The Equity Equation: A Formula for Making Smart Stock Decisions

When starting a company, one of the most critical aspects to consider is managing equity. This article will equip you with a fundamental formula for determining whether to trade company equity for funding, employees, or other deals. The author outlines a straightforward equation that can guide your decisions related to equity allocation, highlighting key factors like valuation, funding rounds, and employee compensation.

The Basic Formula

The core of the Equity Equation is represented by the formula: 1/(1 - n)

• n = the percentage of the company you are giving up.
• The equation determines the amount of improvement needed in your company's average outcome to justify the equity trade.

Funding: Trading Equity for Money

The Equity Equation applies to obtaining investment from venture capitalists (VCs). When a VC invests in your company, they take a certain percentage of equity in exchange for capital. The equation helps to calculate how much the VC needs to enhance your company's value to make the deal worthwhile.

• A higher percentage of equity taken by the VC implies a larger improvement in the company's value is necessary for the deal to benefit you.
• Top VC firms like Sequoia often take a higher percentage of equity, but their reputation and expertise can significantly improve a company's performance.
• The odds of securing a deal with a top VC firm are low, making the high equity percentage a trade-off for potential substantial growth.

Hiring: Trading Equity for Employees

The Equity Equation can also be applied to hiring employees. When you offer stock options to your employees, it's essential to ensure that the equity granted is fair and aligns with the value they bring to the company.

• The equation helps to calculate the percentage of equity required to cover the employee's contribution, considering salary and potential growth.
• Early-stage employees may accept lower salaries in exchange for a larger percentage of company stock, maximizing their potential return.

Valuation: The Foundation of Equity

The Equity Equation is directly tied to the valuation of the company. A higher valuation means that the percentage of equity granted for funding or employee compensation is relatively smaller.

• The valuation is typically based on the post-money valuation of the last funding round.
• The valuation should reflect the company's potential for growth and the value provided by investors or employees.

The Role of "Activation Energy"

The company should strive to make a profit on its equity deals. This "profit" is referred to as "activation energy," which signifies the desired increase in value beyond simply breaking even on the deal.

• The market demand for your company and its attractiveness to investors will influence the "activation energy" you can charge.
• A higher "activation energy" translates to a larger return on investment for the company.

Important Considerations

While the Equity Equation provides a framework for making informed decisions, it is crucial to acknowledge that it is not a guaranteed solution. There are other factors that need to be considered when allocating equity.

• The market conditions and the specific industry can influence the value of equity.
• Building a strong team with a shared vision is as important as securing funding.
• The legal implications and regulatory requirements related to equity need to be considered.

Key Takeaways

The Equity Equation is a powerful tool for startup founders, providing a quantifiable framework for making strategic decisions related to company equity. By using the equation, you can gain a clear understanding of the value of your equity, ensure that your deals are beneficial to your company, and make informed decisions related to funding and hiring. Remember to always be aware of the "activation energy" needed to make your equity deals truly profitable.