The Equity Equation
paulgraham.com
paulgraham.com
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.
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.
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.
Not to deny this, as I don't know anything about you, but... that is a very bold statement.
If not, please don't be "bolder" than this guy: http://en.wikipedia.org/wiki/Ravi_Vakil
Yes, I did.
Just the once, though, huh?
Many times people think that they can transfer great success from one domain into other domain. Michael Jordan and his short baseball stint is the first thing that comes to mind.
I work with MDs and PhDs on a daily basis, analyzing their technologies for their start up companies. By far, I am much more willing to put in extra hours for friendly people than those that cram down my throat how much better they are than me.
I've found that the best response is to sit there, listen carefully, take note of any valid points, and ask followup questions if you need more information on one. You may learn something: despite the overall negativity of the conversation, my boss had many points that I'm going to want to keep in mind as we move forwards.
Understand, there is a lot of self-justification going around when it comes to entrepreneurship. As long as rich people are the distant Bill Gateses and Warren Buffets, people can put them up on a pedestal or say "Oh, they got lucky." But if someone you've grown up with or someone who used to work for you gets rich, you have to ask yourself "Why them and not me? Are they just smarter than me?"
Many smart people will do just about anything to avoid admitting that others are smarter than them, so they instinctively say "Oh, he's just going to fail." And when you succeed, they'll say "Oh, he just got lucky." If you succeed again they'll start saying "The game is rigged!".
But if you stoop to their level and say "Oh, look how smart I am, of course I'm going to succeed," you're just engaging in self-justification yourself. And that's a dangerous mental attitude to get into, because it blinds you to details. The reason you're smart in the first place is because you pick up details that other people don't; you can easily become stupid by believing yourself smart. This comes from experience: I did precisely this in high school and college, and then found that when I actually tried to get something done, the results were much more disappointing than I would've liked.
(Therapy for myself: I think you're smarter than me, I think you will succeed, and I think that if you do succeed, it will be because of skill. But keep what I say in mind anyway. It may be useful.)
Very well said.
Remember, whatever disappointments you have, don't come off sounding like this guy (someone who did well in school, but couldn't get hired at the firm he wanted): http://www.autoadmit.com/thread.php?thread_id=445136&mc=...
I have a friend who (years ago) told me "Damn you're lucky! You have a horseshoe stuck up your [butt]. But you seem to work really hard for it..."
I never forgot that, and in the intervening years I've attributed the majority of my success to luck, rather than skill. Luck, however, that I work hard to create.
The reason is this: If you believe that your success is due to your own skill, you become lax. Complacent. Entitled. You've succeeded so far, so clearly you're da man and you should succeed going forward.
If, on the other hand, you ascribe it to luck, you acknowledge that there's little that you did to make it work. And so you have to keep working hard and scrambling to make the next project successful. Because your previous successes have little bearing on future performance.
http://www.daemonology.net/blog/2006-09-13-encrypted-backup....
This post also shows a phenomenal misunderstanding of what it takes to create a successful software startup:
http://www.daemonology.net/blog/2007-06-21-think-before-codi...
let me know if it's something you're interested in, or if you want to chat about it sometime.
drew (at getdropbox.com)
I think it took several days to move my data to the current system remotely which was not fun. I think its just an unavoidable problem. The severity was lessened by the service calibrating the upload to occur in the middle of the night, which really did help a lot. All of the incremental uploads also are scheduled at night, which is an obvious move.
Edit: That's assuming cperciva has physical access to his server, rather than working with e.g., EC2, or that he has more bandwith to spare.
But anyway, that's why I said if you can improve on their offering then go for it. Given the current options, they're the best that I know of; and I say that knowing that they have a lot to improve. So, if you build a better service, I'd consider switching.
This won't happen to you? Okay. I trust you.
_never confronted by a subpoena_
If you get a subpoena for a passphrase for a client, you will give it up. Yes you will. Now, if someone was holding terroristic bombcodes or whatever and REALLY didn't want people getting them, they ain't backing up anything online. The same people who need real security aren't going to be uploading their data anywhere .
"If you get a subpoena for a passphrase for a client, you will give it up."
Not if I don't have it. This is the point of strong security -- you don't NEED to trust me, because I am not technically capable (nor, unless I'm quite mistaken, is the NSA) of decrypting data backed up using tarsnap.
