As the growth of online businesses continues at an exponential pace, more and more investors are seeking opportunities to purchase these thriving businesses. This creates tremendous opportunities for seasoned SaaS or e-commerce operators who may lack the capital themselves to purchase an online business to partner with investors who are eager to provide the capital so that the operators can take businesses to the next level. The terms of these partnerships tend to resemble private equity deals, but many operators and some newer investors may not know how those deals work or what the options are in structuring investor-operator partnerships.
In big private equity deals, operators are compensated with a combination of salary and options. The salary provides the operator with downside protection to provide peace of mind and financial security. The options are more complicated. As a reminder, options give the recipient the right to purchase shares or interests of a business at a certain price (the “strike price”). Whether to exercise the option is up to the operator, and there is a time limit during which an option can be exercised. Under most circumstances, options will be exercised if the value of the shares/interests is higher than the strike price and won’t be exercised if the strike price is higher than the value of the shares/interests. The source of the complexity of private equity deals is that private equity firms issue operators options in multiple tranches at different strike prices. This creates incentives for the operator to work hard and make the business more valuable as doing so will mean more of the operator’s options are “in the money” and can be exercised at a profit by the operator.
Depending on the size of the deal for a SaaS or E-Commerce partnership, it may not be worth the time and effort to go through the full process that would take place in a private equity deal. Tax considerations or corporate simplicity may also favor a simpler approach. There are many options for structuring these deals, though, and some combination of those options can achieve what should be the goal in forming an investor-operator partnership—aligning incentives to grow the business. Below are some of the common tools for structuring investor-operator partnerships.
This is the simplest form of compensation. In exchange for a working a set amount of time or for performing particular services, the operator is paid an amount of money. This would most likely be in the form of W-2 income, though certain arrangements could also be structured as 1099 contractor income. Salary functions as a floor for operator compensation, but is more guaranteed than the other options. Full-time operators probably need a salary in order to meet their financial obligations, but a larger salary probably means a smaller amount of upside going to the operator.
This is what most people think about when hearing the phrase “joint venture.” Under a revenue sharing agreement, the operator will receive a certain percentage of the money the business generates from sales. A revenue sharing agreement can be with an individual as an employee or with another company (which could include an operator working as an LLC). The simplest form of revenue sharing is a flat percentage, but there can also be tiered revenue sharing agreements where an operator receives a larger percentage of the business’s revenues as those revenues increase. Revenue sharing can be a way for an operator to capture more of the value generated during the time a business is owned, but the operator will not receive any portion of the sale price should the business be sold.
Equity sharing arrangements make operators and investors “partners” in the sense that both own a portion of the business. This is “sweat equity” that is common for startup founders and employees. The two most important aspects of equity sharing agreements are how much equity the operator will receive and what the operator needs to do to receive that equity. The standard for a Silicon Valley VC-backed startup is that a founder will be on a four-year vesting schedule with a one-year cliff. This means that the founder’s equity will vest over a period of four years, but if the founder leaves during the first year that founder will not receive any equity (the “cliff”). Once the cliff is reached, equity will vest in equal installments, usually monthly or quarterly. The time horizon can be shorter for SaaS or E-commerce plays where the goal is to grow and sell the business within 18 or 24 months. This can be handled through accelerating the vesting schedule, which is something that operators will want to make sure is in place. For operators, getting equity has the dual benefits of capturing some of the upside value of a potential sale and providing some amount of control over the direction of the business. The extent of the operator’s control will be negotiated, but some of the other methods of compensation do not offer operators any corporate control.
It is common that even where the investor is providing most of the capital, the operator will still contribute a percentage of the purchase price to gain upfront equity in the business. This is an arrangement borrowed from private equity and venture capital fund structures where the fund managers invest their own money into the fund. The rationale behind this is that the operator is less likely to walk away from the business if growth is slower than expected since the operator has invested his own money and already owns a portion of the company separate and apart from potential equity or revenue through some other arrangement.
Using options grants brings the full private equity model and into the context of SaaS and E-Commerce businesses. The key considerations in negotiating options grants are the quantity of options and the strike price. Quantity should be simple to understand, but calibrating the strike price (particularly if there are going to be multiple tranches of options) can be tricky. This challenge can be magnified by the difficulty in valuing businesses that are privately held, but increasing knowledge of sales multiples in different SaaS and E-Commerce multiples is reducing the difficulty of providing a realistic valuation. The difficulty of establishing correct strike prices for multiple tranches of options can drag out the process of forming an operator-investor partnership and so may not be appropriate in every circumstance.
A few considerations about options that may not be obvious for operators are taxes and a lack of control. In most of these deals there will not be options given at a lower strike price than the fair market value of the shares or interests, but if there are then the difference between the strike price and the fair market value is considered income by the IRS (even if the operator has not received cash to be able to pay such taxes). There is also a lack of control if operators receive options as they will not have all of the rights that come with being a shareholder/member in the company before they exercise the options to purchase shares or interests.
Phantom equity is a construct premised on stock or membership interests only having value in the event of an exit. Phantom equity vests just like regular equity, in accordance with a time schedule, meeting performance metrics, or some combination of those methods. Unlike regular equity, though, holders of phantom equity are not on the cap table of the company. Phantom equity will automatically convert should an exit event take place, but there can be complications based on the wording of the phantom equity plan documents.
Operators need to make sure they understand the intricacies of phantom equity before accepting it as phantom equity offers fewer protections than normal equity does. In most circumstances, phantom equity heavily favors investors and forces operators to continue working in the company to avoid losing all accrued equity in the case of an exit event even in situations where regular equity would have fully vested if another method of compensation had been used.
Incentive Structures and Summary
Any of these methods described above can be tied to incentives. After all, aligning incentives between investors and operators is the purpose of these agreements. The simplest incentive structure is a cash bonus. Historically, businesses distributed cash bonuses to employees in December as a thank you for staying with the company another year. Such time-based bonuses still exist but probably don’t apply to these partnerships. Much more likely would be a cash payment based on meeting a particular milestone in the business. The milestone can be any key metric, but some common ones include the amount of sales, the number of new customers, and the growth in revenue measured against a prior period of time (quarterly, annually, etc.). Equity, revenue sharing, and options grants can similarly be linked to such milestones.
There can also be a combination of different compensation structures. For example, there could be a salary plus incentive-based equity distributions with the operator having some initial equity from contributing upfront capital as part of the purchase price (this being probably the most standard type of deal structure). There can be differences in tax treatment between different compensation structures too, so depending on the amounts involved it may be in everyone’s interests to involve the accountants during the process of negotiating compensation and equity distribution when an investor and an operator join forces to purchase and/or build an online business together.
If you have questions about how you should structure your partnership or you are in the process of entering into a partnership and want an experienced guide to help you chart the best path forward for both yourself and your new venture, contact us at email@example.com and we will be happy to work with you.