How Should Corporations Get Paid For Helping Startups?
One of the top myths in our economy today is that startups and large corporations are enemies locked in an endless war. The conventional wisdom is that establishment entities prey on vulnerable entrepreneurs, or that ambitious upstarts disrupt obsolete dinosaurs.
In reality, startups and corporations can work together to disrupt markets, introducing new products and services to provide value to customers.
Of course, one way to do this is for corporations to acquire startups to form a single team. M&A represents a real commitment to work together, but in this model the startup is no longer independent. For a variety of reasons, acquisitions may not make sense while a startup is still small. So how can corporations and startups work together outside of an M&A transaction?
There are two main ways that corporations and startups can cooperate while remaining independent: 1) big companies can invest to provide capital and advice to help startups grow, and 2) corporations and startups can execute mutually beneficial commercial agreements, also known as business development deals. In many cases, these can be done together, pairing an investment and a business development deal.
Cooperation is in everyone’s best interest
A commercial transaction with a large corporation has the potential to create a step change in value for a startup. These deals can bring revenue, provide access to new customers, improve a startup’s products, and accelerate the overall trajectory of a startup’s growth. The “brand halo” of the large corporation alone can be a motivating factor.
For the corporation, deals with independent startups can facilitate entry into new markets, defend multi-billion dollar lines of business, and provide essential learning to prepare for disruptive scenarios. In some cases, these transactions can even create a pipeline for future M&A.
How to do it
There are five main deal structures for commercial relationships: licensing arrangements, supply chain collaborations, distribution agreements, co-marketing deals, and vendor purchases. Case study examples of these deals can be found here. Executing these deals requires experience, thoughtful planning, resource allocation, and a commitment to ongoing communication and management.
In my role helping corporations manage their innovation programs, I’m frequently asked how big companies should be compensated for helping startups with one of these deal types, and whether the corporation should receive cash, equity, or both. I use the following sequential framework to answer these questions:
1. Which direction is the value flowing?
2. Does the corporation have a venture capital investment in the startup, or is this a stand-alone commercial deal?
3. If the corporation is providing value to the startup, is the benefit sufficiently material to justify compensation?
4. If the corporation is providing material value, is there a preference for equity or cash?
5. If the corporation and startup agree that the compensation should take the form of equity, how should it be priced?
Here’s how to evaluate each step.
1. Which direction is the value flowing?
It may be easier for large companies to help startups, because bigger companies are more established. They likely have more employees, greater financial resources, and market power that newer companies rarely can match.
Sometimes a startup is helping a larger company, though. Maybe the startup has developed technology the corporation would like to incorporate as a component in a larger product offering. Maybe the startup has built an online channel that an established brick-and-mortar retailer would like to access. Maybe the startup has developed data analytics capabilities that could benefit the corporation’s core business.
If the corporation isn’t providing value to the startup, there is no basis for charging the startup. In these cases, the corporation should be paying the startup.
2. Is the deal stand-alone, or part of a larger relationship?
Corporations have limited resources to pursue commercial deals and can’t work with every interesting startup. It may be easier to convince a corporation to consider a commercial deal with a startup where there is already a closer relationship, like an investment.
Especially if the opportunity is a stand-alone commercial transaction, there should be a clear hypothesis about what value can be generated for each party. Unless the corporation has a dedicated business development team with a track record of quickly executing commercial pilots, these deals may take months to negotiate.
If the corporation has invested in the startup, however, there may be greater flexibility to move faster or consider options that wouldn’t be available to third parties. Exceptions may be easier to approve if a startup is already “in the family” of the corporate parent.
For example, suppose the corporation is a large CPG manufacturer with food scientists and “flavor labs” providing expertise in making food taste good. Theoretically, a corporation like this could provide consulting services to a startup to help improve the taste profile of novel products. Would such a corporation help a new arms-length startup this way, at any price? Probably not. But for a portfolio company that has received investment, this could be a possibility.
It’s important to understand whether the deal is something the corporation would consider under any circumstances.
3. Is the deal material enough to justify compensation?
A simple example of co-marketing includes a corporation with a bigger marketing budget providing trade show booth space for a startup. This is a benefit because smaller companies might not be able to afford any trade show floor space, and participating in the booth of a larger partner might generate better exposure than buying a tiny booth at the fringes of the expo hall.
Should portfolio companies pay for this type of marketing? The pro-rated portion of floor space occupied by a startup inside a larger booth might be worth a few thousand dollars, but this could be viewed as part of an overall portfolio company relationship and charging for this space might be considered “nickel and dime” — and not worth anyone’s time. On the other hand, if a large corporation agrees to sub-lease space at multiple trade shows over the course of several years, and the total value of the space provided is in the tens or hundreds of thousands of dollars, it might make more sense to consider formal compensation.
