How much equity for investors and employees?

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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