Equity swaps, in which cash strapped start-ups offer stock in their company instead of money for goods and services, was a popular financing method during the dot-com boom and now they're back, say The Wall Street Journal's Emily Maltby and Sarah Needleman. Example: Limited edition sneaker selling website start-up BucketFeet didn't have the $100,000 it needed to design its site. So it instead promised equity (plus a small amount of dollars) to a Chicago web design firm to get the work done. The idea is the following: One day that equity will be worth far more than the straight-up cash, maybe -- if the company goes the Facebook route, which happens exceedingly rarely. (20 percent of start-ups fail within their first year, according to Needleman and Maltby — or, put another way, there has been one Facebook among all of the thousands of startups of the last seven years.) And it definitely won't happen if this bubble bursts. This isn't necessarily a bad thing. If these companies succeed, someone who did a fresco for the CoolBook.com office in exchange for equity could be worth hundreds of millions. (That sort of thing has happened before.) But, then again, if things turn out the way they did for most dot-com bubble companies, both our start-ups and the people with whom they do business will be left sans anything of value.
These equity swaps were popular during the dot-com boom for the same reason start-ups now have taken a liking to them. As tech companies get more hype (and theoretical value) equity is more alluring -- it has more potential value than cash. During the dot-com boom there came a point when people asked for payment in equity. "Having seen the riches generated by upstart Internet firms that go public, a growing list of Chicago service firms -- architects, consultants, lawyers, marketers and recruiters -- want in on the deals," wrote a James B Arndorfer in a 2000 Chicago Crain's Business article. "They either are requesting or accepting stock as payment from their dot.com clients and forgoing or reducing traditional cash payments for services," he added. Even landlords asked for equity as rent, per another Crain's Business article. Start-ups also like it, as Maltby and Needleman explain, because they don't have to be successful at that very moment to build their business. It's a win-win, until it's not.
When those dot-com companies failed, en masse, a lot of related industries hurt. Take HP, for example, which made lots of hardware for equity deals. As of 2001 (post crash), though, it reported it took a $365 million charge because of "impairment of investments in emerging-market companies," explains a 2001 Computer Reseller News item -- ie. those equity investments didn't end up paying off. That same quarter, HP reported it made zero dollars from its dot-com investments. HP with its own hardware sales business was lucky in a way, think of all the landlords who accepted rent payments in stock form, who never got their payouts.
The same could very well happen today for businesses working with start-ups in tech bubble 2.0 -- if it decides to pop. Until now, we've talked about this tech frenzy remaining relatively contained, which meant that the fall-out might not be so widespread if things get messy. But, with these companies now leveraging their future success to get outside jobs done, the hype has started to spread beyond Silicon Valley. That would be great if we were seeing money pumped into other industries. But it's just future money, so we're not really seeing any growth as a result. And, on top of that, if these start-ups fail (which many of them statistically will), these related industries will never get the compensation they deserve. The only positive scenario here is the rare chance that the start-up will turn into the next Google. And not even Facebook has succeeded at that.
As for the start-ups themselves, they don't have much to lose if they can convince people to accept equity deals. If they succeed, yay for everyone. If not, they didn't put capital they didn't have into building something that failed. But, the lack of money isn't a good sign for their company's success, or for the start-up scene in general. These equity deals happen because investment money isn't there in the first place, perhaps they are a sign of that "cash crunch" Silicon Valley denies is happening.
This article is from the archive of our partner The Wire.