Every startup will need to attract talent, to solve big problems, and embark on the quest to change the world together. The topic of equity will certainly come up multiple times, especially with those that will play a major role.
To avoid frequent dilution whenever someone new joins, usually a predefined slice of the pie is carved out as options to purchase shares, called the option pool. However, sometimes there isn’t enough options in the pool to give, or the type of relationship (ie. cofounder) requires issuing new founder shares.
When new shares are issued, it creates two interesting dynamics: a) each existing shareholder will own less of the pie (% ownership), b) but at the same time, the size of the pie (the valuation of the company) should get bigger as a result of the value the new person brings to the table.
The goal is to be fair to both the existing shareholders and the new person when this happens. Which means, although there are more shares in the company, the share price should increase for each shareholder proportional to the increase in company valuation.
Which means, it is important to understand this perceived valuation increase, to be able to determine the amount of new shares to issue to them.
It is a business transaction, so understanding both side of the table is key to ensure the process is fair and motivating.
The core idea is to evaluate the change in company valuation when a new person joins, and thus understand the value they bring to the table. From there, we can calculate how much equity the value equates to.
When a company has not been priced by outside investors, calculating the exact pre-valuation can be tricky. While a company that has been valued from outside investors may be overvalued, or undervalued. Regardless if a company has been valued by outside investors or not, we should dig deeper to understand the components that make up the valuation independent of the market value.
Here’s a framework for thinking about valuation internally. Basically you have a potential market opportunity to capture which gives the company value, and the valuation of the company is determined by two countering forces a) how much of that market is already captured, and b) how much risk (uncertainty) is imposed on the business to progress further.
- V(t) = Valuation of the company at time t.
- SAM(t) = Serviceable addressable market size at time t.
- Progress(t) = The percentage obtained of the target market at time t.
- Risks(t) = The probability of not reaching an exit before cash runs out.
To understand progress a bit more, we can think of it as material values:
- IP — Intellectual property developed
- Revenue — Annual revenue of the business
- Talent — The amount of key resources in the company
To understand Risks, we can break it down as:
- Capital — Risk of not getting to the next milestone from lack of capital
- Product — Risk of not building the right features
- Technical — Risk of not building the features right
- OpEx — Risk of not being able to make money
- Cultural — Risk of not having the right people
These risks is similar to debt, it can build up and kill the company.
When a new person joins, they are ultimately reducing the risks in the business. They should affect one or multiple risks. Hopefully all positively.
The change in these risks can be thought as the person’s abilities, and how confident we are that they’ll deliver those abilities:
- Competence — Determined by skill match and mastery level
- Confidence —The probability they’ll deliver. Determined by previous track record, and motivation alignment.
One thing to note is that prior years of experience only matters for matched skills that have been mastered, and also their track record of delivering results. It is likely that someone with more experience working at a company like Google, Facebook, will possess high competence, and confidence. However, you can have someone straight out of school that possess a high competence and low initial confidence, where they quickly resolve the confidence to achieve a similar Delta as someone with much more experience from a big company.
The change in risks will give us a new valuation:
The percent changed of the new valuation can be perceived as equity.
Although this is the value this person brings, we should add in an option pool so it accounts for fairness for future employees.
Let’s assume a one year old startup is considering hiring Sam as their COO. The startup has already built a functional prototype of their product and is conducting payed pilots in the market, and has received a pre-seed convertible note of $300,000 outside investment. The company has plans to target a market where the SAM(12 months) is $50 million, with a projected revenue of $400,000 ARR in 12 months.
The company has already developed 30% of the IP needed to hit this milestone, reached $100,000 ARR, and hired 3 out of 10 key people.
Because the company raised just enough to cover the 12 months, they are likely to need to go fund raising 3 months before their money runs out. Capital risk at 12 months is 100%.
The CEO understands the customer problem intimately, is very product oriented and has the analytical abilities to map out the the short term product objectives towards a long term vision. The risk of the company working on the wrong features is 30%.
The company is still missing a CTO, a key hire. Most of the tech is built by a junior developer. It works, but customers are starting to complain about the app performance. There is probably a lot of technical debt and the entire stack will need to be rewritten soon to handle more customers. The risk of the the tech failing before 12 months is pretty high at 80%.
