Nice article, but drastically oversimplified. Paul ignores two critical issues: Risk, and non-linear utility-of-money functions. These two factors become critical when there is a tradeoff between probability of success and the payoff of success.
Suppose, as a simple example, that I have a startup which I think has a 50% chance of succeeding and being sold for $1M, and a 50% chance of failing and being worthless. Now suppose that Paul selects me to participate in YC, but wants 10% of the company, and I think his help will leave the potential valuation unchanged but increase the chance of success from 50% to 55%. If I accept his offer, my EXPECTED return drops from $500k (50% of $1M) to $495k (55% of $900k) -- but I'd still accept the offer, because increasing my chance of getting that first $900k is worth far more than getting an additional $100k on top of that.
On the other hand, suppose a venture capital company comes along and offers to help me expand into a much larger market, where I'd have a 10% chance of the company being worth $100M (and a 90% chance of the company being worthless), in exchange for taking 50% of the company stock. If I accept the offer, my EXPECTED return jumps from $500k to $5M (10% of $50M) -- but there's no way that I'd accept the offer, because I really don't want to spend years of my life on something which has a 90% chance of being worthless.
It's important to understand the numbers, but in the end the numbers, at best, have to guide you rather than making decisions for you.
Actually not. That's why I was careful to speak of the effect of trading equity on the "average outcome" rather than e.g. "average valuation at liquidity." What I'm literally saying is, does the trade improve your odds of getting what you want? That subsumes both your risk aversion and your utility function for money.
Your math is still wrong, because of the non-linear utility of money. If I give up 6% of my company, it costs me 6% of any MONEY I might end up getting, but it doesn't cost me 6% of the UTILITY. If I have a utility-of-money function of sqrt($), you don't have to increase my chance of success by 6.4%; it's enough if you increase my chance of success by 3.2%.
In this case, oversimplifying is warranted, mostly because the things glossed over are either sufficiently complicated that it's hard to make simple, or are things are already generally known.
Take, for example, the 50% point. Once you hand over so much stock that the amount you and the people you implicitly trust hold dips below 51%, you've lost control. Clearly an issue outside of the 1/(1-n) equation, and yet not really relevant. Everyone knows this already.
Then there's the general notion of not handing out too much stock to too many factions, but this too is more or less established knowledge amongst the target audience.
Having said that, the nuance of factoring in odds of success is a worthwhile consideration. Hat off for explaining it!
I agree that simplifying is warranted! I can't understand complex things anyway. Plus if you can't explain it, you don't understand it.. here I feel like I got some modicum
of insight.
"I really don't want to spend years of my life on something which has a 90% chance of being worthless."
How does that mesh with the fact that a failed startup is probably worthless (in the literal sense that you can't make money from it), and most startups probably have >90% failure rate?
I know there is a learning experience in startups and that working hard on something fun is valuable, so worthless is really just talking about immediate money here.
I don't think my probability of failure is 90%. :-)
This isn't as naive as it sounds: If you take VC with standard liquidation preference terms, the company needs to do really well before you get anything back -- so the amount of money you need to avoid "failing" is dramatically increased.
In my case, since I don't intend to take any VC, there's a wide range between "failure" (making less money than I would have earned risk-free by working at the university for the same duration) and "success" (making enough money that I never need to work again).
Also, on a more self-serving note: I'm a heck of a lot more competent than 90% of startup founders. Or even 90% of YC-funded-startup founders for that matter -- and YC-funded startups have distinctly less than a 90% failure rate.
yep, immediately thought of that too. PG writes VERY good stuff most of the time and is very smart about a lot of things, but when he strays into areas in which he is not well versed (the unions essay comes to mind), he ends up writing pieces with obvious holes.
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?
The math equation is correct, but the likely outcomes are nearly impossible to estimate. I have been on the management team of 5 startups and advised many others. There are some "norms" and guidelines for how much to raise at each stage, how much equity to give up, and even how much stock to grant employees as you grow the company.
I wrote an in depth blog on these questions, too long to detail here, but Paul is on the right track. For more details see How much Equity for Investors and Employees?
Paul - This is Seth Levine (quoted in the USA Today article referenced and appropriately called out in your post). Let me set the record straight. While I've seen plenty of articles come to press that has somewhat inaccurate quotes, this was the first time I've been completely misrepresented in an article. I've written a full post on my views here - http://sethlevine.typepad.com/vc_adventure/2007/07/setting-t.... It's particularly frustrating in this case, as I've spent literally hundreds of hours working with TechStars and TechStars companies in Boulder this summer (and am the lead mentor to one very promising project). I actually believe strongly in the model.
