I often talk about the “we’re big, you’re small” phenomenon that often exists when startups are seeking or negotiating a strategic partnership. While that phenomenon certainly gives the big partner a lot of leverage, it also opens some opportunities – and I’m not talking about the obvious ones related to the partner’s size, scale and brand recognition. Instead, I’m talking about getting them to pay for a huge chunk of your R&D costs as part of the deal.
Setting the Stage
This article describes cost-offsetting opportunities that exist with partnerships that involve some amount of up-front technical work on your product. That usually means things like new feature or capability development and product customization. In other words, I’m not talking about pure product distribution or co-marketing partnerships. Instead, will your engineering team be impacted in anyway as a result of the partnership? If so, keep reading.
There are a few activities that create an atmosphere for seeking compensation from your new strategic partner. They are described below.
Product Roadmap Priority Changes – Are there features on your product roadmap that are either required or highly desirable for this partnership? The further down your current roadmap priority list they are, the more this strategic partnership is hijacking your roadmap and the more leverage you have for negotiating compensation. In fact, since the new partner doesn’t know what your detailed roadmap looks like, you should try to seek compensation for things you’re already working on or about to work on.
Product Customization – This is not about new features but rather things like branding, packaging (hardware), special documentation and the like.
Technical Integration – You might need to develop a set of APIs or other capabilities to connect your product to your partner’s to unleash something valuable. Or maybe there’s needed back-end integration that exchanges data for analysis or reporting.
Training & Consulting – This doesn’t as much fit the pure definition of “engineering impacting” but as a startup you probably don’t have a dedicated set of resources for training and consulting with your partner’s product and technical teams (I’m not referring to sales and marketing training). This means your engineers are going to have to step in.
The first method you should use to get up-front compensation from your new partner is to negotiate what’s called “NRE” (non-recurring engineering). As the name suggests, these are one-time and usually up-front engineering costs you will incur as a result of things like were just described above. NRE is a good tool to pursue in the early stages of a new strategic partnership.
Any large enterprise that has previously entered into partnerships like this will be familiar with the NRE concept. And numbers that seem huge to a startup are nothing to a large enterprise. So don’t assign a price tag by taking the expected man-hours of work and multiplying that by some hourly rate.
Your big partner might point to the significant revenue upside and credibility the partnership offers you and all of the resources they’re going to have to devote to the project. But remember, they’re big and you’re small. They can afford to go 6-12 months without any new income from this partnership. You can’t. Successfully negotiating NRE is also a really good indication of how strategic the partnership is to the big partner. If they won’t give you any up-front financial help, you should be scratching your head.
Price Tag Adjustments
Establishing a price for NRE is much more art than science. And, at the end of the day, it comes down to the importance of the project to your partner as well as you’re negotiating skills. But there are some things to take into consideration beyond just the engineering work involved. If any of the items listed below will exist, use them for additional negotiating leverage.
- Exclusivity – Are you granting any form of exclusivity to your partner? If so, it’s probably the best excuse of all to boost the NRE price tag. Also, don’t be afraid of the “exclusivity” word. Instead, read my article titled “Exclusivity – Run Away or Embrace?”
- Engineering Risk – Sometimes the feasibility of developing certain features and capabilities isn’t certain. The more feasibility risk, the more leverage you have to boost the NRE.
- Aggressive Timeline – Most timelines for engineering projects are aggressive by nature and, luckily, startups can move at lightening speed compared to their enterprise counterparts. Take advantage of that. What might not seem terribly aggressive to you might be so impressive to your new partner that you can convince them it’s worth paying extra for.
- Enterprise-Grade Requirements – Unless you’ve done projects like this with other large enterprises or regularly sell directly to large enterprises, your idea of “enterprise grade” might be way off versus your partner’s. I’m talking about things like security, legal compliance (ie – GDPR, OFAC, PCI), scalability, localization, foreign currency support, accessibility and documentation. Make sure you understand this before you come up with your price tag.
