How much equity for investors and employees?

Entrepreneurs face some pretty tough questions at a very early stage. Should I take Angel or VC money? How much money should I raise? How much equity should I give up? How much equity should I grant to early employees? There are some guidelines, but every situation is different.

Paul Graham wrote a blog "The Equity Equation" 1/(1-n), which basically says "You should give up n% of your company if what you trade it for improves your average outcome enough that what you have left is worth more than the whole company was before."  For example, if you take $1 Million from a VC in exchange for 33% of your company, it is a good deal if the company is worth 50% more as a result. Theoretically you owned 100% of a $2M company before the investment, and now you own 66% of a company worth $3M.

Both the entrepreneur and the investor have much higher expectations than just "even money" on their bet. The entrepreneur expects the company to be worth many times this valuation and so does the investor. VCs and Angels can add tremendous value to a growing company, and it is in their best interest to work hard for you.

Shouldn't the entrepreneur negotiate to only give up 20% of the company for $1M? The short answer is that the company is only worth whatever a competitive group of investors is willing to pay at that point in time. The key is to have several VCs or investors competing for the deal to arrive at a "fair" valuation. It isn't always possible to have a competitive bidding situation at each financing round so here are some guidelines for funding sources and percentages.

Friends & Family can usually raise between $30K and $300K and usually take an interest bearing note that is convertible into stock at the next financing.

Angels will usually invest between $300K and $2M. They often take a convertible note too, but with warrants for additional shares or a discount on Series A shares. No loss of equity, at least until they convert at Series A.

VCs want to put in $2M to $8M and usually want 30% to 50% of the company. So they will give you a pre-money valuation somewhere around the amount you raise. Sounds strange, but it usually works out that if you are raising $2M the VCs will value your company at $2M pre-money, and $4M post money so they end up with 50% of the stock. If you are raising $5M they will typically value your company at $5M pre-money. The theory is that if they trust you and your business plan enough to give you $5M, then you have probably created something that is already worth $5M.

The second and third rounds of funding take additional shares of equity and dilute existing investors and founders. Founders usually end up with 10% to 20%, all the other employees end up with about 15%, and the VCs end up with about 60% to 75%.

How much money should I take? Marc Andreessen says take all you can get. My simple answer is a little more than you need to reach the next milestone. Don't cut it too close. Things will take longer than you project, some things will go wrong, and it always take longer to raise money than you think it will. So, figure out how much you need to fund you for a year, or to your next milestone, then add 50% as a safety cushion. That is how much you should raise.

Shouldn't I raise as little as possible now and raise more later at a higher valuation? Great in theory, that is what you hope to do. But, don't cut it too close. Give yourself some extra cash and runway to get to the next level. Companies fail because they run out of cash. This sounds simple but think long and hard about this. Companies fail because they run out of cash...they usually don't fail when they have too much cash in the bank.

Don't worry about giving up too much equity at an early stage. If the company is successful you will be very rich. If it isn't successful then holding 60% versus 30% won't matter anyway.

How much equity should be given to employees? This is another tough question but there are some broad guidelines. To use Paul Graham's theory, you should give that superstar employee enough stock to keep them, and in return they should add double the value you gave up. If you give up 1% equity for an employee, they should add 2% of value to the company. That is much harder than you might imagine.

A basic rule is that each level of the organization should get about one half the options as the level above. If a VP level person gets 100,000 shares, then a director level person might get 50,000, and a manager/supervisor might get 25,000 shares. Here are some "average" guidelines for equity percentages at a liquidity event. They start out higher and get diluted down to these levels after multiple rounds of financing;

• CEO - 4%
• VPs - 1% each
• Director level - .5%
• Managers - .25%
• Individuals - .05

Now, lets do the math for a company that has 100 employees. The VCs will end up with about 60% to 75% of the company depending on how much was raised and how many rounds. Founders and VPs usually have about 10% and employees have about 15%.

The CEO will have 2% to 4% depending on when they joined or if they are a founder. Lets say you have a non-founder CEO and two founders who are VPs; they will account for 6% of the stock. There will probably be 4 other VP level people with 1% each. That is a total of 10% for founders and execs.

You might have five directors with .5% each and ten manager/supervisors with .25% each for a total of 5% equity. Then you have about 75 individual contributors at a variety of levels, but on average they hold .05% each for a total of about 4%. So, founders and execs end up with about 10%, directors and managers get 5%, and individual contributors account for another 5% collectively, for a total of 20% of the company.

Should I sell the company now for $5M or hold out for a $100M exit 5 to 7 years down the line? This sounds like a "no brainer" but it really depends on what stage you are at and how much equity you have given up. If you are one of three founders holding 33% of the company a $5M exit gets you $1,667,000. If you build the company to 100 employees and sell it for $100M you will probably end up with about $2M. See the equity percentages above to understand how I got to $2M.

Talk to other entrepreneurs - These are tough questions. Every situation is different. The investment market conditions change all the time. What worked three years ago may not work today. Experienced entrepreneurs who have "been there - done that" are your best source of advice. They have lived it and most often are happy to help a fellow entrepreneur. Good luck!