I hope you'll consider posting this response up to your main site with a reference to my post clarifying my views.
The article ignores how market prices work - the formula presented lets you know the maximum equity you can give up and still get a positive return by doing so, but incorrectly explains why VCs accept much less - the minimum equity a VC can accept and still expect a positive return on their investment can be far lower than the maximum the startup can afford to give profitably. The VCs are subject to competition with other VCs, so in such cases they cannot force the startup to accept a just-better-than-breakeven deal.
Why can VCs afford to give up stock and founders not? Are you talking about liquidation preferences?
Startups are just as subject to competition. There's a profit margin on taking investment just as there is on hiring someone, and it expands and contracts depending on how hot the startups is.
I think I was unnecessarily unclear - let's say we're talking about buying eggs. Suppose I'm willing to pay up to $3 for a dozen. That doesn't mean that I should buy them if I find eggs for $2.99 - I should keep shopping around, because grocers can profitably sell eggs for $2 a dozen, so I'm bound to find eggs closer to the $2 mark. I need to take into account what would be reasonable for the other party when deciding if a deal is reasonable, not just the limits of what would be reasonable for me. If I'm stuck, and everyone is selling eggs for $3 a dozen, then it matters whether that's beyond my personal threshold or not. If I only note how close a deal is to my personal threshold, without noting whether the other party would be likely to agree to a more favorable deal, I'm liable to get ripped off, unless I have no leverage for negotiating anyway, and I can only take it or leave it.
Even in a simple model, time should be incorporated, right? The total cost for the life of the company of an employee is included, assuming a particular growth rate. What about for investment? "the total cost of this round of funding" doesn't make sense so much. And surely the rate of increased value of your company matters.
Also, it seems, like you note in the end, that there is still a gut feeling, and here it is stated simply: how can you predict how much your company will grow because of an investment?
This is easier if you have sales numbers that show some trend, where investing $N in business development yields X more users leading to Y more profit. If you're reddit, and you haven't even monetized your users before being purchased, this can be harder. Also organic growth implies less direct business development.
One simple question that I think has a standard/GAAP answer: how much is your company worth if you are making $X yearly and growing at a rate of Y%? I vaguely recall terms like "good-will estimates" and "present value of future money" in the single management class I've taken years ago. But is there something standard for a company going through valuation for acquisition or taking a next round of funding. [Ignore for the moment that a company making a nice profit and growing ideally wouldn't need a next round of funding.]
"how much is your company worth if you are making $X yearly and growing at a rate of Y%"
In finance, the standard answer is "the net present value of all future cash flows". Basically, all cash that the company throws off beyond expenses technically belongs to the owners. However, owners could've parked their money in T-bills instead of investing it, and they'd receive interest for it. So you discount these future cash flows by a factor that depends on the rate of interest and the time between investment and cash flow, and then sum up all these discounted cash flows over the life of the company. If earnings are growing, you just figure the increased earnings into your calculations. http://en.wikipedia.org/wiki/Net_present_value
I dunno if VCs and acquirers use this method: they face a problem in that it's notoriously difficult to estimate the future cash flows of an unprofitable technology company. They might be building a stellar product and growing market share for years, then suddenly start raising their prices when they become a monopoly. Or they might be building a mediocre product and growing market share for years, and then lose them all when they start raising their prices and a competitor comes along.
Then my earlier points are even more important.
How much will your company be worth? How much _more_ is it worth after taking more funding? Who knows? All hard questions.
Was this article written in response to Seth Levines comment? What Seth Levine doesn't know or doesn't want to tell is that a lot of YC alums could raise the 5K/founder on their own, so money is NOT the primary reason they are there.
I'd been thinking of taking that footnote out, since it seemed like everyone now finally understood us. But when I saw that old dumb argument again in the USA Today article, I decided to leave it in.
I can't help but laugh at the audacity of another tech-related investment firm commenting like that. He is trying to persuade people that YC is just writing cheques.
From my perspective it's partically an emotional path, not merely an analytical path. A company that's a startup has an intention, and it's one of these:
1. You use resources to incrementally grow a user base and get market share, then sell it off to a bigger company
2. You develop technology that enhances a company's market share and pulls users from a competitive company's market
3. You lose, and the investor loses a small amount of money
The bottom line for me is that the value of your start-up is based on the number of users you can get. It's about your intention X with the assistence of your investor will find the users and people you need. Whether it's a good deal or not is irrelevant if those are not true - take the journey.
