July 2007An investor wants to give you money for a certain percentage ofyour startup. Should you take it? You're about to hire your firstemployee. How much stock should you give him?These are some of the hardest questions founders face. And yetboth have the same answer:1/(1 - n)Whenever you're trading stock in your company for anything, whetherit's money or an employee or a deal with another company, the testfor whether to do it is the same. You should give up n% of yourcompany if what you trade it for improves your average outcomeenough that the (100 - n)% you have left is worth more than thewhole company was before.For example, if an investor wants to buy half your company, howmuch does that investment have to improve your average outcome foryou to break even? Obviously it has to double: if you trade halfyour company for something that more than doubles the company'saverage outcome, you're net ahead. You have half as big a shareof something worth more than twice as much.In the general case, if n is the fraction of the company you'regiving up, the deal is a good one if it makes the company worthmore than 1/(1 - n).For example, suppose Y Combinator offers to fund you in return for7% of your company. In this case, n is .07 and 1/(1 - n) is 1.075.So you should take the deal if you believe we can improve youraverage outcome by more than 7.5%. If we improve your outcome by10%, you're net ahead, because the remaining .93 you hold is worth.93 x 1.1 = 1.023.[1]One of the things the equity equation shows us is that, financiallyat least, taking money from a top VC firm can be a really good deal.Greg Mcadoo from Sequoia recently said at a YC dinner that whenSequoia invests alone they like to take about 30% of a company.1/.7 = 1.43, meaning that deal is worth taking if they can improveyour outcome by more than 43%. For the average startup, that wouldbe an extraordinary bargain. It would improve the average startup'sprospects by more than 43% just to be able to say they were fundedby Sequoia, even if they never actually got the money.The reason Sequoia is such a good deal is that the percentage ofthe company they take is artificially low. They don't even try toget market price for their investment; they limit their holdingsto leave the founders enough stock to feel the company is stilltheirs.The catch is that Sequoia gets about 6000 business plans a year andfunds about 20 of them, so the odds of getting this great deal are1 in 300. The companies that make it through are not average startups.Of course, there are other factors to consider in a VC deal. It'snever just a straight trade of money for stock. But if it were,taking money from a top firm would generally be a bargain.You can use the same formula when giving stock to employees, butit works in the other direction. If i is the average outcome forthe company with the addition of some new person, then they're worthn such that i = 1/(1 - n). Which means n = (i - 1)/i.For example, suppose you're just two founders and you want to hirean additional hacker who's so good you feel he'll increase theaverage outcome of the whole company by 20%. n = (1.2 - 1)/1.2 =.167. So you'll break even if you trade 16.7% of the companyfor him.That doesn't mean 16.7% is the right amount of stock to give him.Stock is not the only cost of hiring someone: there's usually salaryand overhead as well. And if the company merely breaks even on thedeal, there's no reason to do it.I think to translate salary and overhead into stock you shouldmultiply the annual rate by about 1.5. Most startups grow fast ordie; if you die you don't have to pay the guy, and if you grow fastyou'll be paying next year's salary out of next year's valuation,which should be 3x this year's. If your valuation grows 3x a year,the total cost in stock of a new hire's salary and overhead is 1.5years' cost at the present valuation. [2]How much of an additional margin should the company need as the"activation energy" for the deal? Since this is in effect thecompany's profit on a hire, the market will determine that: ifyou're a hot opportunity, you can charge more.Let's run through an example. Suppose the company wants to make a"profit" of 50% on the new hire mentioned above. So subtract athird from 16.7% and we have 11.1% as his "retail" price. Supposefurther that he's going to cost $60k a year in salary and overhead,x 1.5 = $90k total. If the company's valuation is $2 million, $90kis 4.5%. 11.1% - 4.5% = an offer of 6.6%.Incidentally, notice how important it is for early employees totake little salary. It comes right out of stock that could otherwisebe given to them.Obviously there is a great deal of play in these numbers. I'm notclaiming that stock grants can now be reduced to a formula. Ultimatelyyou always have to guess. But at least know what you're guessing.If you choose a number based on your gut feel, or a table of typicalgrant sizes supplied by a VC firm, understand what those are estimatesof.And more generally, when you make any decision involving equity,run it through 1/(1 - n) to see if it makes sense. You shouldalways feel richer after trading equity. If the trade didn'tincrease the value of your remaining shares enough to put you netahead, you wouldn't have (or shouldn't have) done it.Notes[1] This is why wecan't believe anyone would think Y Combinator was a bad deal. Doesanyone really think we're so useless that in three months we can'timprove a startup's prospects by 7.5%?[2] The obvious choicefor your present valuation is the post-money valuation of your lastfunding round. This probably undervalues the company, though,because (a) unless your last round just happened, the company ispresumably worth more, and (b) the valuation of an early fundinground usually reflects some other contribution by the investors.Thanks to Sam Altman, Trevor Blackwell, Paul Buchheit, Hutch Fishman, David Hornik, Paul Kedrosky, Jessica Livingston, Gary Sabot, and Joshua Schachter for reading drafts of this.
