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Risky Business


A new way of thinking about the nature of compensation between businesses is promising to transform the relationship between service providers and their clients as the century draws to a close.

It's an idea espoused by a visionary breed of business owners who see its central tenet -- the exchange between companies of work for equity -- as an important step in the quest to unleash creativity and build enduring wealth for their companies and employees. In this model it is stock -- not cash -- that emerges as the catalyst for creating value.

"Venture design" refers to an arrangement whereby a business forgoes all or part of its normal fee for an equity stake in a project or a company. The assumption is that shared risk will draw intensified efforts from all players, thus ensuring a venture's ultimate success and profitability. A hot topic among professional service providers such as consultants, lawyers, designers, and public-relations specialists.

Lunar Design -- profiled by Inc. senior writer Edward O. Welles in April 1999's cover story, " How to Get Rich in America," -- calls this principle "venture design." When circumstances warrant, the industrial designer forgoes cash compensation and instead offers its expertise -- and that of its homegrown network of business experts -- in return for stock in a client's budding idea or start-up company. The hope? That "a dollar in equity taken in exchange for services rendered could someday multiply into $5, $10, or even $20," writes Welles.

Venture design clearly has the potential to add some serious sizzle to a company's earnings statement. But not every business will profit from taking stock in lieu of cash, cautions Karl Ulrich, a professor of product development at the Wharton School at the University of Pennsylvania. Ulrich, one of Lunar's virtual advisors, outlined the attendant risks of this new business model in an interview with Inc. Online's Mike McLoughlin.

Inc. Online: What types of companies are most likely to reap the benefits of venture design?

Ulrich: My basic sense is that it works for either very small or very large service companies.

It often works very well for one- or two-person firms to take equity in lieu of cash ... if you have skills that are in enough demand that you can really be paid market rates for them and you can keep your overhead real low. These companies can use the balance of their time for venture-related activities.

Larger companies of 40 or more professionals can get away with it because they can earmark 1% or 2% of revenues for venture design and still have that be a significant sum, while not subtracting too much from the basic business model.

The problem would be if you were a firm of say, eight or nine people, where 1% is not really enough time to do anything substantial, and yet to devote 10% really puts your business at risk.

Inc. Online: Are there any specific industries that can use venture design?

Ulrich: There are certainly some industries where it's more common. Two examples are furniture and toys. But I can see it working in a lot of industries.

It makes the most sense to me when the design aspect of the overall effort is really important and the designer is making an important contribution to the final product. If you are the client company, you want to choose projects where there's going to be a good reason for the design firm to have equity. You want the designers to have skin in the game -- to have a big incentive to do a great job where it is going to make a real difference to the commercial success of the project.

Conversely, if you are the design firm or other service provider, you don't want to enter into a relationship where your contribution is not material to the success of the product.

I don't think it makes very much sense to do it unless the service is integral to the success of the venture. For example, it doesn't make sense to exchange equity for janitorial services. No matter how well the janitor cleans your office, it doesn't make you more or less likely to succeed. And just because the janitor has stock in your company, that doesn't make him want to clean your office any better.

On the other hand, if you do e-commerce and your Web designer has stock in your company, that designer is going to think more about how to make it easy to use that Web site than how artistically perfect it is. And that's what you want that person thinking about. There, it makes sense.

Inc. Online: How might this affect the culture and management style of the company?

Ulrich: I think there are definitely some cultural and organizational factors that matter. You want this to be out in the open because in professional service firms compensation is tied very directly to profitability. If people think that the management of the firm is diverting resources toward crazy schemes, there are going to be incentive and morale problems in the organization. I think this is the kind of thing that should really be done by consensus of the key professionals of the firm so everyone knows what's going on and agrees on the basic strategic direction the company's taking.

Inc. Online: So, when does it make sense for a company to begin thinking about swapping work for equity?

Ulrich: Let's assume we're talking about larger companies and not the one- or two-person operations. If you have a company of 20 professionals, then you probably have revenues of something like $2.5 million per year. If you take 1% of that, it's $25,000 worth of services. That's just about enough so you can have a significant stake in a new venture if you invest in one of them -- a $25,000 project that you would do for someone in exchange for equity. Below [the 20-person threshold], you're either having to invest more than a few percent of your resources, or you're not able to ever devote a big enough chunk to be able to have a substantial impact on the project.

Inc. Online: What are some of the questions a company should ask itself about a deal, or ask a client, before entering into a venture design deal? Is there a due diligence process?

