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Editor’s Note: Malay Gandhi serves as the managing director of the digital healthcare investment firm Rock Health, which recently announced its third seed fund.

Startups should give up equity for only one of two reasons: work or cash.

Startup employees and advisors work in exchange for equity (and salary) and they can be fired if they don’t perform, shutting down their vesting. I’m an advocate of bringing on advisors with defined deliverables, earning somewhere around 100 basis points or less unless they’re working part-time at the company or insanely valuable. Investors provide the cash that help startups grow and receive equity in exchange for their risk capital.

Recently, I’ve noticed a third reason for startups giving up equity: an exchange for “services.” This growing trend for “accelerators” and their ilk to take equity in companies without providing any capital is alarming. (These services are not comparable to those provided by proven service providers like law firms that defer or reduce billings in exchange for equity—that is essentially the same as cash.)

I’ve been seeing more and more startups with an admission or expiring “term sheet” from these organizations, looking to us at Rock Health to simultaneously fund them. We understand the initial attraction to some of these organizations—it’s a platform to launch your company, flush with name-brand industry partners and networking events.

You want to believe that eventually the capital will follow.

This practice, of taking equity solely in exchange for “services” is great for the organization that ends up with the equity. When you don’t have to expend any capital, it’s easy to flood the ecosystem with features instead of products and hobbies instead of companies.

But the trend on the other side of this is disturbing—the market isn’t a fan. Lisa Suennen noted it in her recent report on digital health accelerators, quoting a healthcare industry sponsor:

“The accelerators have too much overlap and too many companies vying to create too many redundant ideas. They are pumping up these companies with unrealistic expectations about their odds of success and their ability to be transformative, and it is a disservice to the whole industry when the funnel gets overloaded; it is dilutive of talent and bandwidth and capital.”

Let me be clear: this model will fail to create large scale, venture-backable companies that transform the industry. I question why entrepreneurs would willingly give up equity in their company—up to 10%—in exchange for ambiguous services. This is equity that should be going to employees and exceptional advisors.

Any well-reputed early stage investor could convince an entrepreneur to give them equity in exchange for their promised support, with no capital attached. But they don’t, because the practice is predatory and frankly, would result in selection bias.

Investing nothing for equity turns entrepreneurs into lottery tickets and makes the goal to collect as many as possible. Investing cash for equity forces organizations (like Rock Health and other funds) to make hard decisions on capital allocations. This isn’t a good thing for entrepreneurs, or our sector, and I encourage you to reject this concept before it seems like a norm.

 

Featured Image: Jim Larrison/Flickr UNDER A CC BY 2.0 LICENSE