Summary:
When offering to trade stock for investment or the services of an employee, use the Equity Equation: i >= 1/(1-n), where i is the expected increase in value due to the contribution, and n the share of the company offered in exchange. Even though stock grants can not always be reduced to a formula (there are other factors to consider in a VC deal; it's never just a straight trade of money for stock) and ultimately you always have to guess, it is useful to run the trade through 1/(1-n) to see if it makes sense. You should always feel richer after trading equity. If the trade didn't increase the value of your remaining shares enough to put you net ahead, you shouldn't have done it.
Notes:
- Whenever you're trading stock in your company for anything, whether it's money or an employee or a deal with another company, the test for whether to do it is the same:
- You should give up n% of your company if what you trade it for improves your average outcome enough that the (100 - n)% you have left is worth more than the whole company was before.
- i >= 1/(1-n)
- where:
- i is the expected increase in value due to the contribution
- n is the share of the company offered in exchange
- (1-n) is the share of the company you have left
- i(1-n) >= 1
- i.e. the value of the remaining share in the company should be greater or equal to what it was before
- the trade has left you better of
- n <= (i-1)/i
- the share of the company a projected increase of i in value of the firm is worth
- e.g. determining the share value of a new employees contribution
- examples
- investor wants to buy half your company: how much does that investment have to improve you average outcome to break even?
- intuitively: has to double
- 1/(1-n) = 1/0.5 = 2
- if you trade half your company for something that more than doubles the company's average outcome, you're net ahead
- you have half as big a share of something worth twice as much
- investor offers to fund you in return for 6% of your company, when should you make the deal?
- you should make the deal if you believe the investment will improve your average outcome by more than 1/(1-n)
- i.e. 1/(1-n) = 1.064, or 6.4%
- if investor can improve your outcome by 10%, you're net ahead
- remaining 94% is worth 1.1 x 0.94 = 1.034
- you're just two founders and you want to hire an additional employee who's so good you feel he'll increase the average outcome of the company by 20%; how much is he worth in terms of a share in the company?
- n <= (i-1)/i = (1.2 - 1)1.2 = 0.167 = 16.7%
- suppose the company wants to make a "profit" of 50% on this new hire, how much stock is the employee worth after accounting for salary and overhead of $60k, if the company's valuation is $2m?
- most startups grow fast or die
- if you die you don't have to pay the guy; if you grow fast you'll be paying next year's salary out of next year's valuation
- next year's valuation should be 3x this year's
- if your valuation grows 3x a year, the total cost in stock options of a new hire's salary and overhead is 1.5 years' cost a the present valuation
- new hire could claim 16.7%, so in order to make 50% profit on the hire, subtract a third from 16.7%, i.e. 11.1%
- the total cost in stock of the new hire is 1.5 years' cost at present valuation
- $60k x 1.5 = $90k
- if the company's valuation is $2m, $90k is 4.5%
- the offer, therefore, should be 11.1% - 4.5% = 6.6%
