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Equity vs. Royalty?

What if your dev partner wants a royalty and not equity. How would you calculate that and why?

10 Replies

Brian McConnell
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Brian McConnell Entrepreneur
Head of Localization at Medium.com
Its a reasonable request especially if this a business to business service with a decent revenue model. There are lots of reasons equity can end up being worthless even if the product does well. The main trick is structuring the rev share so that as the team grows the percentage decreases. Also important to have a buyout clause for future funding rounds. If the partner balks at that you point out that if they want unlimited upside they have to take equity. Otherwise you need to be able to buy them out of their revenue share. Overall I think its a good way to motivate early devs. Anyone who has been around for a while knows to treat startup stock as bs funny money. Rev share is easier to predict.
Archer Hobson
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Archer Hobson Entrepreneur
Junior iOS Developer at Velocis
I would be careful with this. I am not sure of your product, but usually equity agreements are dependent on some sort of vesting period, usually around 4 - 5 years. With royalties it would be difficult to tie those payments over time. Also equity is based on the valuation of the company at a liquidity event, royalties are tied to the bottom line, depending on how you set up, maybe forever or just a few years.

Brian makes a good point though, equity doesnt much for early ideas. It might convince early devs and motivate them to stick around, just be sure as a proportion of revenue share that they continue to add that value over the lifetime of the company.

Ultimately, your bargaining position on this is relevant to the stage of your company, if it is revenue producing, then you can figure out a proper royalty share based on your financial growth predictions, then pair that to the value you think he/she brings. If its just an idea, and your desperate for a dev, then you may have no option other than to walk away and find someone to work on more favorable terms.
Robert Clegg
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Robert Clegg Entrepreneur • Advisor
Game Based Learning Expert
Little more of the story here... they, a group of 2 + 1 heavy hitter, agreed to work on a reduced fee + equity (valued on par with the first investors). After the first phase, seeing the potential of product #1, they want a royalty instead (they most probably want to chase another opportunity they have so don't want to be tied down with equity).

I need to calculate this as if none of them will stay with the company after Y1 when the first product is finished.

Just looking for a calculation here. Grunt fund handles equity but has no conversion calc for royalties.
Brian McConnell
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Brian McConnell Entrepreneur
Head of Localization at Medium.com
Its all about incentives. I've got 20+ years of experience as a developer. I start from the assumption that non technical groups who are relying on employee based financing have a high risk of failure. Rev share is a good way to offer shorter term participation in success. I have also been screwed, badly, in equity based deals. Its way easier to track revenue and take a bit off the top. Equity is nice but in four out of my five past gigs it wasn't worth shit.
Don Daglow
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Don Daglow Entrepreneur • Advisor
3-Time Inc. 500 CEO, Technical Emmy® Award, International Speaker, Advisor at Founders Space accelerator

Here are some questions I recommend the teams I advise run through when they're looking at these kinds of issues. (And this is the late night edition so I especially ask fellow FD'ers to audit and feel free to add or disagree):

1. Are they internal to your company or an external team? Sounds like they're external. People with equity are betting on the success of the company, the value vests over time (as Archer mentioned above) so people have to keep helping to maximize value, and that's the kind of commitment you want in house. External teams are betting more on the success of the individual product(s) they touch, which can make a royalty the more reasonable choice, As Brian points out above, if you're not in-house shares can feel like funny money you have no chance to make more valuable.

BUT...

2. How much difference is there in the quality and delivery date of your product if Acme Software implements vs. Betelgeuse Software or Charlie's Software? If they have unique expertise or can make unique creative contributions that fundamentally reduce risk and raise quality, that's a real argument for a royalty, they'll earn it and it should motivate them. If Choice A gets 92 points on your scorecard, B gets 89 and C gets 87 then what you need may be brilliant and useful but its implementation is straightforward. There is no reason to pay a royalty for straightforward implementation UNLESS you get a below-market up-front cost, so the (risk reduction + contribution value = reward) equation stays balanced. Projects where a lot of different teams can execute successfully generally can be done as work for hire without royalty if you're willing to pay a rate where they make money, and you can use targeted bonuses in a contract to give upside and motivation without the open-ended exposure of royalties.

3. How many teams have you talked to and vetted? Ideally you want multiple responses to your RFP. Especially when non-technical founders do not yet have tech leadership there is a tendency to want to go with the first strong team you meet, because suddenly you have a path through the jungle where none was present before. Finding more options before you close a deal is well worth doing, and there are "CTO for Hire" consultants who will help you find and vet them. (I'm a Strategy, Exec Coach, Production and Design type, although I was a programmer earlier in my career, so I don't do CTO work.) They're expensive consultants, but if you don't have a tech co-founder or employee yet it's way better than making a leap of faith with the first team you find. (This drove me nuts when my team was the first one in the mix because we had a great track record and then we had to deal with competitors, but from the client side it's still good practice.)

