development, and digital media shops, sometimes just a few years old, are doing bigger and bigger projects and come bearing cash flow and that scarcest resource, talent. The question is: how should they be compensated when cofounding a company? They’re well aware of the conventional VC bias against funding companies which externally develop their technology, but they do have relevant skills.

I’ve been looking for suggestions for an initial deal structure that is appropriate for the theoretical case of a trusted dev shop putting in $100k in market-value of services over a 6 month period in time. What are the terms of their relationship with the founder? What are the timelines? The discounts? The cliffs? The fine print? How would one set up such a startup to eventually raise capital from outside VCs, who will be wary of ‘dead equity’ (i.e., equity that belongs to departed cofounders)?

I asked a few people for their insight on this question, in an effort to broaden my perspective. I was fortunate to get some thoughtful input from the leadership of DarwinApps, Casual Corp, Coventure, HappyFunCorp, OAB Studios, and World Accelerator. Other interesting examples of companies in this space are Originate and iTechArt.

Over the last few months, I worked with Vlad Lokshin, a student at Cornell Technion, and a team of other Cornell Tech students on creating MarketMap.me. Vlad is also the CEO at DarwinApps, a software development shop. After years of consulting for companies, he learned that this development work doesn’t make sense for start-ups on a pure cash basis, since their budgets tend to be smaller. Vlad and his team at DarwinApps are considering launching DevFund — their attempt at cofounding companies by developing the MVP technology.

Vlad writes:

I believe that the cofounding model aligns goals and incentives in a more efficient matter than pure consulting. It’s also a way for us to work on something bigger than a pure cash turnaround for the work. That said, I’m not sure of the most appropriate structure.


I’ve also asked this question on Quora.There, I ask for advice on how to best structure this for all parties: The development shop, the founders (outside of the dev shop), and potential outside investors.

Currently, I think the following points should be considered:

  • The optimal structure is one that equalizes the contributions of the development shop and investors. If the dev shop puts in $100 of (market-value) labor, they should be compensated for that amount in equity — just like an investor gets their share for $100 in cash.
  • At the same time, a direct equity investment (one where the dev shop acquires a share in the company immediately) puts the founders in a potentially uneasy position of having to dilute their company before a product is built. The same exact thing happens with cash, but I think some founders feel this dilemma more painfully when giving equity for services instead of equity for cash.

The most important thing here is to treat the work and the cash as one and the same. In prior discussions, the value of the work has often been downplayed by some players in comparison to cash (usually with individuals who have never built a product before). If we believe in founders enough, we should believe in their potential more than what they could be paying us to build the product. If the founders believe in our abilities to build the product as a top-of-industry shop, then they should see the structure as a lower risk one (no need for cash to pay for the product) and one where the product should, in theory, come out stronger — as we now have skin in the game.

Thor Ernstsson is the founder of Alpha UX, a product validation company serving real-time user insights to Fortune 500 product managers. Previously he founded Casual Corp–a venture studio–and built Audax Health–a health-tech company that ultimately sold to UnitedHealthcare.

Here’s what Thor had to say:

Venture Studios, Foundries, and Factories are a very interesting emerging model for solving for many common problems founders face. These are particularly relevant to first-time founders, since the learnings they go through often inhibit them from successfully launching a company. Strong support from serial founders, engineers, and other specialized resources that are particularly relevant to the earliest days of a company can overcome that hurdle and (in theory at least) yield companies that otherwise wouldn’t be built.

Our model at Casual Corp. relied on the basic assumption that those kinds of companies should be built if the founders were in other ways exceptional and domain experts in certain fields. Customer development would be reduced to a single person exercise that could be repeated in parallel dozens of times over, ultimately yielding 30+ companies a year.

Fundamentally and theoretically, this model works; practically and actually, it didn’t at all.

Individual companies can be built by strong founders. In nearly every case they need support and specialized resources. Accounting for those resources as “investment” at fair market value is a pretty straightforward way to value contribution. However, valuing the intangibles of time saving, expertise, network, etc. on top of that often results in conversations and incentives that are difficult to overcome, especially early on in a company.

If the founder critically requires all of the things a venture studio offers, there’s potentially a strong selection bias against success… i.e. as an investor wouldn’t you always rather back the founder that overcomes early obstacles like recruiting cofounders based on a strong vision?

