Equity is the most expensive currency for a startup. Before giving employees or VC’s equity, be sure to analyze the investment you expect out of them. As a cofounder bringing on new employees you are probably strained on capital. But you still need a product and some employees to grow your business, so you are considering promising equity in exchange for cheaper engineering. How much equity should you give a first employee to save a little cash? The answer is short…. Not much.
That might sound harsh especially to tell a new employee who is taking a big risk quitting their day job to work for your new startup, at probably a much lower salary than she otherwise would have gotten, but let me explain. At a pre-seed stage, and even up to a seed stage, your company is worth nothing. Literally $0. Even if you pay your first employee with an astounding 5% equity what have you really paid them? The math makes calculating this pretty easy….
$0*0.05 =$0
But you are part of a startup! You will raise that seed round… that makes your worth something right? Yes. Once you have raised a round of funding and have had a valuation then that equity you are promising your employees is worth something! But let’s back up and consider how we get to a big valuation…. When you raise money from a VC, you should expect that their money will give you at least 5x return on your business (not valuation, but business production), otherwise they aren’t good investors. That means if you are generating $1,000 a month, after an investment (assuming it was a good investment), you should be able to grow your business to generating $5,000+ a month. In exchange for an investment, at the seed or pre-seed round, you will give up around 10% of your company. But that isn’t enough, you want to grow even bigger! So you take on another investment, which also helps you grow 5x. Now you are generating $25,000+ a month, but you also gave up another 8% of your company. But you still want to grow bigger right? So you take on another investment in exchange for another 6% of your company. You are now generating $125,000+ a month. Now that is a company that is worth something. At this point, you should be a large enough corporation, that you will have an option pool, which would grant additional amounts of equity to all your employees! Cha-Ching!
There are a few things to notice here.
In this completely hypothetical situation, you have grown your company 125x and have given up 24% of your company. Using simple math here, we can normalize growth per equity:
125/24=5.2
Each percentage of equity given away is worth a 5.2x growth for your business. Being realistic, can a single employee make a 26.2x difference making them worth 5%? Probably not. Can an employee make a 5.2x increase to your business justifying a 1% equity payment?… that is much more realistic. To achieve the 125x business return, 24% of your company has to be free to give to investors. If you are giving away anything more than 1% to employees, you won’t have enough equity to be able to reach this growth.
If you gave your first employees 5% instead of 1%, then you only have enough equity left to give up 20% to investors instead of 24%. This means you will only get 2 investments instead of 3, only growing 25x instead of 125x. Effectively making both the company and your first employees equity worth 25 times less than having used that equity to get that third investment.
Long story short…. For a founder, giving up equity to save cash is tempting. As a first employee, asking for a lot of equity is also tempting. But don’t do it. Saving equity to grow the company is often more advantageous for everyone involved. As a first employee, it may seem you have a smaller piece of the pie, but with the correct investments, you will have a much larger pie… making your small piece not seem so small anymore.
Rules of thumb…