- Completely Unique Requirements – Are there requirements that you would never consider working on if it weren’t for this partnership? What if this partnership gets terminated before ever seeing the light of day? What if it gets announced but the results are terrible? You should get extra compensation for these completely unique and otherwise-uninteresting requirements.
When it comes to presenting the proposed amount of NRE to your partner, do not give them line-by-line detail. In the best case, you’ll be able to get away with a single number that includes a bunch of things that are discretely described but not line-item priced. In the worst case hopefully you’ll only be required to break out the NRE into 2-3 key categories. Do as much as you can to disguise your projections of man-hours, hourly rate, risk, etc. Otherwise, your $250K of potential NRE will get reduced to the $75K that it’s really going to cost you. What’s amazing is that, to a large enterprise, those two numbers are practically the same. Their budget sheet for the total project will either be something like $11.5M (11.535) or $11.4M (11.360). Not much difference at all to them but the $175K difference to you is HUGE.
How Much to Charge?
I have two rules of thumb for this:
- Double/Triple – If you add up the amount that it’s truly going to cost you to complete a given amount of work, it’s going to be significantly less than what it would cost your large partner, if they did it themselves. Presenting them with a $25K price tag is likely to result in them concluding the number is so small that you shouldn’t really worry about it. Instead, double or triple your actual cost estimate. If they had to perform the work themselves, they would allocate twice as much time and have twice as many resources. And their resources are surely more expensive than yours. So even after doubling/tripling your actual cost estimate, you’re still likely to derive an acceptable cost figure.
- Never a Nice, Round Number – When a cost figure like $50K or $100K is proposed to the large partner, it seems like a thumb in the air. Instead, take the result of the double/triple exercise and adjust it to a number like $82,500. It seems just specific enough that the partner will assume there was some good analysis performed and, interestingly, they’ll be less likely to negotiate it.
Introducing Product Pre-payment
Whether or not you’re able to negotiate NRE to cover your unique R&D costs (and hopefully much more than that), you should think about asking for some prepaid license fees (software) or product purchases (hardware). And if you aren’t able to get any NRE, then product prepayment becomes your only opportunity for R&D cost offset. But, usually, such a pre-payment becomes a good tool to pursue in the middle stages of a strategic partnership, after your partner sees progress, has heightened excitement about the potential, and a better relationship has been developed.
Before you even get to the point of discussing a pre-payment, you probably negotiated the basic pricing structure. Usually it reflects a different price based on some metric like volume, users, usage, or the like and usually there are different defined tiers. Here’s an example:
- Up to 10,000: $10.00 each
- 10,001 – 50,000: $8.50 each
- 50,001 – 100,000: $7.50 each
With a prepayment, the partner buys a bulk quantity and they also get the benefit of the volume-tier pricing. In other words, using the example above, if they agree to prepay for a quantity of 30,000 software licenses, they would get the $8.50 unit price, which means they would pay you $255,000. The key benefit to the big partner is the lower unit price versus starting at the highest-price tier until the volumes ramp up. You both win in some way.
In the case of a software license, once the product is launched into the marketplace and their customers start purchasing, the partner actually “consumes” the licenses until they are exhausted. At that point, they might be allowed to make additional bulk purchases or maybe there is some other arrangement. Either way, getting the up-front license fee prepayment ($255K in the above example) can be significant to a startup.
Your partner is probably going to show you their forecast for the first year and try to convince you to give them pricing for that annual volume but starting with the first month. In other words, instead of a pay-as-you go approach, they will want you to take all the risk while expecting you to believe they will actually reach their forecasted volume over time. You have two choices for your negotiation. One is to keep pushing for a pre-payment and the other is to get them to contractually commit to their forecasted volumes. Here’s how this might look in narrative form:
- “We are willing to give you the unit price that’s tied to your first year of forecasted software license volumes but you would need to contractually commit to that same volume. It means that at the end of the year if you have fallen short, we will need to send you an invoice for the remainder. Alternatively, you could pre-pay for that same volume of licenses and if it doesn’t all get consumed within the first year you can continue to draw from it into the second year. In fact, we will give you up to 18 months to fully draw-down any pre-paid licenses.”