There’s a huge caveat to the above comments. Many industries are very difficult to penetrate from the outside, e.g. healthcare, education, government services, and more. Partnering with a source of capital, connections, and expertise for a large equity chunk is often worth it in those scenarios (e.g., Rock Health).

When the value of the studio’s participation is effectively a commodity (like office space, engineering, capital, etc), the equation flips and should be to the advantage of the founders. Potentially the value added resources can justify more advantageous investment terms, but rarely do they substitute for actual capital.

In extreme cases, the venture studio retains majority ownership of the company. In those cases, the incentives for the founders and early employees are extraordinarily hard to align long term. In some cases, follow-on investors will insist on a recap. In others, this becomes an insurmountable obstacle and the company folds because of the passive investor / early dev shop that doesn’t really have any skin in the game or ability to help strategically post launch.

The most important thing to consider is that launching a startup is usually a personal endeavor. The founders’ psychology is probably one of the most important contributors to success of the company. Solving for creating a product through development resources and bypassing customer development and personal struggles from the founders often just masks problems, such as people not actually wanting the product.

I spoke with Thatcher Bell, Managing Partner, CoVenture. He writes:

I have been a “mentor VC” for a decade, at Gotham Ventures and North Hill Ventures. I recently joined CoVenture, an early-stage venture capital firm that develops products and invests cash in exchange for equity. I did so, in part, because I deeply believe your premise: technical talent is harder to find than capital. My comments here relate mostly to new or early-stage startups, as I’ve spent most of my career investing in those companies and it’s what we do at CoVenture.

First, the founders are their startup and define the company it will become. They must own the majority of the company at its founding or they will have insufficient incentive to do what it takes to make it a huge success. Therefore, any investment (whether denominated in cash or development or other service) should be of the minority variety. Ideally, the economics of a development investment look like those of a cash investment; typically, a seed investor will get no more than about 20% of a company for his capital.

Second, the company must eventually own the product development and maintenance functions in-house. If it does not, it will have difficulty raising capital from the best investors and maximizing an eventual exit value.

Third, a firm that develops product in exchange for equity should take little or no cash for their work. Startups are cash-strapped; every dollar they spend on development reduces their runway, chances of success, and equity value. Also, cash usually provides the wrong incentive for a developer: more code usually means more cash, but for a startup, the goal is to get the maximum learning from the minimum (scalable, extensible) codebase.

Fourth, a development-for-equity firm should be very wary about making investments opportunistically in addition to handling cash projects. Making good (development) investments requires all the deal flow generation and evaluation work of a professional investor; the alternative is poor selection.

Finally, a developer-investor must be prepared to remain “live equity.” This means providing value beyond development and, when appropriate, making follow-on investments.

At CoVenture, we have attempted to build a firm from the ground up that observes the principles above. We are a venture capital firm with deep design and development capability, not a design and development shop that sometimes takes equity as compensation. We receive only equity from our portfolio companies; generally a minority stake as outlined above for three to six months of work for a team of three or more. We partner with world-class founders to help them test their ideas in the market, and help recruit permanent technical talent when the results are positive. We don’t have follow-on capability (yet), but we help our companies with product strategy, fundraising and technical recruiting. I’ll be writing more on many of these topics in an upcoming blog post on “staffing an experiment.”

I spoke with Ben Schippers, Co-Founder, HappyFunCorp. HappyFunCorp is a technology development firm that works with top startups (including my cousin at ArchitecturalDesigns.com) and Fortune 500 companies. Recently, HappyFunCorp acquired EastMedia and StartupGiraffe, a company specializing in equity development. HappyFunCorp employs 80 engineers and product architects. He writes:

The premises of this conversation are very complicated. While I do agree with many of my colleagues on some of their points, the equity model breaks, in my opinion, due to conflicting incentives where founders are working with traditional development firms for a blend of cash and equity. On paper this makes sense but in practice, the inherent challenges associated with design, product, engineering, product scope and most importantly, business alignment and incentives, makes the model very problematic for both the firm and the entrepreneur.

Most firms that do decide to take equity do so because their risk is far reduced when compared to that of the entrepreneur, or that of the traditional cash investor. Software firms have the ability to build great software at a far reduced rate vs. lone founders, and therefore entrepreneurs and development firms are rarely on equal playing fields. More times than not, firms retain all the leverage. It’s a rare occurrence to see traditional development firms take all equity deals in exchange for cash. Development firms work within a very traditional time and material model and are not aligned and/or incentivised to make equity deals truly work.

