If You Provide a Strategic Technology or Outsourced Service, Consider Taking Some Equity in Your Fee Structure

I remember the mid to late 90′s well.  Everyone was high on the hog and sniffing Internet glue.  Kids that couldn’t even shave had a paper net worth in the millions, if not billions in some cases.  And some of the most ridiculous deals of the century got funded.  The atmosphere was such that everyone believed they had a billion dollar idea and everyone else was looking for a way to share in it.  If you had a venture backed start-up, your dry cleaner probably offered you a reduced rate in return for some stock options.  Almost every bank, accounting firm, law firm and company that provided a technology or a service was looking for a warrant or the ability to swap some fees for equity.  Some made out wonderfully.  I read that Venture Law Group turned a $15,000 investment in client XYLAN Corporation into about $990,000 in under two years.  In 1999, Venture Law Group’s equity investments apparently generated $30 million and in the next year, $100 million.

Then 2000 came, the Internet bubble popped.  Lots of groups took a bath on their equity and had nothing to show for it since they had swapped out actual fees for the potential to earn much more through equity.  Taking equity in clients faded.  Some viewed it with the same hocus pocus as they did the Internet financing wave itself.  During the next few years it was tough to find start-up and emerging growth financing but it slowly came back, as it always does.  However, those providing technology or services no longer spoke of taking equity in clients.  Having bad memories of the bubble fallout, people were happy with just collecting their usual fees – completely gun shy of having some skin in the game.

Well, I think it’s high time to bring back the equity concept in smart and selective ways.  I think the timing for this is ripe because the landscape has changed significantly over the past few years and companies (for simplicity, we’ll call these guys the “service provider”) are more, now than ever, providing critical technologies or outsourced services to their clients (the “client”).  Some of these services may actually increase the client’s valuation.  Clients large and small look to license a technology or outsource certain services for a number of reasons.  Large clients like to do it because they try to pass on costs and headaches to someone willing to do it for less than it can be done internally.  Small clients, on the other hand, do it because they generally cannot afford the critical mass internally to build something that may only be a feature in their overall product or service offering.  Licensing that feature from a service provider that built a best-of-breed technology may be not only a cheaper solution, but may also net the client a more fulsome product.

I am suggesting that service providers offering these strategic technologies or outsourced services to emerging growth clients need to start considering equity as part of their fee structure.  Otherwise, you run the risk that the client at some point sells its company and walks with the premium value you provided and all you are left with is a few previous years of market level fees.  The purchase price included some value attributable to the service provider’s technologies or services but the service provider received nothing for it.

Take the examples provided by Michael Arrington in his September 2009 post on TechCrunch.  I think they prove out my point.  In it, he describes how “YouTube was just a pretty front end to the core Flash web video technology created by Adobe.”  YouTube was later bought by Google for $1.65 billion.  Adobe’s take – $0.

An even more recent example – Mint.com.  This Internet darling was sold for $170 million in cash to Intuit.  Like YouTube, Mint.com built a great user interface which effectively sat above core technology provided by Yodlee.  Mint licensed the technology from Yodlee and over the course of 2 1/2 years Arrington surmises that Yodlee made about $4 million or so in fees off of Mint.  Not bad, I am sure.  Mint apparently never thought to ask for some equity despite the role their technology would play in Mint’s business model.  In fact, Fast Company quotes a Yodlee Senior V.P. as saying “[i]t would be highly unusual to ask for equity from any of our customers.  And with start-ups, we’d rather have the money.”  Then Mint was sold to Intuit and Yodlee got nothing out of the deal, despite the fact that their product represents some of Mint.com’s core technology.  Granted, Intuit may keep Yodlee’s license in place but my guess is at some point Intuit will replace Yodlee’s technology with its own, thus ending Yodlee’s fees.  Compare that against the company that sold Mint its domain name – they took Series A stock as payment.  According to Arrington, that stock was worth a couple of million dollars as a result of the Intuit deal.

It’s not right for every deal, but if your technology or service will form the basis of a client’s business model, think about taking some skin in the game and hopefully some day you reap an appropriate reward for the value you provided to your client and in helping them exit the business for a great multiple.  Maybe you’ll even get to keep your licensing agreement in place with the new owner – icing on the cake!

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