Whether it's a Mobius or another VC, for me as an entrepreneur, they have not established a community tool to have access to a community that will help grow the start-up quickly. You're not just buying equity in the equation X you're buying into the community's collaboration.
The equity value is not just based on "here's some money for X cents on the dollar" X it has to go beyond that.
"The equity value is not just based on "here's some money for X cents on the dollar" X it has to go beyond that."
Uh, no it doesn't. Equity has value, and so does what you get when you give up value. When you're like for like, emotional attachment doesn't make sense.
It's not an equation, but for employee options my gut has always been that you get options as a function of how much your improve the odds of the company's ultimate success.
Founders get a lot because they take it from zero to something.
Senior folks get a lot because the influence it significantly.
Early grants > Later grants because the ability to change the trajectory is typically smaller.
This is a nice analysis and good thinking, though it's worth noting that liquidation preference makes the VC equation less favorable. I'm not sure how Y Combinator works, but preference plays a shockingly large role when you run these types of calculations against your hypothetical VC deal.
Given PG's formulation, liquidation preference plays no part in the value-of-equity equation, since it can be factored out into the average outcome.
But sure, it does tend to depress average outcome. Then again, if your outcome is dominated by the presence of very-high-value possibilities, a reasonable liquidation preference may be no big deal.
A smart company would give 6% equity to YC just for the advice and publicity. The cash is the least valuable part of the equation. 5k per person can be saved up in a number of months, even for relatively low salaries if you are stingy.
Am trying to remember if I did that after I was rejected from SFP2005...I know that I offered them free equity in exchange for advice and the ability to come to the YC dinners, but I can't remember if I offered cash. Probably not, as I was poor at the time.
Are you asking if YC charges potential investors to attend their demo days?
Interesting if they did... part of YC's function is to introduce follow-on investors to their startups, but I've never thought about their charging investors for that privilege.
Who says there's no business model in the Web 2.0 world?
at a high-level i agree with the post, however practically speaking, you're overlooking several significant issues:
1) diff between preferred vs common shares
2) liquidation preferences in terms sheets
3) supply/demand for investor capital in the market
4) competitive position of VC/company in the market
5) exit targets / preferences / restrictions by investors / entrepreneurs
these 5 factors (& many others) have DRAMATIC impact on the 1/(1-n) calculation you mention. while i don't disagree with you in theory, practically applied the outcomes matter a fuckload.
Very good article thanks -- why am I not surprised? :-) Few minor points. Sometimes, not often, your initial valuation may affect the subsequent rounds (they shouldn't but may). Crowded cap tables are also problematic. Initial employees contributions, however small, will entitle them to more shares that the later ones -- which may cause discontent. Finally think about how many 6.7% you can give up?
I am not even going to get into option analysis; talk about introducing non-linearities. But even in a linear stream Paul's footnote that YC combinator brings to table a lot more than 6.7% (?) is probably correct, but it should also take into account the effects of the multiplier of the later rounds and options on both side.
But it's not that simple. Startups are always measured against their competitors. So even if the 1/(1-n) shows that it is a net gain for me, it may be an overall loss if my competitors make deals that are worth significantly more for them.
For me, the question that the startup should ask more critically is around the total dilution-to-exit. If taking Paul's money for 6% now reduces the dilution at some subsequent round from, say, 40% to 30%, then by my reckoning the founders end up with 66% instead of 60% of the final position. Key here is usually a combination of the value-add from the VC, and their ability to underwrite/cornerstone a good part of that follow-on round. (Although obviously this is only relevant if a larger follow-on round is going to be needed!)
I read only some of these comments and I have to say: EASY !!!
This is static analysis of a single decision; and it has to be viewed with those limitations in mind.
Option analysis and risk, nor is dilution after each round is talked about here. Yes if the Google founders had given shares left an right they would be in serious trouble making isolated decisions. Nonetheless, it is hard if not impossible to bring mathematical rationality to something fairly dynamic, if not irrational.
These comments are very confusing. Paul -- a simple question: doesn't the amount of capital offered/invested have a big impact on the calculation? Sure I'd give up 6% of my pre-natal company for $1 million. But would I for $1 thousand? No. Doesn't your analysis suggest that in both cases the calculation is 1/(1-n)? Yet the ability to add 6.4% value at exit given $1 million is vastly different than if given $1 thousand...