Ulrich: You should ask the same questions that any savvy investor would ask about a new venture. The basic ones that I would ask are:

  • Is the market real?
  • What's the market size and the market growth rate?
  • Does the technology work, or is it likely to work in meeting the needs of the customers in that market?
  • Does the team have the skills, attitude, and resources to make it happen?
  • How will you cash out the equity?

That's what a venture capitalist will ask. The other thing you're looking for is you want to make sure that the valuation -- the amount of equity that you're getting in return for your services -- is reasonable. It's got to be similar to what the other early-stage investors are getting.

Inc. Online: How much equity in a particular company should you be asking for?

Ulrich: That's going to depend entirely on the situation. It would be pretty rare to be getting 30% or 50% of a company. That would mean that you're doing a huge chunk of the venture--and that's usually a bad sign. You want to look for ventures where there will be other investors. Other investors are the ones you're going to look to establish some credibility for the venture.

A new venture should probably be worth at least $500,000 and generally a million or more dollars. A design firm is typically going to put in tens of thousands of dollars worth of services into the project, so they would expect to be getting single-digit percentages in these kinds of ventures.

It would be different if it were a very, very early stage venture, but I think those are very risky. I think most people should shy away from those.

Inc. Online: What percentage of a company's revenues should come from venture design?

Ulrich: The revenue side is harder to talk about than the cost side or the investment side. What you want to regulate is how much of your company's annual capacity is being invested in exchange for equity as opposed to being on a fee-for-service basis. You want to be careful about how much you are investing in these kinds of projects. I think for most fee-for-service companies, it's a single-digit percent: 1%, 2%, 3%. ...

Inc. Online: ... Of your annual resources?

Ulrich: Think of it as your annual professional staff hours. If in three or four years you've managed to generate some big returns, you may choose to reinvest those resources to do more of these projects. But that's a problem you'd like to have to deal with, right? The harder thing is controlling the amount of the input that you apply.

Inc. Online: What is a warning sign that you've overcommitted too much of your resources to venture design?

Ulrich: Profitability. That's the one thing I'd look at. Are you still profitable at a reasonable level? Are you able to pay out bonuses to your staff that are roughly competitive? If you can't do that, it says that either there's some other problem with the business or you've invested too much in nonrevenue-producing activities.

Inc. Online: At what point are these equity stakes turned into cash?

Ulrich: As soon as possible! But the usual timeline on these things is pretty long. It usually takes four to seven years before a venture turns profitable.

Most companies enter into these deals with the assumption of cashing out in a liquidity event of some kind such as a public offering or the acquisition of the business by a third party. Of course, not every venture gets acquired or goes public. But if you own a 5% stake in a private company that's profitable, you have a claim on those earnings. So rather than a one-time payment, your equity stake might be an ongoing revenue stream in the form of a dividend to shareholders.

Inc. Online: Where do the profits go?

Ulrich: You can plow them back into the activity, or you can pay them out as bonuses or dividends. I would think you'd do a little of both.

Inc. Online: Is a large portion going to be invested into more venture design projects?

Ulrich: That's going to really depend on the company philosophy and on the appetite of the employees to do more of it. It's not a very steady revenue source. Let's say you get a $400,000 return on one of these projects. My gut feeling is that it would be smart to pay out some of that in bonus and dividends but that you would probably also reinvest some of it [in venture design].

Inc. Online: What is the main reason someone should choose equity over cash on a particular project?

Ulrich: The reason a service provider would enter into one of these agreements is that you believe that by doing a great job the client company is more likely to be successful. Therefore, you want some upside.

It's important to ask yourself two questions: "Is what I'm contributing going to materially influence the outcome? Can I really make a difference here?" When you can answer both of those questions in a positive sense, then I think those are the projects where taking equity makes sense.

Inc. Online: Do you have a checklist that companies should run through before they make venture design a part of their business mix?

Ulrich: I would ask: Is our current business model healthy? Do we have some surplus that we can invest? Do our professionals have an appetite for doing some of this? Are they willing to forgo some portion of their bonus and/or work some extra hours in return for equity in these projects? Which projects should we invest in? Is it a good deal from a standard investment perspective? Can we make a difference?

Inc. Online: Any cautionary advice about using venture design?

Ulrich: It's extremely risky. You should think about this as the "hopes and dreams" part of your business. This is not the bread and butter. You should not invest your parents' retirement fund in this kind of thing. Yeah, it might pay off, and it's fun, and it gives a kind of passion to the business, but it's not a reliable return. It shouldn't be a very big fraction of your real business.

Think of it like the 2% of your stock portfolio that's in crazy stocks. It's not the T-bills part of it.

Mike McLoughlin was a reporter for Inc. Online when this article was written. He is now the ad master for inc.com.

Last updated: Dec 20, 1999

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