When To Give Equity To An Employee Or Investor

When To Give Equity To An Employee Or Investor?

In the whirlwind world of start-ups, one of the most challenging aspects founders grapple with is equity distribution. This involves deciding what percentage of your company to give away in exchange for investment or to an employee. Such decisions are pivotal and can make or break your business's future. A common question is, should you accept an investor's offer? The answer lies in the equity equation: 1/(1 - n).

Understanding The Equity Equation

The equity equation is a simple yet powerful tool that assists in making an informed decision about equity distribution. It's essentially about trading a part of your company for something that significantly enhances the company's average outcome. This means you should give up 'n%' of your company if what you trade it for improves your average outcome enough that the remaining (100 - n)% you have left is worth more than the whole company was before.

Equity for Investment

For instance, let's consider that an investor is interested in acquiring half of your company. Now, how much should that investment augment your average outcome to break even? As per the equity equation, it should double. This means if you trade half of your company for something that more than doubles the company's average outcome, you're net ahead. You'll have half as big a share of something worth more than twice as much.

The General Case

On a general note, if 'n' is the fraction of the company you're giving up, the deal is considered beneficial if it makes the company worth more than 1/(1 - n).

For example, if a funding organisation proposes to fund you in return for 7% of your company, where 'n' is .07 and 1/(1 - n) is 1.075. Hence, you should accept the deal if you believe it can improve your average outcome by more than 7.5%.

The Role of Venture Capital Firms

Venture Capital (VC) firms often play a significant part in start-ups. An investment from a top VC firm can be a great deal. They typically like to take about 15-30% of a company.

Equity for Employees

The equity equation can also be used when offering stock to employees, albeit in a different direction. If 'i' is the average outcome for the company with the addition of a new person, then they're worth 'n' such that i = 1/(1 - n), which translates to n = (i - 1)/i.

For instance, if you're two founders looking to hire an additional skilled employee who can increase the company's average outcome by 20%, n = (1.2 - 1)/1.2 = .167. Therefore, you'll break even if you trade 16.7% of the company for him.

Considerations for Hiring

However, it's crucial to remember that stock isn't the only cost of hiring someone; there's usually salary and overhead as well. And if the company merely breaks even on the deal, there's no reason to do it. It's beneficial to translate salary and overhead into stock by multiplying the annual rate by about 1.5.

It's also crucial that they like beer...

Employee Salary and Equity

The salary of early employees plays a significant role in equity allocation. The lower the salary, the more stock can be given to them. However, remember that this comes at a cost to the company's current valuation.

Share Options To Incentivise Employees

Note that often times equity can be given to employees in the form of Share Options. Share Options gives employees the right to buy shares of a company at a fixed price, at a certain time in the future.

They therefore have an incentive to grow the company as if they are able to increase value of the company, the shares they will purchase will be more valuable than they cost.

Often, if the employee doesn't have the money to actually buy the shares when they time hits, they will simply sell the Option back to the company, getting a cash windfall.

They are commonly used as a form of compensation for employees, since they're such a good incentive for the employee to perform, and to stick around (ie not leave). 

Equity Distribution: A Balancing Act

Ultimately, equity distribution is a balancing act. While there's no formula that can guarantee flawless equity grants, understanding the equity equation can help make informed decisions.

Conclusion

Equity decisions should always leave you feeling richer. If the trade didn't increase the value of your remaining shares enough to put you net ahead, you probably shouldn't have done it. Therefore, whenever you make any decision involving equity, run it through the 1/(1 - n) equation to see if it makes sense.

Notes

  • The equity equation helps to understand when and how much equity to give away, whether it's for investment or hiring.
  • The role of Venture Capital Firms and the impact of employee salary on equity distribution cannot be overlooked.
  • Equity distribution is a balancing act and should always be done in a way that leaves you feeling richer.

Fun Quiz: What Office Jargon Sh*t Do You Say?

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