I guess I'm the only dumb one here. Can someone explain to me how he came up with the 1.5 as a multiplier for the new hire's salary? Also the part where he talks about making a 50% "profit" on the new hire and then proceeds to subtract a third from 16.7%. Why 50% and why 1/3? How did he come up with those numbers? Please enlighten me.
ok, so we're a new c-corporation out of north carolina, three new unc mba graduates with a fourth ruby coder out in pasadena. we have a hotmail-sized concept with a working prototype already built. it's addictive, the kids are going to love it (parents too). all we want to do is hire ourselves and knock the project into beta. we also know that if we launch and gain x users right out of the gate, we will be able to get a better deal from investors.
questions = what is x? how many users does a hot new web 2.0 service need before jaded vc's start paying attention? what are the other eye openers in your opinion? until i read this article, i had been of the point of view that you should turn down all investment until you launch if at all possible. is that correct or am i wrong?
I am thoroughly fed-up hearing this self-serving tripe from investors.
If all I am looking for is financial independence (say $3M), why would I trade an 80% probability of success for a 5% probability of achieving 100 times that by selling out to VCs?
Sure, my expected return is 6 times greater, but now I need approximately 31 (=log 0.2 / log 0.95) bites at the cherry to guarantee an 80% probability [1] of success. That's 6 lifetimes of startups for a serious serial entrepreneur (most of us have energy for one, maybe two, startups).
Unlike VCs, who invest in a portfolio of companies, I don't have a portfolio of lives.
[1] This assumes only two outcomes from a VC-backed company: zero return or $300M exit. Obviously there are a range of returns, but this is a reasonable approximation since VCs have no interest in seeing low returns - they'd rather kill the company than waste their time.
And I am thoroughly fed up with people who jump to conclusions after misunderstanding something I've written, and post comments using language they'd never use talking to someone in person. (At least, language I hope they'd never use.)
"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."
If Sequoia took ordinary stock for their money that argument would have some legs. But otherwise, it is self-serving (for the VCs). Once you take their money at valuation X, liquidation preferences and control clauses guarantee that you're not getting anything until the company is worth at least 10X. It doesn't matter whether the founders still have 95%, they've given up control over the outcome that matters to them.
Angels are a different story. I have angel investors myself, carefully chosen, and with a term sheet that is much fairer than anything you'll get from VCs (they can't screw me; I can't screw them).
I used to have some deference for VCs, but after hearing their self-serving arguments and witnessing their arrogance for years, I don't waste my time (being profitable also helps).
Don't get me wrong, we could grow faster with VC money, and I'd do it on the right terms. But these days, if a VC contacts me I always ask them within the first 2 minutes whether they'd invest on similar terms to the existing angels. The answer is always "no". They never have a good response to the obvious question: "how do your terms make sense for a founder?".
As for language, I apologise. I have not used the expression "self-serving tripe" in person with a VC, but I've been close. They need to hear it sometimes.
So very useful. These are issues we all have to parse through and while you note it's not a magic formula, it's certainly a good one to understand as a young entrepreneur. Thanks.
Nate Westheimer
BricaBox.com
Paul, I really liked your article and I have always wondered about working out these financial details. Its cool how you did it for employees. I liked the fact that you kept it simple.
The theory is that the market will grow and/or you will
exhibit exponential growth. Take for example Google which is valued by the outstanding shares value (market cap) which is driven mostly by public perception of market growth and Google's operation with respect to real and perceived growth..
So apply this to your startup.. get VCs to bid on it.. If you have revenues then you can go to a bank and
see what type of credit line your business qualifies for.
But since most startups don't have revenue then you really don't know.
Essentially your initial idea is worth $0... this is why angel investors are nice to have. They make the first real
valuation.
Nice article, but drastically oversimplified. Paul ignores two critical issues: Risk, and non-linear utility-of-money functions. These two factors become critical when there is a tradeoff between probability of success and the payoff of success.
Suppose, as a simple example, that I have a startup which I think has a 50% chance of succeeding and being sold for $1M, and a 50% chance of failing and being worthless. Now suppose that Paul selects me to participate in YC, but wants 10% of the company, and I think his help will leave the potential valuation unchanged but increase the chance of success from 50% to 55%. If I accept his offer, my EXPECTED return drops from $500k (50% of $1M) to $495k (55% of $900k) -- but I'd still accept the offer, because increasing my chance of getting that first $900k is worth far more than getting an additional $100k on top of that.
