Pricing - equity and profit share
Welcome to the fifth and final article in my pricing series. Previously I’ve discussed Fixed Price, Time and Materials, a Hybrid combination of both, and Value based pricing.
For this last article, I talk about two mechanisms that, whilst not a pricing method by themselves, usually impact how a project is priced. That is, taking an equity share in a client project, and taking a profit share in a client project.
When an agency takes equity in a project (shares) or takes a profit share in a project, this generally means that the project is developed at a discounted price (or possibly even for free).
You as the development partner directly take on some of the risk, because if the project doesn’t meet financial expectations then you may be out of pocket, or may not make the profit you’d hoped.
However, if the project exceeds expectations - it can be a very lucrative arrangement.
What is an equity share? 🤔
“In investing, what is comfortable is rarely profitable”
– Robert Arnott, Entrepreneur
An equity share is where you are given shares in the business. In an agency or freelancer model, this would generally be in return for a discounted development cost.
For example, a startup developing a “Facebook for Dogs” may offer you 10% equity in their business, if you agree to develop their MVP for a discount of 50%.
In the above scenario, if it was a $50,000 project, then you would only charge $25,000 and in return, they would give you 10% of the total shares of the business.
You would only see money from these shares if:
- The business distributes dividends
- The business is acquired (sold)
- The business IPOs (goes public)
- You sell your shares to someone else
With dividend payments, you are not selling your shares, but the company is choosing to distribute its profit to its shareholders. This is a very common method for founders to pay themselves and get cash out of the business. However it’s important to note that companies can decide to never distribute dividends, and simply reinvest their profits into the company (and founders pay themselves a wage instead).
This means your equity might not turn into money for a long time (or ever) so it’s a gamble.
For an equity arrangement you definitely need a contractual agreement in place, and both parties will need lawyers.
As with any investment, you should also be kept informed about the business performance. You should receive regular updates from the business letting you know how they are tracking compared to their goals, their current financial situation etc.
So there are certainly some things to think about before taking on an equity share and offering a reduced price for the build.
What is Profit share? 🧐
“Nobody ever lost money taking a profit”
– Bernard Baruch, American financier and statesman
For a profit share arrangement, you come to an agreement with your client that you will receive X percent of the business profits for Y number of years (or forever).
Similar to an equity share, this would generally be in exchange for developing the project at a discounted rate.
For example, a startup developing a “Twitter for Birds” product may offer you 25% of their profit for the first 5 years if you agree to develop their MVP for a discount of 50%.
In the above scenario, if it was a $50,000 project, then you would only charge $25,000. And you would then have a legally prepared agreement stating that you are the receiver of 25% percent of all profits the company sees in the next 5 years.
In one way profit share is similar to an equity share, in that you could receive money if the company realises a profit.
However, startups often reinvest profit back into the business when they start making money (for running costs or hiring more staff). Or often raise the founders' salaries to make up for the early years of less income - and all this means there may not actually be any profit to share.
The other downside compared to equity is that profit share is usually for a fixed timeframe (e.g. 5 years), and if in that period the business has a liquidity event such as an IPO, you can’t sell your shares because you don’t actually own any.
Like equity, you definitely need to get a good lawyer to guide you through this process and balance what you want out of the deal with what is on offer.
You also need to be kept informed about the business's finances for the length of your profit share, and regularly see the profit and loss statements of the business - keeping an eye on your investment.
Benefits of an equity or profit share 👍
- Possibility of making more money (possibly significantly more) than just developing the project for a set cost
- Could allow you to build a portfolio across many different clients and industries
- The possibility of being more involved in the project as you have an ongoing financial stake
- The possibility of more ongoing work now that you have a financial relationship
Negatives of equity or profit share 👎
- You need to thoroughly understand the business plan and the people who will be carrying it out. As you are putting a lot of trust in them meeting expectations.
- If the project does not meet financial expectations, you will never recoup the money that you discounted
- Being “in bed” with your client at this level could put undue stress on the relationship. E.g. you blame lack of sales and marketing as the cause of the financial issues, whilst they blame the technology you developed
- You are gambling cash-in-hand for a future payout. This could potentially cause short-term financial strain (payroll, your own scaling issues etc).
- You are relying on the company actually realising profits, which they may not if they just reinvest in the business, staff, more products, or larger salaries
- With profit share, a liquidity event may not happen soon (or ever), so your money may be tied up for a very long time
My experience with equity and profit share 📖
“Opportunities are like sunrises. If you wait too long, you miss them”
– William Arthur Ward, Motivational writer
I was offered profit share quite a bit, especially in the early years when my agency was working on a lot of startup MVPs.
I understood how it was beneficial to the client, as it was an easy way for them to save valuable money up front and offset their risk. But for me, I’m slightly risk adverse and it seemed too close to gambling for me.
I was involved in startups before starting my agency. I was a frontend lead for a startup that built an amazing product, went from 5 people to 50 people very fast, and then imploded.
I then founded my own startup with some friends, worked really hard, went through a prestigious accelerator, and then fizzled out because we could not find product-market-fit before our runway ran out.
So I know that the real hard work comes after the product is built - when you ask people to open their wallets for you.
In all the times I was offered profit or equity share, it was from founders who I didn’t know very well. And if you look at these two arrangements as going into business with someone - then I would never recommend going into a business with someone you don’t know very well.
For this reason, I kept my client relationships simple and chose not to have my remuneration tied to their possible future profits.
I certainly wanted them to be profitable and did my best to help with that, but I didn’t do it because I needed that money back. I did it because I believe that’s what running a good agency is all about.
Having said that, if it was someone I trusted and knew well, or someone I had total faith their project would be a financial success, then I would consider taking on equity or profit share for discounted development.
Never say never, otherwise you are closing yourself off from many opportunities.