How to structure a development partnership with an unfunded startup?

My co-founder and I have a fledgling software company. We recently started talking to a non-technical entrepreneur who is looking for a development partner. He has potential backers, but needs to demonstrate a prototype version of a web site and hardware. We have offered to develop that for him. As he is currently unfunded, he has offered us equity for the prototype, and the final product would be developed and paid for as a standard development contract.

As we will be developing our own company too, we don't want to co-found with him or be involved in the day-to-day running of his company.

As this kind of deal is new territory for us, we're unsure of how best to structure and price it. Is the combination of equity for the prototype and cash for the final product reasonable? Should we consider something else, like profit-sharing?

Ok, having been in similar situations I can say:

• Your company is a separate entity to his company.
• Your company would take non-voting shares / stock in his company. The value agreed would depend on how you value your time for the prototype. I'm guessing its around 5-10%
• You would set the price for the final product on hourly rate or quoted staged deliverables. (like any other development contract you would take on).
• You will only get paid when
  
  • HIS company pays a dividend on shares. You hope over time this adds up to more than you put into it.
  • You sell your shares to someone else
  • He sells the company (and you sell your shares along with it).

So the math would like something like.

• Hourly Rate: $150 per hour
• Agreed Risk Multiplier: 3x
• Prototype development: 100 hours

$150 * 100 * 3 = $45,000 as the target amount to be paid off.

Alternatives include :

• Delayed payment. This says "in 2 or 3 years you agree to pay us the amount if you progress with the business beyond the prototype". Basically your allowing him to earn enough to pay you back, with an agreed multiplier (eg 1.5x to 3x). basically its better if he can loan the money from the bank instead.
• Profit share. I avoid this because accountants are good a messing about with the definition of "profit" so you never know where you stand and you may be waiting a few extra years because it only gets calculated once per year.
• Cost of goods sold (COGS) repayment. This is something I do prefer, each time they sell the product or service, they pay you an agreed amount (eg 5% of that one sale). Ideally this is indefinite (like paying for the use of a patient) but more likely its paying off an agreed amount (with the multiplier of 2x-3x). This has a risk that they don't sell enough to ever pay you back but it is a good middle ground that sees you go your separate ways eventually.

Given your description I would go with the last option, (COGS). It works well and provides a balance between all parties with a little risk accepted all round.

WARNINGS.

• If the product doesn't go past prototype your out pocket and he isn't. Paid prototype and equity first version is safer for you.
• I'm not a lawyer OR accountant, these are ideas that you need to get formalised with both legal and accounting specialists.
• The real question is "does this detract from your own business plans?", if yes then go and do your own thing.

These three questions/answers may help.

Do you need cash? Then make the prototype for cash. Treat it as a regular contract and move on.

Do you think his idea is better than yours? Then apply the same risk assessment formula you used on yours on his (how much do you need in cash vs equity to be comfortable with the risk).

Do you believe your startup has potential and this other gig will not be a short term cash grab (he says no to straight cash)? Ignore distractions and work on your startup.

Notes:
Non tech entrepreneurs know that tech guys often undervalue their own skills and/or are terrified of the business end of things and are will to take deep cuts in the name of staying in their comfort zone.

Working on two startups is straight up ridiculous. You will meet some people who are doing it (and think they are clever for it). But you won't find anyone who was actually successful at it.

Valuing a startup is only easy when you are selling shares for investment (you are selling promises for cash), or purchasing shares on what you think are pennies on the dollar (investors invest what they can lose). You are in neither position. You are trading you time for some equity in something you likely have no control over and yet will have a great impact on your life (You cannot afford to lose, otherwise you wouldn't be here asking).

As a company can you afford to take on a client for free?
Being pessimistic for a second, the chances are even with a potential product that funding is not likely nor does funding equal profits.

As such regardless of what promises are made now and what equity is being offered you need to be sure you can write off any work you do for them. The fact the project has limited risk for the client but seems to have a far greater then normal risk for you means if you do take it on, you need to be compensated for that risk.

Just bare in mind 100% of 0 is 0

That said there maybe other advantages working with the client, in terms of moving your own business forward and you should way those intangible benefits up. In terms of equity, we get about 3 pitches a week from people suggesting they have a great idea, but no capital and would we developer the site for equity. In each case we decline (to much risk) but point them to either potential points of investment but also suggest they get involved with programs like Ignite and Launch48 as a potential route to meeting developers rather then traditional agency.

Personally I would offer as much advice as you can, and even offer some limited technical consultancy but I wouldn't as a business have a contract based only on equity and a distant promise.

Make him pay some significant amount up front, maybe not the full price of the prototype but some real money.

The biggest risk here isn't that the business will fail - it's that it will never be started - that this non-technical founder is just not serious or has no idea what he is getting into - and that the "potential backers" are investors that turned him down and he didn't understand it (they always say "yes if" when they really mean "no").

Getting an investment requires lawyers and accountants and long tedious procedures that cost real money - if he can't raise money from family, friends or a bank loan that means one of two things:

1. He doesn't believe in the business enough to bet his own money and reputation on it - in that case it will never happen and you should stay away.
2. He really can't raise any money - in this case he won't be able to complete the process of getting investors and starting the business - and you should stay away.

You should get an amount of money that is significant for him personally as proof that he is serious and has the motivation (and resources) to pull this off.

Step 1: decide for yourself if you believe in his product. Would you invest in it? Because that's what is going to happen, no matter what the deal says today.

Imagine you work out some kind of deal. After 3 months, you deliver a prototype. Looks pretty good to you, but it's not quite enough for him, his "potential investors" just need to see one more thing... What do you then? You already committed so much of your time, so you keep going and add that one extra feature. And another one... By the time you finally understand that it's a lost cause, you lost a lot of energy and have nothing to show for it.

Step 2: Take the deal if you strongly believe in two things: 1) the merits of the product 2) the capacity of the founder to succeed with the product.

There are many ways to evaluate if the founder is any good. Definitely, no matter how much equity you get, insist on a token cash payment (say, 10% of the fair cost of the development). Why? It's a test for the founder. If he won't even fork $XX, which is a great deal, it means he doesn't take you seriously, or is not willing to do what it takes to succeed. Cash is a great way to separate the dreamers from the serious founders.