On the other hand, suppose a venture capital company comes along and offers to help me expand into a much larger market, where I'd have a 10% chance of the company being worth $100M (and a 90% chance of the company being worthless), in exchange for taking 50% of the company stock. If I accept the offer, my EXPECTED return jumps from $500k to $5M (10% of $50M) -- but there's no way that I'd accept the offer, because I really don't want to spend years of my life on something which has a 90% chance of being worthless.
It's important to understand the numbers, but in the end the numbers, at best, have to guide you rather than making decisions for you.
Actually not. That's why I was careful to speak of the effect of trading equity on the "average outcome" rather than e.g. "average valuation at liquidity." What I'm literally saying is, does the trade improve your odds of getting what you want? That subsumes both your risk aversion and your utility function for money.
Your math is still wrong, because of the non-linear utility of money. If I give up 6% of my company, it costs me 6% of any MONEY I might end up getting, but it doesn't cost me 6% of the UTILITY. If I have a utility-of-money function of sqrt($), you don't have to increase my chance of success by 6.4%; it's enough if you increase my chance of success by 3.2%.
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In this case, oversimplifying is warranted, mostly because the things glossed over are either sufficiently complicated that it's hard to make simple, or are things are already generally known.
Take, for example, the 50% point. Once you hand over so much stock that the amount you and the people you implicitly trust hold dips below 51%, you've lost control. Clearly an issue outside of the 1/(1-n) equation, and yet not really relevant. Everyone knows this already.
Then there's the general notion of not handing out too much stock to too many factions, but this too is more or less established knowledge amongst the target audience.
Having said that, the nuance of factoring in odds of success is a worthwhile consideration. Hat off for explaining it!
I agree that simplifying is warranted! I can't understand complex things anyway. Plus if you can't explain it, you don't understand it.. here I feel like I got some modicum of insight.
"I really don't want to spend years of my life on something which has a 90% chance of being worthless."
How does that mesh with the fact that a failed startup is probably worthless (in the literal sense that you can't make money from it), and most startups probably have >90% failure rate?
I know there is a learning experience in startups and that working hard on something fun is valuable, so worthless is really just talking about immediate money here.
I don't think my probability of failure is 90%. :-)
This isn't as naive as it sounds: If you take VC with standard liquidation preference terms, the company needs to do really well before you get anything back -- so the amount of money you need to avoid "failing" is dramatically increased.
In my case, since I don't intend to take any VC, there's a wide range between "failure" (making less money than I would have earned risk-free by working at the university for the same duration) and "success" (making enough money that I never need to work again).
Also, on a more self-serving note: I'm a heck of a lot more competent than 90% of startup founders. Or even 90% of YC-funded-startup founders for that matter -- and YC-funded startups have distinctly less than a 90% failure rate.
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yep, immediately thought of that too. PG writes VERY good stuff most of the time and is very smart about a lot of things, but when he strays into areas in which he is not well versed (the unions essay comes to mind), he ends up writing pieces with obvious holes.
Do you have any specific holes you could point to as examples?
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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?
The math equation is correct, but the likely outcomes are nearly impossible to estimate. I have been on the management team of 5 startups and advised many others. There are some "norms" and guidelines for how much to raise at each stage, how much equity to give up, and even how much stock to grant employees as you grow the company.
I wrote an in depth blog on these questions, too long to detail here, but Paul is on the right track. For more details see How much Equity for Investors and Employees?
http://dondodge.typepad.com/the_next_big_thing/2007/08/how-m...
Paul - This is Seth Levine (quoted in the USA Today article referenced and appropriately called out in your post). Let me set the record straight. While I've seen plenty of articles come to press that has somewhat inaccurate quotes, this was the first time I've been completely misrepresented in an article. I've written a full post on my views here - http://sethlevine.typepad.com/vc_adventure/2007/07/setting-t.... It's particularly frustrating in this case, as I've spent literally hundreds of hours working with TechStars and TechStars companies in Boulder this summer (and am the lead mentor to one very promising project). I actually believe strongly in the model.
I hope you'll consider posting this response up to your main site with a reference to my post clarifying my views.
seth levine
Ok, if you were misquoted, I'll take that paragraph out.
The article ignores how market prices work - the formula presented lets you know the maximum equity you can give up and still get a positive return by doing so, but incorrectly explains why VCs accept much less - the minimum equity a VC can accept and still expect a positive return on their investment can be far lower than the maximum the startup can afford to give profitably. The VCs are subject to competition with other VCs, so in such cases they cannot force the startup to accept a just-better-than-breakeven deal.
