Ask HN: How do I manage equity and dilution in a lifestyle business?

> I think the way it works in most startups is that you agree to an equity split, and if one founder leaves, the company dies or you buy him out and that's that.

It is increasingly common for founders to have vesting schedules to prevent this exact issue. If the founders have a four year vesting schedule and one founder bails after year one, then they forfeit the un-vested equity.

>Now, each time they go out for another round of funding, their old investors are diluted by the new shares created to sell to new investors.

Yes and no. It depends on the valuation. A previous investor's absolute ownership percentage may decrease in subsequent funding rounds. But, if the valuation increase outpaces the rate of dilution the previous investor winds up ahead. For example, Peter Thiel's ownership in Facebook has been diluted in subsequent funding rounds but the value of his investment has increased many times over based off of the increased valuations.

>My thought is that every 6-12 months or so, we simulate another round of funding.

This sounds overly complicated. Rather than the equity gymnastics, why not implement a profit sharing program for your employees? This seems more appropriate anyway since it sounds like you are focused on running this as a lifestyle business for the long haul.

If you are set on providing equity, then why not just create a standard employee option pool (i.e. carve out 10-20% of shares outstanding to allocate employees)? With four year vesting you take very little risk.

>It is increasingly common for founders to have vesting schedules to prevent this exact issue.

First, the likelihood of anyone besides me being here for four years is pretty small... and next, well, then I've only pushed the problem out a few years. Granted, someone having 50% of the company after four years is certainly more fair than having 50% of the company after one year, but it's still very likely a company death, if someone with 50% of the company leaves.

>This sounds overly complicated. Rather than the equity gymnastics, why not implement a profit sharing program for your employees?

Do you have a link where I can read up on what profit sharing means and how that differs from equity? I do not know these things.

>If you are set on providing equity, then why not just create a standard employee option pool (i.e. carve out 10-20% of shares outstanding to allocate employees)? With four year vesting you take very little risk.

Because 10% of my company right now is maybe twenty to thirty grand. If you could get a job on the open market that paid $130K in salary and benefits, would you instead work for some crazy guy for $30K cash plus another twenty grand in equity?

>First, the likelihood of anyone besides me being here for four years is pretty small...

That is the point. If your employee leaves before they have vested their shares they don't get to keep them.

>but it's still very likely a company death, if someone with 50% of the company leaves.

No, not necessarily. Founders of successful companies leave after several years of service all the time (happened recently with Xobni, for example).

>Do you have a link where I can read up on what profit sharing means and how that differs from equity? I do not know these things.

There are lots of resources if you just do a quick Google search. The basic idea is that your employees would get a % of profits you generate in a given year rather than equity.

>If you could get a job on the open market that paid $130K in salary and benefits, would you instead work for some crazy guy for $30K cash plus another twenty grand in equity?

No. Not because I wouldn't want to work for equity (I have done that before) but because there doesn't be a clear path to liquidity of those options. You've described this as a lifestyle business which typical means no imminent source of liquidity for shareholders. This is why I suggested exploring a profit sharing structure.

If you are saying that this is a business that can't support livable compensation for employees for the foreseeable future, then I think there are bigger issues though.

Sorry if I am not fully understanding what you are getting at.

>No. Not because I wouldn't want to work for equity (I have done that before) but because there doesn't be a clear path to liquidity of those options. You've described this as a lifestyle business which typical means no imminent source of liquidity for shareholders.

Assuming the liquidity issue was solved to your satisfaction, would you work for equity in a company where the valuation of the percentage of the company you were earning plus the salary you were earning was 1/3rd of your fair market value?

All things being equal between this theoretical opportunity and another with a more attractive compensation structure, no.

If I believed that there was a longer term value to the equity that could make up for the shortfall in cash compensation, maybe.

But, the specific case you've laid out leads me to believe that there isn't significant growth potential in this business. Am I interpreting that wrong?

>But, the specific case you've laid out leads me to believe that there isn't significant growth potential in this business. Am I interpreting that wrong?

It depends on what you call 'significant' - If we did everything right, we could be bigger than slicehost and linode. Now, it's a long ways from here to there, and the competition is tough, but that's the market.

My thought is just that, well, I've only managed to get this to a "it supports me and only me" level, and while I think we can sustain 10%+ growth a month if we don't screw it up (we sustain 10%+ growth on months when we don't screw it up, and I strongly believe that if we quit screwing it up, we could sustainability grow at that level for quite some time.) I'd like the option of continuing even if we only end up with 30% a year growth, you know? because we do screw it up. I went three months without adding new servers (I'm slowly working through the waiting list right now) not only did I loose a bunch of revenue, I hurt my reputation. I Look like some kind of amateur.

edit: I think part of what you are hearing is that I don't show "business guy" confidence in places where my customers will see me. (Nerds, as a general rule, hate that shit. Talking big means nothing. Show me.) Obviously, I think the thing has potential for growth. I'm living off $30K year when I could fairly easily be making 4x that working for someone else. I mean, the business guy promoting this would have said we could go after amazon. (which, I admit, is something of a stretch; at a minimum we'd need a giant wad of investment capital.)

But my real question here was this:

If your time is worth $130K per year, and the company is valued at $200K (and you assume that's a fair valuation) are you going to go work for that company for a year for $30K plus 5% of the company (valued at $10K)?

I mean, I guess you can take issue with the valuation. (I mean, I've refused to sell, more than once at what I think the market value of my company is. With this growth potential, I think it'd be stupid to sell at 1x earning) but still, this idea of giving a key employee 5% and expecting them to work for dramatically below market wages seems kinda silly unless you think you have 'emerging social network' valuations.

Would you really call it a $200k company with a 409a valuation? You say "a little more" -- definitely less than $500k or so?

I'd probably bail on a $200k company with 5 years of effort sunk into it, on the principle of "throwing good money after bad", or at least try to shift it into a different line of business, or try to get my involvement down to 5h/week while producing $50-100k/yr of revenue, and doing something else.

Yes, more than $200K, less than $500K if you are valuing it as 1 year revenue plus hardware value (not hardware cost)

This is something I have certainly thought a lot about. in fact in 2007, i did begin to walk, then I changed my mind,[1] in part due to new market realities, and in part due to the recognition that I was doing it wrong, and that there were much more reliable and economical ways to set up my system. In 2007, by the same metrics, the place was worth probably not that much more than five grand, which is really sad, considering that I personally dumped way more than that into the company in 2007.

My main mistake in the first three years was to use 'enterprise grade' hardware... used hardware, obviously, I couldn't afford the new stuff. The thing is, 'enterprise' is great if you can afford to pay the support tax, otherwise it's horrible. If you are relying on free support, use stuff that other people use.

but the point is, irrational or not, I'm not walking away from this at this point. Selling for one years revenue plus the value of a bunch of servers and a reasonable job (all the acquisition offers I have gotten sounded like HR acquisitions.) seems kinda silly when we grow by between 10 and 20% every month that we have available hardware.

But you make a good point; it may be irrational to expect other people to value equity in the company.

[1]http://www.kuro5hin.org/story/2007/12/7/3649/26418

well, thanks everyone, for talking with me about this. I think I might end up taking the conventional route (small percentages w/ vesting that only matter if we get big or some kind of profit sharing/bonus structure.)

It will mean that until I have more traction I won't be able to hire everyone I'd like to hire, but after talking with some of those people, I'm not sure that larger slices of equity would have made that big of a difference.