The company has a complex operation, with a small number of customers, is just getting by. In order to scale, the company needs a COO, the position Sam would fill. Currently the company is losing money every transaction and need to ensure it doesn’t get out of hand. The risk on the business being able to operate efficiently as it grows is high at 90%.
The team is still small, so every hire is critical. The CEO has assembled a team of mission aligned individuals dedicated to the long haul, but there is a lot more work to be done for this young team to build a world class high functional organization. The risk of culture is 50%.
Based on these numbers, the valuation after 12 months, without Sam:
Progress(1year) is 0.28
Risks(1year) is 0.70
V(1year) is $4.25 million
Sam brings years of operational management experience to the team, is willing to put in some money into the company, and his personal brand on the line. After several interviews and hanging out together, the CEO has a good sense of Sam’s competencies and trust that he is aligned on the mission.
Sam is planning to make an investment of $40,000, which will increase the company’s runway by 2 months. Reducing the capital risk by 10%. At the same time, having sold a previous company, he should reduce the capital risk even further by another 10% with a confidence level of 30%. So he should bring down the risk of capital by 13% bringing the new Capital risk to 87%.
Sam has worked on many similar products before, and understands the industry quite well. He can be a great help to the CEO, which brings the product risk down to 25%.
Unfortunately Sam is not very technical, and cannot contribute to the technical team. The risk of the technology remains at 80%.
Sam has managed complex operational products in the past at scale. He should able to instill processes, best practices, and discipline. Competence on operation should reduce the OpEx risk by 50%, however, because the team never worked directly with Sam, and there are big differences between his previous projects and the companys, the confidence level is only at 20%. The new risk on opex is 80%.
Sam has managed teams of 50+ people, and has the soft skills required to gel a team of high performers. Sam is also very aligned with the mission of the company, and believes the team can achieve the mission. He should be able to reduce the risk on culture by 10% with a confidence level of 20%, bringing the new culture risk to 48%.
Based on these numbers, the new risk is 64%. So the new valuation after Sam joins for a year should be $5 million, a difference of $0.79 million. The company decides to pay Sam $60,000 a year, and an option pool of 20%. The company should consider giving Sam 12.6% stake in the company.
New Person’s Perspective
When considering taking equity from a startup for going salary, you need to consider the upside opportunity, but also the downside risks.
Since equity is usually vested over 4 years, with a year cliff, the way to think about it is using the probability of future value working at the company vs opportunity cost working some where else.
- V(t) = The company valuation at time t.
- E(t) = Equity percentage of the person at time t.
- P(t) = Probability of an exit potential at time t.
- O(t) = The person’s opportunity cost for duration t.
- S(t) = The persons’s salary working at the company for duration t.
So solving for equity we get,
If Linda is planning to join a company after a priced Seed round. She wants to determine her equity position after the 1 year cliff. At her current position, she is making $200,000 per year. So presumably in 1 year she would be making around $230,000 per year. Let’s say the company’s last priced round the valuation at Seed was $10,000,000, so presumably in 1 year the valuation will be around $30,000,000 as they get ready to raise the Series A. The probability of exit potential is 50%. The company offered her a salary of $80,000 per year. Based on these parameter a fair equity position after 1 year cliff,
She should have 1%.
But what if the company valuation isn’t $30 million after a year, and valuation is only $15 million. Then she should be getting 2%.
Usually, vesting period is for 4 years and evenly distributed per year.
One school of thought, to get the total equity for 4 years, we can add up the Equity for each year like so:
This approach isn’t exactly fair for Linda, since she isn’t rejoining each year and is taking a bigger initial risk.
On the other end of the spectrum, we could consider just multiplying the equity of the first year by four. This isn’t exactly fair for the company, since the valuation and her salary will likely increase significantly over time.
What is fair is to take the average between the two
One type of opportunity cost is not starting another company. Which could be a useful exercise to go through using a similar approach as using the company’s perspective formula.
There is no exact science to this question, but having a framework of thinking about it will help you not only understand what value they bring to the table, but also what areas of the business require the most attention. This model is fairly new, give it a try, and would love to hear your thoughts.
Link to example model