Why can VCs afford to give up stock and founders not? Are you talking about liquidation preferences?
Startups are just as subject to competition. There's a profit margin on taking investment just as there is on hiring someone, and it expands and contracts depending on how hot the startups is.
I think I was unnecessarily unclear - let's say we're talking about buying eggs. Suppose I'm willing to pay up to $3 for a dozen. That doesn't mean that I should buy them if I find eggs for $2.99 - I should keep shopping around, because grocers can profitably sell eggs for $2 a dozen, so I'm bound to find eggs closer to the $2 mark. I need to take into account what would be reasonable for the other party when deciding if a deal is reasonable, not just the limits of what would be reasonable for me. If I'm stuck, and everyone is selling eggs for $3 a dozen, then it matters whether that's beyond my personal threshold or not. If I only note how close a deal is to my personal threshold, without noting whether the other party would be likely to agree to a more favorable deal, I'm liable to get ripped off, unless I have no leverage for negotiating anyway, and I can only take it or leave it.
Even in a simple model, time should be incorporated, right? The total cost for the life of the company of an employee is included, assuming a particular growth rate. What about for investment? "the total cost of this round of funding" doesn't make sense so much. And surely the rate of increased value of your company matters.
Also, it seems, like you note in the end, that there is still a gut feeling, and here it is stated simply: how can you predict how much your company will grow because of an investment?
This is easier if you have sales numbers that show some trend, where investing $N in business development yields X more users leading to Y more profit. If you're reddit, and you haven't even monetized your users before being purchased, this can be harder. Also organic growth implies less direct business development.
One simple question that I think has a standard/GAAP answer: how much is your company worth if you are making $X yearly and growing at a rate of Y%? I vaguely recall terms like "good-will estimates" and "present value of future money" in the single management class I've taken years ago. But is there something standard for a company going through valuation for acquisition or taking a next round of funding. [Ignore for the moment that a company making a nice profit and growing ideally wouldn't need a next round of funding.]
"how much is your company worth if you are making $X yearly and growing at a rate of Y%"
In finance, the standard answer is "the net present value of all future cash flows". Basically, all cash that the company throws off beyond expenses technically belongs to the owners. However, owners could've parked their money in T-bills instead of investing it, and they'd receive interest for it. So you discount these future cash flows by a factor that depends on the rate of interest and the time between investment and cash flow, and then sum up all these discounted cash flows over the life of the company. If earnings are growing, you just figure the increased earnings into your calculations. http://en.wikipedia.org/wiki/Net_present_value
I dunno if VCs and acquirers use this method: they face a problem in that it's notoriously difficult to estimate the future cash flows of an unprofitable technology company. They might be building a stellar product and growing market share for years, then suddenly start raising their prices when they become a monopoly. Or they might be building a mediocre product and growing market share for years, and then lose them all when they start raising their prices and a competitor comes along.
Thanks!
Then my earlier points are even more important. How much will your company be worth? How much _more_ is it worth after taking more funding? Who knows? All hard questions.
Was this article written in response to Seth Levines comment? What Seth Levine doesn't know or doesn't want to tell is that a lot of YC alums could raise the 5K/founder on their own, so money is NOT the primary reason they are there.
No, I'd been working on it for a while.
I'd been thinking of taking that footnote out, since it seemed like everyone now finally understood us. But when I saw that old dumb argument again in the USA Today article, I decided to leave it in.
I can't help but laugh at the audacity of another tech-related investment firm commenting like that. He is trying to persuade people that YC is just writing cheques.
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Possibly not the sole reason, but the first footnote leads on to this.
From my perspective it's partically an emotional path, not merely an analytical path. A company that's a startup has an intention, and it's one of these:
1. You use resources to incrementally grow a user base and get market share, then sell it off to a bigger company
2. You develop technology that enhances a company's market share and pulls users from a competitive company's market
3. You lose, and the investor loses a small amount of money
The bottom line for me is that the value of your start-up is based on the number of users you can get. It's about your intention X with the assistence of your investor will find the users and people you need. Whether it's a good deal or not is irrelevant if those are not true - take the journey.
Whether it's a Mobius or another VC, for me as an entrepreneur, they have not established a community tool to have access to a community that will help grow the start-up quickly. You're not just buying equity in the equation X you're buying into the community's collaboration.
The equity value is not just based on "here's some money for X cents on the dollar" X it has to go beyond that.
"The equity value is not just based on "here's some money for X cents on the dollar" X it has to go beyond that."