My next post will be about the importance of cash flow, keeping burn rates low, and how to avoid excessive equity dilution.

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Comments

[Jason]

Great post !!!!!!!!

[Dave]

really great post don. altho i thought paul's post was on target in general, it was a little too simplistic & i think you captured most of the details well.

i also think Leo Dirac's post & presentation on liquidation preferences at Gnomedex was very enlightening as well:
http://www.embracingchaos.com/2007/08/vc-term-sheets-.html

regards,

- dave mcclure

[Alan]

Thanks Don. This puts potential payout into perspective for those thinking about founding or working for a startup.

[chris]

Great post, Don. How often are you seeing immediate/accelerated vesting upon change of control? I see the temperature changing in this regard...

[Dave Schappell]

Great post -- I enjoyed your post in tandem with Paul Graham's.

For folks who want a spreadsheet that lays out Paul's formulas (yes, they're simple... but it's helpful to iterate with actual numbers), I've posted it here:

http://www.nosnivelling.com/Paul Graham equity formulas.xls

[Dave Schappell]

Don -- this version may have a better URL for Paul Graham's Equity Formulas spreadsheet -- my apologies:

http://www.nosnivelling.com/Paul-Graham-equity-formulas.xls

[Mario]

"The second and third rounds of funding take additional shares of equity and dilute existing investors and founders. Founders usually end up with 10% to 20%, all the other employees end up with about 15%, and the VCs end up with about 60% to 75%."

This is just disgusting!

If the contribution investors make to the success of a startup is so valuable like that, well, they shouldn't even bother to look for entrepreneurs. They could do it all by themselves.

Except they can't! They have always been clueless actually.

Even the founders of companies like Cisco had to go through dozens of VC's untill someone gave them the money to start that company (and, in that case, only to completely screw them later).

Web startups, which I presume is the kind of main interest amongst your readers, can be started completely without VC's.

And, even when they are absolutely necessary at some point, it's only after the startup's product, strategy and maybe even its revenues are already well established.

In that case, VC money is used mainly for "acceleration" and not for bootstrapping.

Obviously, they shouldn't get that indecent amount of equity that you suggested at the expense of the founders.

And if you think I'm wrong, just take a look at Facebook's history.

Or, even better, considering the entire software industry history, ask your ulitmate boss at Microsoft what he thinks about your post.

And, by the way, please don't mention Paul Graham's articles as if he would agree with the kind of nonsense you say about equity.

Anyone who has ever read his articles know he wouldn't.

Mario.

[Don Dodge]

Mario, I agree the venture investing landscape is changing. One of the points of my post was to encourage entrepreneurs to get to keep expenses low, get to revenue as fast as possible, and avoid multiple financing rounds and equity dilution.

Venture Capital investing is extremely risky. Most startups fail. That is why the equity dilution is so high. Believe me, if startups could get bank financing at any interest rate they would do it. They can't. So, risk capital like VC money is the usual alternative. The equity dilution over multiple rounds of funding is a fact of life...one that some people don't understand before they start down the VC road. Again, I am trying to open their eyes.

I have written many times that it is much easier, and much cheaper to start a company now. Many web 2.0 companies can get major traction without VC money. I think that is great.

BTW2, Paul Graham understands the equity process very well. Whether we agree with it or not...thats the way it is. Paul is doing great things at Y Combinator to change that. I applaud him.

[Mario]

Well, as I said, maybe we should ask Bill Gates what his opinions on this are.

After all, his choices in that area certainly had a tremendous effect in making him one of the richest men in the world.

And, frankly, not having a board of investors also gave him the freedom to do things like (as he often puts it) "betting the company" on new initiatives, like DOS or Windows itself.

Anyone who is familiar with the history of the industry knows how bold those moves were.

On the other hand, the guys who had the real control at Apple kicked Steve Jobs out of that company, with disastrous consequences.

And I'm not a great fan of Paul Graham.

A friend of mine is participating on the current round of incubation at Y Combinator and if there is at least some small bit of thuth on what he says about the experience, it's not so interesting at all.

I just felt that you mentioned him in a way that gave the impression that he would agree with most of what you said when, in fact, he wouldn't.

And, as we both know, he is quite popular with startup founders wannabes right now.

Cheers.

Mario.

[Lee]

Sorry, but how is $2 million dollars "very rich"? I don't see the point of working 5-7 years to build a 100-person company if at the end thats all you get, and most of the reward goes to the VC's. It would be much better to have a so-called "lifestyle" business in that case.

[Don Dodge]

Lee, I agree that working 5 - 7 years for $2M doesn't make you very rich. You seem to have missed my point.

My point was to avoid equity dilution by getting to cashflow break even as soon as possible. And that selling out early for less money could actually be a better deal.

If you go down the VC financing path you better be thinking in terms of a $500M to $1B exit. Then your 4% of the stock is worth $20M to $40M.

[Jake Kennedy]

I really appreciate this post. Equity participation definitely needed to be addressed. So many things that entrepreneurs don't consider stops them dead whaen they make a gaffe with private investors or VC s because they did not know what to address or how. I'll be thinking this one over tonight. I'm looking forward to the next one.