How much equity should I give investors or new employees in my startup?

How much stock should you give a new investor or employee? Here is how to think about it. Say you’re giving up n amount of ownership. The only way it’s worth doing that is if you expect the average outcome of your company to rise by a factor of more than 1/(1-n). So if you give up half of the company the average outcome needs to double for it to be worth it. Why is this? The amount you keep of the company needs to be worth more than what the whole company was worth before, so any multiplier greater than doubling and you’re ahead. This is true whether you’re talking about investors or new hires.

Taking Money from a Great VC

So if Y Combinator takes 6% then 1/(1-n) = 1.064 which means YC only has to improve your outcome by 6.4%. Think how low that bar is. YC only needs to make your company 6.4% better for you to win. Greg Mcadoo from Sequoia said at a YC dinner that if they’re going to invest by themselves Sequoia likes to own about 30%. So 1/(1-n) = 1/.7 or 1.43 which means Sequoia has to increase your outcome by over 43% for it to be worth it. Notice how much higher that number is from the 6.4% bar set by YC. You need the bar to be so much higher because the higher the percentage you take the more you have to improve the outcome for it to be worth it. My opinion is that getting money from Sequoia is an extraordinary bargain for an average startup (though keep in mind they fund an extremely small fraction of those that apply). The reason Sequoia purposely doesn’t charge the market price for their investment is that the founders need to have enough stock so that they can still feel like the company is theirs. That being said, the formula is only the financial side of the equation, which is why it doesn’t tell the whole story. But just on the purely financial side, taking money from a great VC is a good deal.

How Much of the Company You Should Give to an Employee

You can use the same calculation to figure out how much of the company you should give to an employee. It just depends on how much an employee multiplies your average outcome by. Let’s call that i. In that case you’d break even with giving up n amount of the company where n = (i - 1)/i. For example, say you have two founders and hire a really good hacker who you expect to increase your outcome by 20%. Then i=1.2 and n = (1.2 - 1)/1.2 = .167. So break even happens at 16.7%. Now, keep in mind that 16.7% is the absolute most you’d give, because it is the break-even point. It’s not the number you want to offer. Of course the hacker is going to cost you salary and overhead. However, if the company’s valuation triples every year this ends up translating into stock at a rate of about 1.5 times the annual rate. And you also want a 50% “profit” on the hire which is a third off that 16.7% down to 11.1%. You want that profit because at the break-even point the founders aren’t getting anything after all that risk and work. If your hacker is costing you $60k a year, then 1.5 times that is $90k. At a $2 million valuation that’s 4.5%. 11.1% - 4.5% leaves 6.6% to offer. This is one reason why your early hires should accept less salary, because the salary comes out of their stock. It’s important to keep in mind that these are all loose figures and of course you can’t distill a stock grant to a formula. At the end of the day you still have to take an educated guess. But it is helpful to do the math so you have a sense of the range you’re guessing in and you don’t give up too much.

The Post-Money Valuation of Your Last Round

What valuation do you use to do the calculations? The natural answer is the post-money valuation of your last round. That probably undervalues the company though because time has passed and investors bring more than cash to the table. Why is this important? The lower the valuation the more the $90k salary eats into the stock grant and the smaller the grant looks. If the last post-money valuation does undervalue you, that means the salary cost of the grant is overstated and you can probably afford to offer slightly more than the formula indicates. Here’s the upshot of all this. Any time the founders trade equity for anything, an investment or a new hire, they should end up feeling richer. Otherwise it wasn’t a smart trade.