If you’re a contractor working with startups, you can be a venture capitalist.
(pause for impact of sweeping statement…)
But seriously – as a freelancer, you’re in a unique position to be an investor, by virtue of your skillset and the types of clients you might choose to work with. This varies depending on your niche, and is particularly true if you work with greenfield apps, for startups – because you now have the ability to choose how you get paid by your clients.
HOW can freelancers become investors?
If you’re working as a freelance software developer for a corporation, you’re out of luck – cash payment is probably your only option.
But if you’re working with a startup, things can start to get interesting. And if you’re in a position to take some calculated risks, they can pay off really well.
You might be thinking, “But I can’t afford to invest right now – I’m just trying to pay my bills.” Here’s the thing: some of these models give you the flexibility to invest just a little bit of your time – and even that little bit can pay off A LOT in the end. So don’t write it off quite yet.
Heads up: There are 5 things you CANNOT forget to do if you go with any of the models below, so stay tuned for our post next week.
Model #1: Full Equity Compensation
When Dan started his first agency, he and his buddies took projects only for equity compensation. Basically, they would isolate a business problem, create the technical product, and recruit their friends (!) to quit their jobs and run the company for a set equity stake.
While handing off a business to your friends is a little atypical, it’s fairly common for early stage startups to pay contract developers in equity (because they don’t have a lot of cash).
There are some pretty obvious pros and cons to this approach:
- Pro: 10 years later, we have investments in several companies that are still viable, and poised to make sizable exits at some point.
- Con: Dan made no money for a year. This was frustrating (*ehem*). Make sure you have a spouse or partner who can bring home the bacon if you do this, or have a stockpile of savings to live off of. Also, these investments may or may not pay off, so this is a real leap of faith. You have to reallllly believe in the business and in the team.
The upside of full equity compensation is that you can typically get way more equity per unit of time than other options. You’ll probably end up with more equity in the projects you work on than FT employees and even later stage investors (especially if you’re coming into the project in its fledgling state).
How much equity should you ask for? Like I mentioned above, it really depends when you get involved. If you come up with the idea, recruit a friend to work on the business and then peace out, you’re in a position to get a fair amount (think ~5-15%). In other situations, you can probably swing anywhere from 1-5%.
Of course, it also depends on the scope of work involved for you, but any of these options provide a lot of equity for the time you invest.
Model #2: Convertible Equity / Safe / KISS
While full equity gives you insight into your piece of the pie right off the bat, sometimes it’s nice to know that your investment directly correlates with the amount of work you put in.
If that sounds appealing, you might want to consider accruing the time you work with a startup towards the value of a convertible note.
What it is
Basically, a convertible note is an agreement that gives you the right to acquire shares in an entity upon some “convertible” event.
Usually, this “event” is when the company sells shares of preferred stock in a priced round, but it can also manifest as a time-based conversion (see #4 below).
So why should you consider this (or not)?
- Pro: Founders like convertible notes because they give them breathing room – which makes it easier for them to say “yes”. With a note, a startup doesn’t have to commit to a predefined/arbitrary valuation (in our experience, trying to agree on this can quickly derail a negotiation).
- Pro: You, as the investor, have the flexibility to quantify what your services are worth, and assess whether you’re comfortable with the size of the investment you’re making at any point in the project. You’re being compensated for every hour you work, and there’s no binding agreement to complete an MVP. If you believe in the project, the equity you’ll get by working more is a great motivator. And if you aren’t feeling motivated, it’s time to either move on or re-negotiate.
- Con: Because you don’t know what the valuation of the company will be when they fundraise, you can’t calculate what your equity stake will be. It could end up being 0.25% or 5% — there’s just no way to know. But it’s also a little subjective at this early stage, because if you pick the next Google, you’re going to make out like a bandit no matter what.
If you’re working with family or friends, notes are a great option.
They can be great motivators in situations where you aren’t comfortable with money changing hands (e.g. you’re doing an act of service for a friend, but they want to make you feel valued for your time). We did this recently with my cousin, Abby, to help her launch her NYC-based jewelry company, EACH Jewels.
How it works
When we structure a convertible note, we typically inflate our hourly rate to account for the risk we take here (because there’s always a chance we won’t see a return on our investment).
So if we typically charge $100 / hour, we’d charge at least $200 / hour to accrue towards a convertible note.
Practically speaking, if we work 200 hours on product, we’ll get a $40,000 note in compensation. If a “convertible event” (e.g. funding round) takes place, that note then converts into >=$40k of equity (the exact value will depend on the discount rate, which depends on the terms of the round).
There are lots of “open source” convertible note versions floating around the Internet, but we recommend Y Combinator’s safe (simple agreement for future equity) if the company you’re investing in doesn’t already have a prepared version from their legal counsel. We also recommend you work with Clerky to write up the paperwork if you don’t already have a copy reviewed by a lawyer.
500 Startups also has their own version of a convertible note, which they call a KISS (“Keep It Simple Security”). If you decide to use it, we recommend you use the equity version (again, we’ll get the “why” of this later).
