Should Your Startup Give Performance-Based Warrants? - 22 March 2010

http://www.businessinsider.com/should-your-startup-give-performance-based-warrants-2010-3

By Mark Suster

Business Insider

 

Large companies can be strange sometimes.  As startup entrepreneurs
we all want to work with them because having their name as reference
clients makes it so much easier for marketing, PR, selling to other
customers, fund raising and even recruiting.  Plus, we’re all allured by
the false sense that our contract with BigCo is going to “make us”
because once they start using us it will spread like wildfire and the
revenue will flow in.  Sometimes it actually does.  Usually it goes more
slowly than we hope.

But I say they can be strange because of their behavior in working
with startups.   I’ve observed the following scenario in both of my
companies and in countless others I’ve advised or invested in:
-
your company becomes moderately high profile in a few press articles

- BigCo calls you to review your product and decides they want to use
you
- They negotiate a “master agreement” to work with your company
with some maybe minimum guarantees in terms of revenue
- Somebody
high up in the company reads the agreement and says, “if we’re going to
work with these guys and make them successful then we better share in
the upside.”
- What they mean specifically is ownership in your
company.  I’ve heard the following so many times that it still makes me
scratch my head, “if those guys are going to get rich off of our backs
then we’re going to look like fools if we don’t have equity.”

Why I say this is strange is that with the exception of a few
outliers (YouTube, Salesforce.com, etc.) the economic benefits to BigCo
never warrant all of the time and effort they put into getting a stake
in your company and trying to make that stake worth money.  For most
BigCo’s I think they’d be better off just having a normal commercial
relationship with you at an arm’s length transaction.  But I’m not going
to change that, so if they want to share in your success how should you
deal with it?

I’ve already made clear that I think raising equity from “strategic money” is an oxymoron.
 If a company wants to invest in your company and you haven’t read that
post please do.  I make exceptions for companies with proper venture
capital funds that are mostly autonomous like Comcast, Disney
(Steamboat) and Intel Capital – all of which are great funds.

So Plan B for many BigCo’s is to take “performance-based warrants.”
 The following is a guide to what these are, whether to offer them and
how to structure them.

What are Performance Based Warrants? A “warrant” is a
right, but not an obligation for a company to buy stock in your company
at a future date and at a pre-agreed price.  Think of it as similar to
an employee stock option.  Simplistically, if your company is worth $5
million and you have 5 million shares worth $1 / share they might get a
right to buy 250,000 shares (5%) at $1 / share with an expiration date
of 4 years hence.

What is a “performance based” warrant?  It’s one in which the company
must achieve a milestone in order to actually own the warrant.  Let’s
say you give a warrant to a channel partner to sell your product.  In
the above example you might say that the channel partner earns 25,000
shares for every $100,000 of your product that they sell in the next 12
months with up to a cap of 250,000 shares.  In this example if they sell
only $10,000 in total in year one they own zero warrants the same way
that an employee with options who quits after 6 months usually owns no
options when they leave your company (due to the cliff period in most
vesting programs).

Should You Offer Them? Often the reason that
startups offer performance-based warrants (PBW) is because they’re asked
to.  You should think of PBW’s in the same way as you think about
employee options – they are an incentive for an important partner in
your business to help you achieve success over time.

In the early days of your company they can be an important way to
motivate your partner to achieve objectives that are jointly agreed.  If
those objectives would make your company substantively more successful
then you should be willing to allocate small amounts of warrants to your
partners but they need to be based on achieving real results and they
need to be for small amounts of ownership.  You obviously also need the
consent of any investors you have.  Future investors aren’t likely to
mind that you had a PBW program because the dilution will be taken
before they invest.

How Should You Structure Them? So let’s think first
about employee options and how they can be similar to company warrants.

Early in your company’s evolution, high-potential individuals take a
bigger risk to join you so you’re more liberal with your allocations to
them.  Having a few high-potential individuals determines your success
trajectory more in the early stages.  Same with PBW’s.

The more senior the person is the more likely that they’ll have a
substantive impact on your success so the more options they get (and if
they’re senior the more options they’ll want in order to join).  Same
with partners who are able to have a huge impact on your potential
success.  The reason you have vesting is so if the employee leaves early
and you didn’t get the full value you were expecting you didn’t have to
part with all of the shares that you allocated to them.  Every share
option you allocate to an employee is dilution both you and your
investors face so they shouldn’t be allocated lightly.  This is why
company warrants should be performance-based, too.  Like an employee if
they provide value they get value.  If they don’t provide value, they
shouldn’t walk away with value.