This is further compounded due to the nature of building software. Software is very tricky and never ‘done.’ Who is valuing the worth of development? Does that include product support or design? What happens when the set, agreed upon value is spent and the product is incomplete? These questions always arise and there’s no clear answer or way to contain these conflicts, especially when blending cash and equity.

Development firms have all the current leverage. Because of that, the tendency is for them to begin playing the equity game with potential interesting entrepreneurs. The reality however is that entrepreneurs should only play the equity game with newer, very focused firms that specialize in this practice and not traditional work for hire or a blend. Development firms that advertise part equity and cash are simply not mature in defining their model, and thus they have no business taking stakes in others. Great software will continue to be built for cash and for equity but rarely for both when it relates to offsetting cash.

Provided the entrepreneur found a trusted modern firm that understands equity structures, here’s how a typical deal could work:

  • $100K worth of development in exchange for no more than 25% of the company
  • Vesting equity equally divided into set milestones, in this case:
  • 5% vest after design phase
  • 5% vest at clickable prototype
  • 5% vest at beta launch
  • 5% launch of v1
  • 5% launch at the end of month 4
  • Typical project timeline to MVP would be 4 months ($25K per month)
  • Small release at month 3 to collect user feedback
  • Incorporate feedback from beta launch and launch MVP (week 16)
  • Following month 4, agree on a 50% reduced rate ($12,500) to cover hosting, maintenance, and new feature development for 3 months
  • Help identify key technologist and product hires to transition in-house (week 13 onward, however this can take 1 year)

Although this model can work, it’s my belief that entrepreneurs are better advised working with businesses that do business in strictly cash or equity. Specifically, it’s also my belief that hybrid businesses and funds will have a very difficult time obtaining long term success unless these new firms only work for equity. Entrepreneurs should remain focused on raising a traditional friends and family cash round, then either hire development in house or use an outsourced dev firm to build their MVP and Version 1.0. Entrepreneurs should then use that to raise their next round.

Lucky Lance Gobindram, President, OAB Studios, writes:

I’m ultra-selective and laser focused about the companies we work with at OAB. And that’s because we don’t just design pretty products, or write clean code. We act as true technical co-founders to entrepreneurs who we believe in and are building things we want to see in the world.

We don’t only work with startups (agencies help pay the bills while our startups come of age), but it’s our bread and butter. We’ve helped multiple startups, including a ffVC company and quickly growing sticker app Hi-Art, move from founder with idea on a napkin, to venture-backed company with a thriving product and top-notch team.

The process usually goes as follows:

  • Founder approaches us with an idea.
  • If we believe in them and agree on an MVP, we start building. Our MVPs take anywhere from 6-10 weeks to get to market.
  • After releasing the MVP, we work on a lean scrum to iterate based on early data/feedback until we start to see signs of product-market fit. During this process, we start opening up our tight network of product, data/growth and design advisors to help; what at OAB, we like to call Guerilla Development.
  • When we start seeing promising traction, we work closely with our founders on fundraising. A number of our startup clients actually got their first commitments from investors intros we’ve made.
  • During and after fundraising, we team with the founder to recruit for a full-time CTO to join the company. Our rolodex is deep and our technical expertise helps wade through a lot of the noise.
  • After funding closes, we remain involved & invested by keeping a board seat, helping with tech hiring/strategy, and continuing to introduce our founders to our close network of trusted advisors and investors.

We’ve seen this process work a number of times, and really believe in it. A key goal of ours is to “become obsolete” by Series A, and that makes us different than a lot of other shops. We don’t take 30 or 40% of your company, we take 3-5%. We know it’s important to keep the cap table clean, and we want to focus on where/when we add value and then get out of the way. In exchange for equity, we discount the project cost, which is already low because we offshore most of our development, by 10-15%. Outsourced development used to be a dirty word for startups, but we think that’s changing. We recruit strictly from India’s top universities (e.g. IIT, Symbiosis) & rigorously vet/train everyone that joins our team.