As mentioned before, a big catch with notes is that they may never convert. In this case, note holders are usually the first to be repaid. YC explains this in their SAFE Primer:
What happens to a safe if the company shuts down and goes out of business?
In a dissolution, any money that the company has to distribute would be distributed to safe holders before any money is allocated to holders of common stock.
So while convertible notes are still an investment, the risk is mitigated a bit more than with pure equity compensation.
If you like the idea of getting a little more ROI for your time, but using notes by themselves feels too risky, check out Model #3.
Model #3: Convertible Equity with Cash Cap
You want to invest in a company you’re working with, but you also have bills to pay.
One solution to this that we’ve used with great success is to give founders the option of capping their cash investment at a certain threshold (e.g., $50,000), and then applying accrued hours over that threshold towards a convertible note.
- Pro: This model incentivizes everyone involved.
- You, the programmer, know that you’ll get paid a predictable amount of cash for the work you’ll do up front. And once you pass that cap, you’ll reap all the benefits of a convertible note (with a team you know is reliable since they’ve already paid you cash).
- For the founders, they get line of sight into their budget for the first round of development and can plan accordingly. And after that point, they’re assured that you’re now a stakeholder and essentially part of the team.
- Con: Same as a general convertible note, but mitigated by the up-front cash payment. You’ll likely end up with less equity though, since part of your payment is in cash.
Model #4: Convertible Debt (i.e., convertible note with time-based conversion)
This is similar to models 2 and 3, with one important difference. If the startup doesn’t receive funding or get purchased within a certain timeframe, they are legally bound to pay you in cash, at your standard hourly rate (or whatever you negotiate).
- Pro: You have some degree of protection if the startup never raises a round of funding — it’s theoretically the best of both worlds (security of cash, potential upside of a convertible note).
- Con: If they don’t raise a round, you don’t reallly have a guarantee that they’ll pay you. If they’re depending on raising that round to stay in business, they may not make it. This, of course, is a risk any time you work with a startup, so if you’re comfortable taking them as a client in the first place, this shouldn’t be too much of a concern
Note from Dan: We don’t recommend this arrangement, and here’s why:
Let’s examine two scenarios:
On one hand, let’s say the company you’ve invested in is blowing up. They’ve hit product-market fit and they’re making so much money that their bank is blocking their check deposits. In this case, you’ll get your money back, sure, but at the expense of a chance to make an incredible investment.
That’s pretty silly. You might as well have just taken the cash from the get-go.
On the other hand, the company you invested in is currently struggling, and can barely pay its existing bills. In this case, they just don’t have the money to pay you back, so your agreement won’t mean much anyways.
Ticking time bombs like debt repayment can also be a large source of stress for founders. Startups are stressful enough as-is. </dan>
Model #5: Revenue-Sharing
We recently had an anchor client (a longer-term project that gives us some stability to take risks elsewhere) who wanted to create a new line of business based on apps. Now, they already had a very successful core business selling their product in paper form—and because of that, they didn’t want to give away any equity.
What does a revenue sharing agreement entail? Well, in our case, we were guaranteed to receive 100% of all revenue, up to a certain dollar threshold (let’s say $10,000), and a percentage of all revenue after that (let’s say 10%).
But they did want a partner who had “skin in the game”, and would be invested in their success, long-term. So instead of an equity model, we created a revenue-sharing agreement specifically for the apps.
So if the line of business brought in $20,000 of revenue in a given month, we’d make $12,000 (first $10,000, plus 10% of the subsequent $10,000).
Here’s a quick summary:
- Pro: By guaranteeing a certain chunk of revenue, we had assurance that we’d be paid for our work (given the other party did their part 😉 ).
- Pro: By giving us a percentage of all revenues after that threshold, our partners kept us motivated to give the product our all, since the sky was the limit on how much we could ultimately make.
- Con: As with any equity agreement, there’s an element of trust here. If your partner doesn’t hold up their end of the bargain (e.g. sales), you may not make very much at all.
- Con: There can be a pretty significant up-front investment of time to get the product off the ground. This model is not one that allows for much flexibility in terms of the time you’ll need to put in – it’s basically all or nothing (though there’s room to negotiate on how you get paid).
The beauty of working on new projects is that you have a lot of flexibility to design the compensation that works for you. And, in the case of startups (and a lot of small businesses), alternative models for compensation are really attractive because they want flexibility too.
The 5 examples above are all models we’ve used successfully. You can pick and choose pieces of each to create something that works for you. I’m sure there are more creative strategies that would work great. It’s just that no one has thought of them yet.
One recommendation: Find a lawyer who specializes in contracts for startups, and have them review whatever you sign. There are a LOT of nuances when it comes to equity and partner agreements, and you want that you’re protected. (Obligatory disclaimer: Please consult an attorney if you’re going to pursue an equity arrangement. The App Hacker does not assume any responsibility for any consequence of using any document mentioned in this article.)
Note: if you’re going to take equity in a startup, there are 5 things you MUST know about alternative compensation (on the blog next week).
So sign up for our email list, and stay tuned. 🙂
Have you tried any of these approaches to compensation as a freelancer or agency? Tell us about your experience! What worked / didn’t work? Comment below or email me at firstname.lastname@example.org.