Uh, no it doesn't. Equity has value, and so does what you get when you give up value. When you're like for like, emotional attachment doesn't make sense.
It's not an equation, but for employee options my gut has always been that you get options as a function of how much your improve the odds of the company's ultimate success.
Founders get a lot because they take it from zero to something.
Senior folks get a lot because the influence it significantly.
Early grants > Later grants because the ability to change the trajectory is typically smaller.
This is a nice analysis and good thinking, though it's worth noting that liquidation preference makes the VC equation less favorable. I'm not sure how Y Combinator works, but preference plays a shockingly large role when you run these types of calculations against your hypothetical VC deal.
Given PG's formulation, liquidation preference plays no part in the value-of-equity equation, since it can be factored out into the average outcome.
But sure, it does tend to depress average outcome. Then again, if your outcome is dominated by the presence of very-high-value possibilities, a reasonable liquidation preference may be no big deal.
A smart company would give 6% equity to YC just for the advice and publicity. The cash is the least valuable part of the equation. 5k per person can be saved up in a number of months, even for relatively low salaries if you are stingy.
I'd honestly be surprised at this point if nobody has offered to pay YC to take equity in a startup.
Am trying to remember if I did that after I was rejected from SFP2005...I know that I offered them free equity in exchange for advice and the ability to come to the YC dinners, but I can't remember if I offered cash. Probably not, as I was poor at the time.
My offer was ignored, BTW.
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Are you asking if YC charges potential investors to attend their demo days?
Interesting if they did... part of YC's function is to introduce follow-on investors to their startups, but I've never thought about their charging investors for that privilege.
Who says there's no business model in the Web 2.0 world?
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I'd be more surprised if that ever worked. Sounds clueless and suplicating at best, insulting otherwise.
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Here's a quick calc to help play with the numbers:
http://tinyurl.com/yorkoq
Feel free to click and change change any of the assumptions as you guys fight it out :)
at a high-level i agree with the post, however practically speaking, you're overlooking several significant issues: 1) diff between preferred vs common shares 2) liquidation preferences in terms sheets 3) supply/demand for investor capital in the market 4) competitive position of VC/company in the market 5) exit targets / preferences / restrictions by investors / entrepreneurs
these 5 factors (& many others) have DRAMATIC impact on the 1/(1-n) calculation you mention. while i don't disagree with you in theory, practically applied the outcomes matter a fuckload.
see leo dirac's presentation on term sheet liquidation preferences for just one perspective on this: http://www.embracingchaos.com/2007/08/vc-term-sheets-.html - dave mcclure http://500hats.typepad.com/
Very good article thanks -- why am I not surprised? :-) Few minor points. Sometimes, not often, your initial valuation may affect the subsequent rounds (they shouldn't but may). Crowded cap tables are also problematic. Initial employees contributions, however small, will entitle them to more shares that the later ones -- which may cause discontent. Finally think about how many 6.7% you can give up?
I am not even going to get into option analysis; talk about introducing non-linearities. But even in a linear stream Paul's footnote that YC combinator brings to table a lot more than 6.7% (?) is probably correct, but it should also take into account the effects of the multiplier of the later rounds and options on both side.
But it's not that simple. Startups are always measured against their competitors. So even if the 1/(1-n) shows that it is a net gain for me, it may be an overall loss if my competitors make deals that are worth significantly more for them.
My apologies -- here's a version with a better formatted URL for the Equity Formulas spreadsheet:
http://www.nosnivelling.com/Paul-Graham-equity-formulas.xls
For me, the question that the startup should ask more critically is around the total dilution-to-exit. If taking Paul's money for 6% now reduces the dilution at some subsequent round from, say, 40% to 30%, then by my reckoning the founders end up with 66% instead of 60% of the final position. Key here is usually a combination of the value-add from the VC, and their ability to underwrite/cornerstone a good part of that follow-on round. (Although obviously this is only relevant if a larger follow-on round is going to be needed!)
I read only some of these comments and I have to say: EASY !!!
This is static analysis of a single decision; and it has to be viewed with those limitations in mind.
Option analysis and risk, nor is dilution after each round is talked about here. Yes if the Google founders had given shares left an right they would be in serious trouble making isolated decisions. Nonetheless, it is hard if not impossible to bring mathematical rationality to something fairly dynamic, if not irrational.
These comments are very confusing. Paul -- a simple question: doesn't the amount of capital offered/invested have a big impact on the calculation? Sure I'd give up 6% of my pre-natal company for $1 million. But would I for $1 thousand? No. Doesn't your analysis suggest that in both cases the calculation is 1/(1-n)? Yet the ability to add 6.4% value at exit given $1 million is vastly different than if given $1 thousand...