Guidelines:

1. Make the warrants tied
to objective measures.  Best if it can be revenue goals but if
not find another objective way of measuring

2. Make the warrants time
based. It is usually best if they earn the warrants over time.
 If you simply to a revenue number (say hitting $1 million in sales) and
they hit it in year 1 then you’ve lost your carrot for year 2.  I know
all the arguments for rewarding them hugely in year 1 one when it
matters more like having an uncapped sales bonus, but I think it makes
more sense to earn them over a 2-3 year period to keep them focused on
milestones for a longer period of time.  While I’m a huge believer that
sales bonuses should always be uncapped, I think capping PBW’s is a good
idea.  Example: you allocate 4% in warrants to channel partner ABC.
 They earn 1% in year one for hitting $200k in sales, 1% in year 2 for
hitting $500k in sales and 1% in year three for hitting $1.5 million in
sales.  You hold back 1% for the end of year 3 if they hit cumulatively
$2.2 million in sales (e.g. a chance to earn back some warrants if they
missed their year 1 or year 2 targets).  Numbers obviously have to be
right sized for your company.

3. Make the numbers
achievable.  If you bother having a PBW program assume that
you’re going to give out the warrants in the same way that you assume it
for employee stock options.  There is nothing worse than having a
partner 6 months into the deal who realizes that the goals you set are
not achievable so they stop trying.  If the goals are achievable but the
partner isn’t performing you have a “carrot” to use in difficult
conversations.  If the goals are unrealistic you’ll end up renegotiating
them or they’ll have no meaning.

4. Have minimums but a
sliding scale. Like sales programs I’m not a fan of an “all or
nothing” figure.  If 1% of your stock for year one equals 50,000 shares
then you might give 10,000 shares when they hit $50,000 in sales and a
sliding scale between $50k-$200k.  You might allow them to “pre earn”
some credits for year two but I still feel that it’s best not to let
them earn the whole amount in year one.  My rationale is simple.  In a
sales program you want your rep selling as much as possible as quickly
as possible and any bonus payments will have a significant impact on
that person’s earnings.  If it’s a big company earning a small stake in
your business they shouldn’t feel too disappointed if they hit $400k in
year one but only got 1% of your company (plus maybe 50% of those sales
count as a credit on their year 2 target).

5. Have a regular meeting
with a senior sponsor to go through objectives. The whole reason
for PBW’s is to drive incentives of a partner or customer to help you
succeed.  I strongly recommend you set up a quarterly meeting with a
senior team of this partner to discuss how they’re doing against their
targets.  It’s basically an excuse for you to have a regular meeting
with your customer.  I see the PBW as a good excuse for them to want to
have the meeting.  Your broader goal is about how to make the
relationship work better.

6. Make the warrants for
common stock and not preferred stock.  This is the same as with
employee stock options.

Common Mistakes

1. Giving free warrants – There is not reason to give customers or
partners free warrants.  If they value your product / service they’ll
buy it.  If they don’t value your product / service they won’t.  You
could use the same argument to say, “why give performance warrants
then,” and to that I’d say, “I can’t argue with that logic.”  I think
PBWs are stupid because they very seldom are worth much money for the
company that gets them yet it makes them commit to more than they
otherwise might without them.  As a result, with the right partner and
right structure they can be effective.  Just don’t give them free.

2. Subjective warrants – I also see warrants given out without hard
metrics.  Things like introducing us to clients, they help us close
partnership deals where there is not revenue attached, etc.  I believe
that PBW’s should have hard metrics.

3. Unrealistic warrants – Many entrepreneurs create complicated or
unrealistic warrants structures.  Like unrealistic sales targets these
can create more tension than no program at all.  If you set up a PBW
program assume your partner will get most of what you allocate for them.
 You want them to earn.  Don’t go in with the opposite mentality.

4. Too many warrants – I also see many entrepreneurs who are quick to
hand out warrants to just about anybody that seems like they’re going
to add value.  I recently saw a company that gave 4% options to their PR
firm because “it was going to ‘make them’ early in a crowded market and
this PR firm was ’super connected.’ ”  The PR firm actually didn’t do
badly but 4% was a lot of dilution.  The startup argues that they did
free work so they saved cash.  I can’t argue with that, but just be
careful.  This same company then looked to get a channel partner on
board and that company wanted 5%.  You can see how stuff adds up
quickly.  They’ll never really value the options enough to make it worth
your taking huge dilution.

5. Strategic equity – Bad idea.  They seldom help as much as you
want.  Already covered the topic here.

Anyone else have positive / negative experiences with
performance-based warrants?  Anyone have structuring tips?

Mark Suster
is a former entrepreneur and currently a partner at GRP Partners. This post was originally
published on Mark's blog, Both Sides of the Table.
It is republished here with permission.