If you are just starting up, it can be tricky to figure out the right amount of equity to give away; be it to investors or to your first employees. On one hand, you are losing control over your business with every percentage ownership you give away. But at the same time, you need these investors and employees to grow your business and make your ownership worth something.
The Equity Equation
According to celebrity investor Paul Graham, the answer to this is straight-forward – for each percent ownership you give up to an investor or employee, your company should grow sufficiently enough for the value of your owned stocks to be higher than what they were without the investor or employee. He calls it the equity equation and is denoted by 1/(1-n). For instance, you can give up 6% of ownership if you believe this investment can grow your company by more than 1/(1-0.06); that’s 6.4%.
Convertible Notes For Times When Valuation Is Not Clear
In the early stages of your startup, you do not have a defined product or revenue. This makes it difficult to estimate the value of your company. To put this another way, without knowing the value of your company, it is difficult to know what a $100K investment should get the investor in terms of stocks. In such situations, insist on convertible notes rather than fixed equity. To put this simply, convertible notes are essentially debts provided by the investor to the startup. But instead of you having to repay them, these debts are automatically converted into equity when you go for your next round of funding. Insisting on convertible notes helps you make sure that you do not give away a significant amount of equity for an investment that may not be a lot of money once your business starts making money.
Valuation Is Not Everything
The growth of a company is measured by how much its value has grown between the various investment rounds. And while this may sound counter-intuitive, this is also the reason why you should be conservative on valuation. A startup whose valuation and revenues are consistently on the rise is regarded as healthy. In such cases, investors are likely to offer more founder-friendly terms for funding. This may include the option to cash out a part of your own stake during a round of investment.
Too much focus on valuation could mean that your business becomes volatile. In these instances, there is higher pressure on the founders to constantly show a similar trajectory in growth. This is unsustainable and your startup may eventually slow down or even show negative growth. This is bad from an investment point of view since drop in valuations could definitely mean investment terms that are not founder-friendly. So while investors may continue to hold preferred ownership and cash out, founders may end up with a raw deal.
Watch Out For Dilution Clause
Besides the number of shares you own in your company, another important point to take care of is dilution. To put this simply, each time you raise money, investors get equity which previously belonged to someone else. So for instance, if your company had 1000 shares and you owned 100 of them, you own 10% of the company. But when a new investor walks in and they are issued 200 shares, then your 100 shares are now only worth 8.33%.
Investors protect themselves from this sort of a scenario by what is called the ‘anti-dilution’ clause. This clause uses different methods to make sure that the investors’ share of ownership remains unaffected no matter how many new shares are issued. As a founder, you should protect your interests and try to avoid such clauses that can easily evaporate all your ownership in a company.
Image Credit: 401(K) 2012
