Service investments are still very rare and not many people talk about them. It is not professionalized and celebrated like venture capital and closing a funding round, but it will get there.
KAPSLY’s mission is to professionalize and standardize service investing and make it accessible to service agencies that want to support startups. We have done deep research to find the right approach. Not just from a legal perspective, but especially to make sure that the match between startup and service investor is right. Money is exchangeable and it doesn’t make a huge difference from which investor it comes. Service investments are different every time. No project is the same, no service provider is the same. Nevertheless, the concepts remain the same and hence there is huge potential to standardize the service investment approach. Nobody wants to hire a lawyer every time a relatively small value of services is invested. That’s also why most service investments are not very good deals, and the reputation has not been the best in the past, especially among traditional investors. KAPSLY is changing that and in the following paragraphs, you will learn why our approach is better and beneficial to future investors, besides the immediate benefits to service providers and startups.
The next 5 steps will outline how the startup – service provider relationship should be set up and why I believe this is the best way.
1. Understand the founders’ vision and do your due diligence.
When it is clear that your potential new client will require financial support (i.e. service investment) you should find out whether you believe in the business model and the founder team. Ideally, you create your own checklist with the most important characteristics. Some traditional attributes to look at are the founding team (do you believe they can build and manage a successful startup?), the product/solution (have they validated their hypothesis about the proposed solution?), customers (have they identified the right target group?), traction (do they already have paying customers?). Besides that, you should also check if you can agree on the general terms for the project. Try to estimate the total project costs, how much can you afford to invest at most? Be transparent with the startup. The KAPSLY marketplace helps to provide the required information.
As a service provider, you are not doing anyone a favor if you start working on a project that you are not buying into. In case the startup must raise money later, they need strong partners who are absolutely convinced and can show this conviction to investors as well.
2. Agree on the roadmap and next steps.
Once you have done your due diligence and agree on the general terms with the startup, it is time to discuss the next steps. This can also be the time where you want to challenge the startup on their plan. Do they really know what they want and can they back it up? This is sort of extended due diligence, so you see there are no clear lines between the steps but they are rather an ongoing process. Discuss openly how your services contribute to the future of the business and what results should be achieved.
Discussing these topics early on will help to align expectations and avoid arguments later. It should also be the foundation to define milestones and the project scope.
3. Sign the Agile Service Agreement
Now you have defined the milestone, the project scope, your investment budget, and the total project cost, so it is time to make it official and sign our Agile Service Agreement. Initially, we called it a convertible service agreement because you do not have to commit to equity right away, similar to a convertible loan. It defines the rules of the collaboration but gives you enough flexibility for the things we cannot anticipate yet. Our service agreement gives you time to get to know each other and convert your service investment into revenue or company shares later. Revenue shares are especially interesting for startups that plan to stay self-funded (bootstrapped). At this point, you can also define the percentage of revenue you should get and the duration for how long the startup will pay you back. In case the startup exceeds the expectations, it would be fair to define a maximum payback amount within a specified time. For startups that plan to do fundraising in the future, you would probably go for company shares as the startup will need cash to continue building their business. Then you can define a maximum valuation at which your service investment should convert (valuation cap) and/or a discount on the valuation. In some cases, also an interest rate is defined that will increase the value of your service investment over time. If this is all new to you, you want to get yourself familiar with convertible loans, we apply the same principle to our Agile Service Agreements.
The key benefit is that the “rules” are clearly defined while you also keep flexibility. By defining your investment budget and using a convertible approach we reduce the risk by limiting the total amount and giving you time to get to know each other. The service provider is probably one of the earliest investors and carries a high risk. Hence a valuation cap or discount can be a fair measure to account for that risk and make it more attractive to the service provider. In general, the service provider should receive the same terms as other investors that invest at the same time.
4. Build trust through transparent collaboration
When you start the collaboration, we believe it is important to establish trust. One way to do that is by creating transparency and tracking your time for example, even if you have a milestone-based compensation plan. In the service agreement, it will also be defined that you implement a Plan, Do, Check, Adjust rhythm and meet regularly. This may sound obvious, but I wanted to mention it nevertheless. Building trust is extremely important when you want to invest your services in your client.
A close relationship will help to observe how the business evolves over time. That allows you to judge much better how the client will perform in the future.
5. Decide whether to invest or not.
After six months of working together, you should have quite a good picture of the further collaboration potential. Now is the time to decide what to do with the outstanding service value. Keep in mind that the startup should always have the option to simply pay you back with cash. Especially if the collaboration does not continue, it would not make sense to convert to a success-based compensation. Otherwise, you can now convert your service value into virtual company shares (also called Phantom Stock) or receive revenue shares over the defined period. Virtual company shares give you the right to a cash payout that is based on the value of shares. The financial benefit is the same as if you were a real shareholder. Virtual share agreements are a lot easier to set up. For the conversion, you and the startup must agree on a share price to define how many shares you will be entitled to. Ideally, the startup has a valuation from a funding round. We are also happy to assist in finding a fair valuation.
Those are the five steps we identified as the most promising process to enter “service for equity” or other success-based compensation models. The goal is to make sure there is a good fit between startups and service providers. The Agile Service Agreements provide enough flexibility to allow the startup to grow while also giving the service provider more security to receive a return. The kapsly.com marketplace has incorporated this process and we also make it available to our Service Partners who want to use it for their own clients.
Finally, what does it mean for traditional investors? I believe the benefit to traditional investors is that startups can build their business much further before they need external funding. We will have much more insights about how effectively they are using the resources and this reduces risk. Hopefully, many startups will not even need venture capital anymore and become cash-flow positive with the right help from professionals. This is probably the biggest service our platform could do to venture capitalists.
If you have any questions, please do not hesitate to contact us.