Paul Graham: How to Share Startup Shares

July 2007

An 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?

These are some of the difficult questions that the founders face. But there is an answer to this:

1 / (1 - n)

No matter what you are going to exchange your company’s shares, whether in cash, or employees, or shares of another company, the formula is the same. You should change n percent of your company in the event that, as a result, the remaining (100 - n)% of yours is more than the cost of the company 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 so that you stay with yours? Obviously, the cost should increase in 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 left, which will cost as a whole.

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

For example, the Y Combinator venture capital fund offers to 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 total cost by 10%, you will benefit, because the remaining 0.94 is 0.94 x 1.1 = 1.034. [1]

This fair equation shows us that, at least financially, taking money from a leading venture company can be a great move. Greg Mcadoo of Sequoia recently said at a dinner at YC that when they invest on their own, they usually take 30% of the company. 1 / 0.7 = 1.43, i.e. the transaction will be worthwhile if they increase the total value of the company by 43%. For a mid-sized startup, this is an extremely lucrative deal. The opportunity to say that Sequoia has invested in them, even if they never receive the money, will increase startup prospects by more than 43%.

In general, deals with the Sequoia fund are so good precisely because it consciously takes a small part of the company. They don’t 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 a year, and invests only in 20. Therefore, the chance to be among them is 1 in 300. Those who succeed are unusual startups.

Of course, you need to consider other parameters when attracting venture financing. This is never a simple exchange of money for stocks. But everything happened just like that, then getting money from such a popular company would be luck.

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 so 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 it 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 even if in general you do not lose, then there is no reason to do so right away.

I think you can take into account salary and other costs in this formula by multiplying the annual value by 1.5. Most startups either grow fast or die. In the latter case, you will not have to pay him at all, and in the first 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 extra margin should a company have as an “activation energy" for a transaction? Since this, in essence, gives the company an advantage in hiring employees: if the market appreciates your attractiveness, you can demand more.

Let's take an example. The company wants to get 50% of the “profit” from the new employee mentioned above. Then we subtract a third from 16.7% and get 11.1%, its “retail" price. Suppose, over time, it will cost 60 thousand dollars a year, because of salaries and other costs, we multiply by 1.5 = 90 thousand dollars, i.e. 4.5% 11.1% - 4.5% = supply 6.6%.

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

Of course, these calculations are to some extent a game. And I do not urge to give out 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 payout table of some venture company, you can analyze it.

Formula 1 / (1 - n) can also be used in a broader sense - whenever you have to make a decision in matters of the company's share capital in order to verify their appropriateness. You should always feel richer after an exchange of company shares. If, after the sale, the cost of your own part does not rise so much that you remain at your own, you should not (should not) have done so.

Notes

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

[2] The obvious choice for evaluating your company is a post-investment assessment of the value of the company, after receiving the last tranche of investments. This will probably result in the underestimation of your company, because a) in spite of 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 different participation of investors.