Customer-funded development — structuring a deal
This is the second post of a short series about what I think is an underused business model among software entrepreneurs, namely sponsored (i.e. customer-funded) development. Key points of the first post included:
- If you have an invention you can’t fund yourself, having your first customer(s) pay for development may be the key to realizing your dreams.
- Likely prospects are companies that:
- Are sufficiently hard-core technically to value your bleeding-edge ideas …
- … and to be willing to invest in projects with obviously high risks of failure.
- Are sufficiently limited technically to believe that your team is significantly stronger than what they could hire and deploy themselves.
This post covers the nitty-gritty of sponsored-development deal-making.
As per the previous post in this series, suppose you are fortunate enough to identify the right customer for a sponsored-development relationship. Then the deal process is likely* to go something like this:
- You start as you would in any other unproven-vendor sales cycle.
- You politely turn down the inevitable offer to simply hire you and your team onto their payroll. 🙂
- You explain that you have to keep the intellectual property yourself. This is crucial. If they don’t firmly agree, walk away from the sales cycle at that point.
- You ascertain whether there’s really a deal to be done. This is harder than it is in other kinds of sales cycle.
- You get to the neighborhood of “Yes”.
- You politely reject the first offer they make to fund you, because one of terms will be that, if all goes well, they can buy your company at a price in the range of 3-5X what they will be investing. That’s not nearly enough upside for you.
- You do a win-win deal.
*Actually, the deal process is likely to fail. Most deal processes do. But if it does succeed, it’s likely to look like what I just outlined.
Two of the bullets above allude to challenges in agreeing on deal terms. The first concerns IP ownership. The structure you should insist on is:Â
- You keep the IP.
- You grant the customer any specific license rights they ask for.
- The only thing you refuse to grant is some open-ended lawyerish 10-clause sentence that boils down to “We can do anything we like, including things we haven’t thought of yet.”
It is important to agree on this framework early in the discussions, and never to waver. And by the way, I have personally negotiated a number of deals with just that dynamic — the other party thought they had a natural right to work-for-hire, but were agreeable to a substitute set of licensing rights instead.
Later in the deal negotiation, most customers will try to use the obvious power imbalance to recapture control from you. If you handled the IP discussion successfully, they will likely revisit it briefly, and then pivot to an alternative way of controlling the IP after all — a suggestion that they buy you outright, or else get an option to buy you later on. My thoughts on this approach start:
- An option to buy you could be OK if the acquisition price amounts to a Very Good Exit.
- It’s not OK, however, if the exit is merely Pretty Decent. After all, you need to be rewarded for your entrepreneurial risk, both before and after signing the deal.
- A warrant to buy a fraction of your company could be a good compromise, as you and the customer share in the upside.
In both cases, recall some maxims of negotiation theory:
- Whenever possible, negotiate about basic principles of the deal, or the general scope of possible outcomes, not about deal particulars. Those efforts have much more leverage than simply asking to have some specific numbers changed.
- This is particularly important for the weaker party. If both parties have agreed to a general principle that winds up favoring you, perhaps your negotiating partner/opponent can’t claw that concession back. But if you’re just negotiating about the details of your respective positions, it’s easy for them to keep making additional demands.
Understanding the decision-making structure of your prospect is crucial; doing so is one sales skill you absolutely have to learn. And it won’t be easy. You start with all the standard issues for big enterprise sales, including:
- Who all has to say “yes”? How pre-committed are they to doing so if the people you’re actually talking to want to do the deal?
- How will additional levels of approval give your prospect a tool with which to negotiate more favorable deal terms?
Things will be even more complicated in the case of innovatively sponsored development, because:
- If there are any investment-like financial terms to the deal (for example the warrant idea mentioned above), a whole different part of the customer could get involved in the discussions too.
- If the whole deal structure is new to the customer, they could simply chicken out at the last moment. No matter how good a job you do of understanding your prospect’s decision-making, you could still get tripped up.
The whole thing will surely tax your ability to navigate an enterprise deal.
And finally, there’s a class of scenarios that overlaps with those we’ve been discussing, namely those in which the customer is looking at their deal with you as the first example of a new way of doing business. For example:
- They might want to tie sponsored development to an equity investment, as the start of a new VC-ish profit center
- They might want to resell your technology as a first step to turning themselves from a brick-and-mortar enterprise into a tech vendor.
I’ve seen a number of such situations, some involving sponsored development and some not. They don’t typically go well, because it usually turns out that whoever is driving the new initiative doesn’t really have corporate buy-in and reliable backing to the extent that they need. If you’re selling into such a situation, ask to meet somebody very senior in the company, very early in the sales cycle. When you do, check whether they seem to actually understand what it is that they’re supposedly committed to. If you can’t get to see them at all, or if they don’t seem to have seriously thought things through (yet), be very wary about committing much more time or energy to the relationship.
But despite all my concerns and warnings, I still believe that customer-funded development should be a bigger part of software innovation than it currently is. And it could be the ticket to realizing your entrepreneurial dream.
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