Nivi · July 19th, 2007
As this nuclear winter of venture hacks continues, I thought you might enjoy our thoughts on Paul Graham’s The Equity Equation. Paul says,
“Whenever you’re trading stock in your company for anything, whether it’s money or an employee or a deal with another company, the test for whether to do it is the same. You should give up n% of your company if what you trade it for improves your average outcome enough that the (100 – n)% you have left is worth more than the whole company was before….
“In the general case, if n is the fraction of the company you’re giving up, the deal is a good one if it makes the company worth more than 1/(1 – n) [Ed: This is the equity equation].”
Read the rest of The Equity Equation first; it is great. As usual.
We have some additional thoughts. As usual. =)
Summary: 1. You have to pay market rates regardless of the equity equation. 2. Consider the opportunity cost of spending shares on employees and investors. 3. Offers from top-tier firms increase your valuation.
You have to pay market rates regardless of the equity equation.
In practice, you raise money or hire an employee because you need to, not because you want to. And you have to pay a market rate no matter what the equity equation says.
Say the equity equation tells you to pay a prospective hire above market. You should still pay the hire a market rate and save the company some equity.
Say the equity equation tells you to pay a prospective hire below market. The hire will simply argue that the market values her higher, and that you should pay her a market rate. It’s tough to fight this normative leverage.
When you’re hiring, first figure out the market rate for the position. We previously posted a table of market rates for employees. When you evaluate a candidate, ask yourself whether she is likely to increase the next round’s share price (include the dilution of her market rate options). If the answer is yes, she is a possible hire. If no, she is a no hire. This approach forces you to think about building value, not filling a position.
# Consider the opportunity cost of spending shares on employees and investors.
“One of the things the equity equation shows us is that, financially at least, taking money from a top VC firm can be a really good deal. Greg Mcadoo from Sequoia recently said at a YC dinner that when Sequoia invests alone they like to take about 30% of a company. 1/.7 = 1.43, meaning that deal is worth taking if they can improve your outcome by more than 43%. For the average startup, that would be an extraordinary bargain. It would improve the average startup’s prospects by more than 43% just to be able to say they were funded by Sequoia, even if they never actually got the money.”
You need to consider the opportunity cost when you spend equity. You should only give out equity if it increases your share price optimally. You can buy a lot of things with your equity—buy things that increase your share price the most.
Is selling 30% of your shares to a top-tier firm the most effective way to spend your shares? What if another investor will give you the same terms for 20%? Should you take it? Could you spend the remaining 10% on killer developers and sales guys? Could you spend the savings on great advisors? Could you spend the saved equity on the best board members money can buy?
Entrepreneurs should think about unbundling money and value add. Get money on the best terms and get the best value add.
Would you hire an investor to serve on your board if he didn’t bring money with him? If the answer is no, his value add is literally worthless. If the answer is yes, then put a price on that value add and adjust their offer (in their favor) so you can compare it to other offers apples-to-apples.
(Note: This is not an argument not to take money from top-tier firms, we have raised money from top-tier firms.)
Offers from top-tier firms increase your valuation.
“The reason Sequoia is such a good deal is that the percentage of the company they take is artificially low. They don’t even try to get market price for their investment; they limit their holdings to leave the founders enough stock to feel the company is still theirs.”
When a top-tier firm offers to invest, the market price for your company immediately goes up. Firms tend to invest in herds and everybody wants to steal a deal from a top-tier firm.
The last-and-final offer from a top-tier firm will be slightly less than market. They will argue that they should pay less because they bring a lot more value than their competitors, they have a brand, et cetera. But overall, an offer from a top-tier firm increases your valuation.
Top-tier firms try to avoid increasing your valuation when they make an offer. For example, they may give you an exploding term sheet. But, in practice, in this market, we rarely see exploding offers from any firm.
Many firms add lots of value and help like crazy. But entrepreneurs should understand that the top firms pick the best companies, they don’t make the best companies. They say so themselves.
The top firms are mainly in the business of making money for their limited partners by picking the startups that are going to succeed with or without their value add.