I guess I'm the only dumb one here. Can someone explain to me how he came up with the 1.5 as a multiplier for the new hire's salary? Also the part where he talks about making a 50% "profit" on the new hire and then proceeds to subtract a third from 16.7%. Why 50% and why 1/3? How did he come up with those numbers? Please enlighten me.
ok, so we're a new c-corporation out of north carolina, three new unc mba graduates with a fourth ruby coder out in pasadena. we have a hotmail-sized concept with a working prototype already built. it's addictive, the kids are going to love it (parents too). all we want to do is hire ourselves and knock the project into beta. we also know that if we launch and gain x users right out of the gate, we will be able to get a better deal from investors.
questions = what is x? how many users does a hot new web 2.0 service need before jaded vc's start paying attention? what are the other eye openers in your opinion? until i read this article, i had been of the point of view that you should turn down all investment until you launch if at all possible. is that correct or am i wrong?
- Srini
I am thoroughly fed-up hearing this self-serving tripe from investors.
If all I am looking for is financial independence (say $3M), why would I trade an 80% probability of success for a 5% probability of achieving 100 times that by selling out to VCs?
Sure, my expected return is 6 times greater, but now I need approximately 31 (=log 0.2 / log 0.95) bites at the cherry to guarantee an 80% probability [1] of success. That's 6 lifetimes of startups for a serious serial entrepreneur (most of us have energy for one, maybe two, startups).
Unlike VCs, who invest in a portfolio of companies, I don't have a portfolio of lives.
[1] This assumes only two outcomes from a VC-backed company: zero return or $300M exit. Obviously there are a range of returns, but this is a reasonable approximation since VCs have no interest in seeing low returns - they'd rather kill the company than waste their time.
And I am thoroughly fed up with people who jump to conclusions after misunderstanding something I've written, and post comments using language they'd never use talking to someone in person. (At least, language I hope they'd never use.)
This is covered in other essays, e.g. http://www.paulgraham.com/guidetoinvestors.html
I don't see how I have misunderstood you, eg:
"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."
If Sequoia took ordinary stock for their money that argument would have some legs. But otherwise, it is self-serving (for the VCs). Once you take their money at valuation X, liquidation preferences and control clauses guarantee that you're not getting anything until the company is worth at least 10X. It doesn't matter whether the founders still have 95%, they've given up control over the outcome that matters to them.
Angels are a different story. I have angel investors myself, carefully chosen, and with a term sheet that is much fairer than anything you'll get from VCs (they can't screw me; I can't screw them).
I used to have some deference for VCs, but after hearing their self-serving arguments and witnessing their arrogance for years, I don't waste my time (being profitable also helps).
Don't get me wrong, we could grow faster with VC money, and I'd do it on the right terms. But these days, if a VC contacts me I always ask them within the first 2 minutes whether they'd invest on similar terms to the existing angels. The answer is always "no". They never have a good response to the obvious question: "how do your terms make sense for a founder?".
As for language, I apologise. I have not used the expression "self-serving tripe" in person with a VC, but I've been close. They need to hear it sometimes.
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Just in case readers would like the formulas in a simple spreadsheet, I posted it as a download from my server:
http://www.nosnivelling.com/Paul Graham equity formulas.xls
So very useful. These are issues we all have to parse through and while you note it's not a magic formula, it's certainly a good one to understand as a young entrepreneur. Thanks. Nate Westheimer BricaBox.com
Paul, I really liked your article and I have always wondered about working out these financial details. Its cool how you did it for employees. I liked the fact that you kept it simple.
The famous KISS principle. In case you don't know: Keep It Simple, Stupid
Great article! Very informative.. I think you just improved my prospects by 10% and that advice was free!
Sorry for my ignorance, how can one calculate his company value ?
Most of the time it is made up..
The theory is that the market will grow and/or you will exhibit exponential growth. Take for example Google which is valued by the outstanding shares value (market cap) which is driven mostly by public perception of market growth and Google's operation with respect to real and perceived growth..
So apply this to your startup.. get VCs to bid on it.. If you have revenues then you can go to a bank and see what type of credit line your business qualifies for. But since most startups don't have revenue then you really don't know.
Essentially your initial idea is worth $0... this is why angel investors are nice to have. They make the first real valuation.
How can you determine the improved outcome? thanks!
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