Paul Graham: how to share shares in a startup

July 2007

The investor is ready to give you money for a certain percentage of your startup. Agree? You are about to hire your first employee. How many shares will he promise?
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This is one of those difficult questions that confront the founders. But there is an answer to this:

1 / (1 - n)

Whatever you are going to exchange your company's shares, whether cash, or employees, or another company's shares, the formula is the same. You should change n percent of your company in the event that in the end your remaining (100 - n)% more than the company cost before the exchange.

For example, if an investor wants to buy half of your company, how much should these investments increase the value of the entire company in order for you to stay with yours? Obviously, the cost should increase by two: if you sell half for something that doubles the value of your company, you will not be at a loss. You will have half, which will cost as a whole.

In general, if n is the part of the company that you donate to, the deal will be good if the value of the company is more than 1 / (1 - n).

For example, the Y Combinator venture fund offers to profoundly fund you in exchange for 6% of your company. In this case, n is 0.06 and 1 / (1 - n) will be 1.064. If we increase the final cost by 10%, you win, because your remaining 0.94 is 0.94 x 1.1 = 1.034. [one]

This fair equation shows us that, at least financially, taking money from a leading venture capital company can be a great move. Greg Mcadoo of Sequoia recently said at a dinner at YC that with self-investing they usually take 30% of the company. 1 / 0.7 = 1.43, i.e. the deal will be worth it if they increase the total cost of the company by 43%. For a medium-sized startup, this is an exceptionally good deal. The ability to say that they were invested by Sequoia, even if they never get the money, will increase the prospects for a startup by more than 43%.

In general, transactions with the fund “Sequoia” are so good precisely because he deliberately takes a small part of the company. They do not even try to get market value for their money; they limit their appetites so that the founders can feel that the company is still theirs.

The fact is that “Sequoia” receives about 6,000 business plans per year, and invests only 20. Therefore, the chance to be among them is 1 to 300. Those who succeed in this are unusual startups.

Of course, you need to take into account other parameters when attracting venture financing. This is never a simple exchange of money for shares. But it all happened that way, then getting money from such a popular company would be a success.

You can use the same formula when allocating shares to employees, but in this case it works differently. If i equals the approximate value of your company after hiring an additional employee, then they cost n such that i = 1 / (1 - n). What does n = (i - 1) / i mean?

Imagine that you are two founders, and you want to additionally hire a competent programmer who is so good that you feel: “yes, he will increase the total value of your company by 20 percent.” Then: n = (1.2 - 1) /1.2 = 1.167. It turns out that you will not lose anything if you give him 16.7% of your company.

This does not mean that you need to give him exactly 16.7% of the company. The opportunity to become a shareholder is not the only advantage, because there is still a salary, and other costs that you will incur in connection with hiring an employee. So if even in general you do not lose, then there is no reason to immediately do so.

I think you can take into account the salary and other costs in this formula by multiplying the annual value by 1.5. Most startups either grow quickly or die. In the latter case, you will not have to pay him at all, and in the first case you will pay him a salary based on the value of the company in a year, which is likely to be 3 times more. [2]

How much additional margin should a company have as an “activation energy” deal? Since this, in essence, gives the company an advantage in hiring employees: if the market assesses your attractiveness, you can demand more.

Let's look at an example. The company wants to get 50% of the “profits” from the new employee mentioned above. Then we subtract one third from 16.7% and get 11.1%, its “retail” price. For example, over time, it will cost $ 60 thousand per year, because of wages and other expenses, we multiply by 1.5 = $ 90 thousand, i.e. 4.5%. 11.1% - 4.5% = 6.6% offer.

By the way, please note that the first employees should take a small salary. This will allow them to get more company shares.

Of course, these calculations are to a certain extent a game. And I do not urge to distribute shares of the company, strictly following this formula. Often you will have to act at random. But at least you will know to what extent. Now choosing a number, following your own intuition or from a typical payment table of a venture capital company, you can analyze it.

Formula 1 / (1 - n) can be used in a wider sense - whenever you have to make a decision in matters of the company's share capital to test their feasibility. You should always feel richer after the exchange of shares of the company. If, after the sale, the cost of your own part does not go up so much that you stay with yours, you should not (should not) do it.

Notes

[1] That's why we can't believe that someone found the deal with Y Combinator bad. Does anyone really find us so useless that we cannot increase the potential of a startup by 6.4% in three months?

[2] The obvious choice for evaluating your company is a post-investment valuation of the company, after receiving the last tranche of investments. Probably, this will result in the undervaluing of your company, because a) despite the fact that you only received the last tranche, the company is supposedly worth more, and b) the assessment at the initial stages of financing usually reflects other investor participation.