Side Note: Make sure to talk to your accountant about how to treat these pre-payments on your balance sheet and P&L. Although you’re collecting cash up front, which is great for your bank account, you are not likely to be able to claim the amount as Revenue until the licenses are actually consumed over time.
I find that software license pre-payments are somewhat easier to secure than hardware product pre-purchases. That’s because hardware involves production runs, inventory (and associated obsolescence risk) and other things associated with a physical product.
This option can get a little tricky and risky, but should be a part of your menu to discuss with advisors. Essentially, your partner participates in a round of funding, either one-off by themselves or part of an organized round of funding that includes other investors. If the partner is investing solo, using a convertible security can be simple and convenient. They’ll end up with equity later, when the convertible security converts to equity.
Regardless of the type of fundraising instrument that is used, below are some considerations when raising money from what we call “strategics”.
- The more equity they end up with, the more their presence on the cap table can skew future acquisition dynamics – assuming they are a candidate acquirer. My general rule of thumb is to keep their equity in the single digits, and low-to-mid single digits is safer in this regard.
- They can try to leverage their investor status for requests (or demands) that only, or mostly, benefit them. This pertains to your product roadmap and other elements of company strategy.
- They might request a seat on your board of directors, which gives them much deeper insights into company status and strategy. It also gives them additional voting and governance rights that could be dangerous. An “observer” seat still gives the deeper insights, but removes the voting rights.
If you decide to raise funding from your new strategic partner, work with your attorney and advisors to shape things to remain fair and not accidentally screw up your future acquisition landscape. And set proper expectations with your new investor regarding the issues mentioned above.
On-Going Engineering Support Fees
If your partnership involves an API or similar integration, it’s almost certain that some level of on-going engineering efforts and support will be required. For sure this is the case if you’re licensing some technology to your partner and they are incorporating it into their product (read my related article titled “Licensing Your Technology”). This on-going support will impact your R&D resources and you should try to offset those costs by charging a support fee.
The support fee is usually a recurring fee that is paid either on a monthly, quarterly or annual basis. Your partner might expect you to cover your on-going engineering costs using the gross margin from the license fees. That’s fine as long as your gross margins are high enough. But if they squeeze you so hard on pricing that your gross margins are thin, this won’t be the case.
Put on-going engineering support fees on your initial negotiating list. Being required to waive it might help you stick on a higher license fee than otherwise possible. It’s all about “give and get”.
The Benefits of Starting with a Letter of Intent (LOI)
Some founders go straight from verbal agreement to lawyers on both sides papering things up for signature. What a missed opportunity and added risk for misunderstandings. Remember, attorneys charge by the hour. So you want them to be as focused and efficient as possible. Listen to my 5 min podcast recording that explains the benefits of incorporating an LOI into the process.
I often talk about how an ideal partnership is one that offers huge benefits to both parties. If your prospective partner really benefits from what you have to offer, they should be willing to help offset some of your risks and dip into their deep bank account to help cover your unique R&D costs. They will evaluate the NRE and pre-payment options and likely negotiate some mix of them. In fact, they might even be interested in a traditional equity investment in the company, which adds a third source of funding into the mix. You and your advisors can debate your appetite for each and the ideal overall mix.
I also often talk about how a good deal is reflected by a balance of price and terms (read my article titled “Tell Me Your Price and I’ll Tell You My Terms”). Keep that in mind when negotiating things like NRE, license fee prepayments and on-going engineering support.
If you’re also looking for advice on landing a deal with strategic partner, check out my related articles below:
Best of luck find that perfect strategic partner and negotiating a great deal.