Try to discern whether the opportunity is a one-off favor, or something that rises to the level of materiality for both parties.
4. Is there a preference for cash or equity?
There are multiple reasons why corporations and startups might prefer payment under commercial deals to be equity instead of cash. Equity can include a stock grant, or warrants, which are the right to purchase stock in the future at a specific price. For the purposes of this analysis, warrants function similarly to employee stock options.
Startups generally want to extend their cash runway. Every dollar spent that isn’t immediately offset with revenue brings the startup one step closer to insolvency. Cash out the door usually means that the startup is raising that much more money from venture capitalists, so in many ways, paying with equity is what the startup is going to do anyway.
For the corporation, holding equity in a startup provides an opportunity to generate a greater return. $1M in cash from a commercial deal can be reinvested in the core business or paid as a dividend to shareholders, but it’s possible that a startup investment can appreciate faster.
For both parties, an equity relationship can create alignment and cause the corporation to care more about the startup and the commercial deal. If there is greater upside, and equity at risk, the bigger company may try harder if things aren’t going smoothly. Ownership sometimes breeds greater commitment.
One of the main reasons that corporations frequently choose not to be paid this way is an inability to value the startup’s equity. If the corporation doesn’t have an experienced venture capital team, evaluating whether the equity is a “good deal” may be intimidating.
Most importantly, both parties must agree on the preferred form of compensation, cash or equity.
5. How should equity be priced?
Unfortunately, there is no industry standard for how to price equity in these deals. While it is fairly standard for advisors and outside directors on a startup’s board to receive 0.5-2.0% ownership, there is no rule that says, for example, “help with FDA regulatory issues and get an extra 5–10% fully diluted ownership” — deal makers must price additional ownership by valuing the volume of services provided, and those services are typically very specific to the corporation. That uniqueness is what makes the corporate “ventures” team valuable as a partner for startups.
In my experience, these deals are often worth single digit equity grants or low double digits if executed at scale. Most entrepreneurs I’ve met don’t want to give away tens of points of ownership for commercial deals, otherwise they limit their own exit values.
The problem is that the economics of how to do these deals depends on two factors that are neither standard, nor predictable:
A) what’s the quantifiable value that the corporation is providing?
B) what’s the most recent valuation of the startup in question?
Let’s go back to the example of the CPG corporation providing flavor consulting services for portfolio companies, and assume for simplicity that the corporation charges $500k per product. Pricing should contemplate the “replacement cost” if the startup had to do it themselves, as well as the value created through the corporation’s expertise — hopefully better tasting products result in millions of dollars in revenue growth for the startup.
Now let’s say the CPG does this for PortfolioCompany1 and PortfolioCompany2. PortfolioCompany1 asks for help with 2 products, resulting in a bill of $1M. PortfolioCompany2 asks for help with 5 products, resulting in a bill of $2.5M.
The CPG could get paid in cash, but decides to help extend their portfolio companies’ runway, and agrees to receive equity instead. How does the corporation calculate the amount of equity owed? It depends on the valuation of each company.
If PortfolioCompany1 has a $20M valuation and PortfolioCompany2 has a $40M valuation, we can calculate the percentage equity due to the corporation providing the services. PortfolioCompany1 equity is worth 5% but the PortfolioCompany2 deal is worth 6.25% ownership.
What if PortfolioCompany2 asks for help with 2 products, resulting in the same bill of $1M to be paid by PortfolioCompany1? Because of the different valuations, the equity value in this scenario is only 2.5%. The corporation has provided the same exact service volume, but $1 million is nonetheless worth a different percentage of each startup. And of course, if the services cost only $250k per product, the equity levels change again.
To calculate the amount of equity exchanged between a corporation and a startup, it’s critical to know the value and volume of services being provided and the most recent valuation of the startup.
In summary, here’s how corporations can increase the odds of success when pursuing business development deals with startups:
- Develop a menu of specific commercial options like the ones described above. Your corporation probably has more choices than you think.
- Discuss these options internally with P&L operators to determine which ones are realistic and which are complete no-go scenarios.
- Once you have a list of things your parent company would actually do to help a startup, you can price the cost to your corporation and the potential value to an external partner.
- Then you can forecast how much volume of each available service a startup or portfolio company might want. Ask them!
- Knowing the most recent valuation and desired service volumes, you can estimate equity value for each portfolio company.
I’ve personally worked on dozens of commercial deals between startups and corporations. In the majority of these cases, value was flowing from the corporation to the startup; but while the larger company could have asked for equity, cash was the form of compensation. Cash is simpler, resulting in a relatively low number of cases where equity is the instrument in commercial deals, but it doesn’t mean it can’t be done.
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