4. How regularly will you update the software? How long till version 2.0? Will they be doing this or will your in house team take the process over once you're up and running? If the external team moves on then a royalty in the original Work will stop generating revenue, and later versions (Derivative Works) will have a lower royalty (if they made unique contributions) or no royalty at all. IMHO it's critical to not grant a perpetual royalty in a product line, or in more than one version of a product -- I've been brought in by companies to unravel the problems this can create, and they're significant. If their team does the updates, improvements etc. and continues to add unique value then the royalty in the next version is completely reasonable, but it's negotiated separately based on that contribution.

Royalty life expectancy can be an emotional issue and has to be handled with some tact. Even when they're implementing someone else's idea and doing a solid but routine job of implementing a spec (vs. designing it or enhancing it) I've seen team leaders get emotionally stuck on long term royalties even though they produced essentially the same software that Team B or Team C would have produced. A specialized software development attorney will help you craft a deal that's fair to both parties, but if the dev team seems emotionally disabled over the royalty issue and aren't adding unique value (or reducing risk in a unique way) I'd pick a different team to work with.

5. Are they more than an external team, they're key creative parents of the product? Or maybe they're the only ones who've actually figured out how to build a robotic duck billed platypus, which is what you happen to need? Are both your and their ideas and creative DNA intermixed with lots of genes coming from both sides? Then many of the cautions I just described don't apply, because they really do have a critical role and deserve a critical stake in the rewards for the project, which brings us back to the points in Question 1 above.

Hope this is of use to you!

Don
Don Daglow
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Don Daglow Entrepreneur • Advisor
3-Time Inc. 500 CEO, Technical Emmy® Award, International Speaker, Advisor at Founders Space accelerator
PS: Robert, I just saw your comments on another thread and it's clear you know a lot about software development. I hope my comments still raise some useful questions for you to consider, but it's clear you have a lot of relevant expertise.

Don
Don Ross
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Don Ross Entrepreneur
Managing Partner Digital Health at Life Science Angels
"They don't want to be tied down with equity." You don't want to be tied down with paying a royalty in perpetuity. A fair approach is to calculate the discount (amount the developers are putting at risk). Call this amount X. Then cap the royalty payments at some multiple--perhaps 3X. Royalties are paid until this amount is reached (time is variable rather than the amount). The multiple could be more or less depending on the level of risk in your company and how much you need these particular developers. This also provides a buyout number.

Another thing to keep in mind: CASH IS KING. Early stage companies always are starved for cash. A royalty scrapes cash off the top. If you can negotiate it, you might try for a threshold of initial sales before the royalties kick in.
Keith Wright
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Keith Wright Entrepreneur
Helping customers prevent costly product losses by being prepared for the next temperature threat
Hi Robert. You mention "dev partner." What does that mean? Are these people co-founders or just software developers helping you out? What's your definition of a "partner?"

You also mention, "After the first phase, seeing the potential of product #1, they want a royalty instead ." Why is that? This tells me that at one point they were fine with developing this at a reduced cost plus some equity. But after seeing first phase they want to switch to reduced fees plus royalties.

In my mind, if you're paying them to develop the code (at a reduced price) plus giving them royalties, they're not really a partner, but a hired team that's agreed to change their payment terms. But a partner to me would mean that they believe in what you're doing and want a piece of the action - equity.











Mike Moyer
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Mike Moyer Entrepreneur • Advisor
Managing Director at Lake Shark Ventures, LLC
In the Grunt Fund you would calculate Theoretical Value of a royalty is two times unpaid royalties. You can be a little more generous with the equity amount if the vendor allows you to pay in equity because you can conserve cash. If he insists on cash I would push for a lower rate.

Here is an article I wrote on the subject of royalties:http://www.slicingpie.com/the-idea-premium/

Robert Clegg
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Robert Clegg Entrepreneur • Advisor
Game Based Learning Expert
Thanks everyone. Here's another comparable I found helpful in thinking about this, a finder's fee. In essence the company is raising money so it would look for various ways to do that. An alternative way to do that is with a finder. And those finder's fees are readily published, within a range of course.

I've seen the Lehman formula at 5% of the first 1M, 4% for up to 2M... down to 1% of a 5M deal and higher. Finder's sometimes cover expenses as well up front (that's the tricky part).

So, if someone could just raise the money for your project, those would be the fees. But it's not that easy, and those up front fees can run you 5k a month sometimes depending on whom you are dealing with (financial consultants, business plannner/plans, etc)

So in essence, you have individuals that not only have skill in making what you have happen, but believe as well. So I'd use the Lehman formula as a minimum baseline to begin calculating a royalty and look to provide a little kicker/incentive beyond that.

Advantage being that at the end of the production sprint you at least have a product not just business plans and hypothetical financials.
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