And it’s not just early-stage founders who notice. We’re often asked by top-tier VCs to evaluate the code of companies they’re thinking of investing in. We’re happy to do it…but we’d rather be building 🙂

Lastly, I asked for input from Gary Millin, CEO, World Accelerator, a domain name-based accelerator. He said:

As CEO of World Accelerator, I have had to find structures to do deals where we are contributing a domain brand in return for ownership or value in a business. Much like contributing development time, there are often different values placed by different sides on those different contributions. Therefore, navigating to a solution where both parties come out winners takes creativity. We have found ways to do this with several of our companies: Doctor.com, Revenue.com and Lawyer.com, to name a few. With that as a backdrop, as I ponder the question, my view is that a hybrid approach would work better than all cash or stock. Also, I would lean to fair market value warrants over stock to reduce tax issues for the recipient of the stock, and also incentivize parties to create value beyond current levels. I see the equity as a kicker to further incent and align parties and lower cash costs, and not a full replacement for cash. I would expect at the extreme of all stock that the company would have to overdeliver equity relative to its true value. Lastly, I would suggest a range of equity or warrants is offered, vs. a fixed amount. This way the development shop can trade in a reduction in fees for the equity or warrants and also decide the amount. They will know their risk tolerance and interest and let them push for more equity. First a price is set for the warrants or equity and rates are set for the project whether it be fixed or hourly. Then the development shop can decide how much to take via a reduction in fees up to the cap. In my view, if decisions like that are given to the other party to make, they would find the receipt of the equity component more tangible as compared to a situation where it is dictated to them and more easily mentally discounted in value. Finally, with our domain deals, I find no two deals are alike and they depend on many factors that one learns over time. Likewise, I would expect the right answer of the mix of cash vs. stock vs. warrants will depend on several factors and may differ from deal to deal.

Vlad Lokshin concluded:

The people you interviewed make great points. Even more importantly: they went through it. So, they have theory and practice to compare — I’m much lighter on practice. There are so many repeat themes that make so much sense, but it takes hearing them from industry experts who have been through it to make the points truly stick.

A few specific points that I’d like to highlight:

  • “Fundamentally and theoretically, this model works; practically and actually, it didn’t at all.”
  • “The most important thing to consider is that launching a startup is usually a personal endeavor. The founders’ psychology is probably one of the most important contributors to success of the company.” (translation: it’s mostly about the founders. )
  • We are a venture capital firm with deep design and development capability, not a design and development shop that sometimes takes equity as compensation.”
    (translation: focus.)

The numbers can work — which was my original ask. The caveat: the numbers really aren’t that important. It’s all about finding domain experts that can add more value than the dev shop, and for really treating the whole thing — psychology included — as a partnership / collective of founders. It’s all about collective focus and vision. Whether it’s the firm that focuses on JUST this model, or the founders focused on JUST the one problem they’re passionate about solving — success is rooted in disciplined focus.

Our prior successful partnership had everything to do with the founders, and very little to do with the numbers. Each product took a ton of care and thought from our side — we really did act as co-founders (and still do, as “successful” means they’re still growing). That’s powerful when nurtured properly, but hardly scalable.

I would say CoVenture is the closest thing to what DevFund was intended to accomplish — but it’s clear that they’ve gotten to where they by focusing. They are a VC firm that takes equity, not cash, as compensation. They even put cash in sometimes — and that’s ALL that they focus on. They’re not a dev shop that sometimes takes equity, or a startup that sometimes takes cash. They’re doing just one thing, and doing it well. Just like a startup laser-focuses on one thing, and does it really, really well — CoVenture is doing exactly that with their “VC firm that builds software for equity” model.

DarwinApps has enough partner projects to grow larger that need my attention, and we need to put our primary focus behind our main product: Mightysend. That said, if anyone else thinks they can lead the DevFund model — and truly focus it on investing product (and ideally cash as well, eventually) into founders with deep domain-expertise, please contact me.

I want to thank David Teten of ffVC, Thor of Alpha UX, Thatcher of CoVenture, Ben of HappyFunCorp, Lucky of OAB Studios, and Gary of World Accelerator for all of their wonderful insights. Please keep building or helping those who are building (and laser-focusing on whatever it is that you do best!).

 

Partner (manga) — Photo credit: Wikipedia.
(This is the detailed notes for my prior post on how founders can work with software development shops.)

Subscribe to my newsletter