- 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.