I'll be glad to discuss this remote secure backup project with you. It was once on top of my list for a DIS application, but I dropped it for various reasons that I would be glad to share with you.
If yes, I've improved your life -- they use my delta compression work (bsdiff, originally written as part of FreeBSD Update) to reduce the size of updates which have to be downloaded. As of about a year ago, my work had saved users around the world well over a hundred years of waiting for updates to download.
This is not to belittle, just to put your "100 years" in context. It's great work and you've saved me personally a lot more than 5 minutes.
1. Open up Microsoft word.
2. Type all that out.
3. Save it as "Resume.doc"
4. Don't open it again until your next job search.
Seriously, Word?!
I have no opinion of you or your entrepreneurial abilities in the same way a physicist has no opinion of gravity.
If I can measure what you've done (e.g. in terms of customers, revenues, successful exit sale, etc.) then I'll respect you (or not).
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!
If by "average outcome" you mean "expected value of the utility function", and assuming that my utility-of-money function is sqrt($), I don't need to improve my "average outcome" by more than 6.4% for the deal to be worth accepting; it's enough if I can increase my "average outcome" by 3.2%, since that's how much UTILITY giving up 6% of the MONEY costs me.
Seriously, these issues, and a lot of other issues, are covered in "How to Win Friends and Influence People". Read it. If I could figure out a way to get you to feel like you came up with the idea to read it, I would, but I can't, so just read it.
Most mature and intelligent people love it when someone is able to offer useful critiques of their work, as long as they're civil about it. For example: http://en.wikipedia.org/wiki/Socratic_method
Seriously, would you want this guy making a few million? Not only would he be a douche, but he'd be a rich douche. Imagine how he'd treat his waitresses and waiters then. Or his local cops. Or anyone not as smart as he is, which is, apparently, EVERYONE. I'd even call him a detriment to our society, because the child just seems to act like a Paris Hilton with brains. Smart people can be civil, and it's just silly to watch everyone go "Cperciva you're so awesome! You should do X with your life!" and him go "Oh ho ho, didn't you think I already considered that? I turned down a headhunter yesterday, in fact. Now go make me a sandwich."
The dude's a genius, but he could learn a little humility. But he's obviously not going to learn until some event wakes him up to it, so I'm done caring that maybe one more nice person could exist in the world.
(Kudos for being able to imagine a Paris Hilton with brains.)
What's depressing is how often people don't think of other people.
I'm not saying being rich would entitle him to any particular behaviour; they're orthogonal things.
About the hypothetical waitress, either she could find another job to pay for college, or otherwise her ability to go to college depends on cperciva getting rich.
There are other examples where you could argue that raw capitalism may not be in the general interest. Think, for example, of real state; that's more of a zero sum game. In my area, rich foreign people are buying most of the real estate for summer houses they'll visit once every other year or so, while locals have a hard time to find a first accomodation due to pumped prices. Many people have to migrate to save up for a house here. Since the utility of that real estate is way lower for the foreign rich than for the local poor, I claim that in this case raw capitalism is reducing overall value.
I know I took criticism personally and reacted very badly once or twice in the past, so I see your point. But I realised I was being a baby and grew from the experience. No speech on humility can make you humble. At best, it will convince you you should be humble, and maybe by acting humble some of it will sink in and stick. Real humility comes from realising your mistakes. [Edit:] That's painful at first, but necessary to get over your ego.
[PS: Sorry, I drifted into replying to other comments of yours, and the end result may be confusing.]
- that for essentially all startup shareholders, the present hope of future utility varies linearly with the number of shares, and
- that the utility function for most founders is a step function.
Both sound right to me separately, but don't they contradict each other? Maybe most founders just live with this paradox without realising?
Most startup founders (initially at least) hope to get a few million, and wouldn't risk that to get a few billion. That's the step. And the most common form of liquidity event is a small-scale acquisition that gives the founders just that level of wealth, since otherwise they won't sell. So in the most common (and most commonly hoped for) good outcome, happiness varies linearly with the number of shares.
"So in the most common (and most commonly hoped for) good outcome [...]"
Isn't the omission of good in the first paragraph a lapsus, i.e., do you mean most founders think success is the most likely outcome? Or do you mean founders should ignore the possibility of failure for the purposes of making these decisions about stock?
For large investment or VC funds, the utility-of-money function associated with any particular investment is almost linear. There's a very good reason for this: As far as Sequoia is concerned, a dollar earned from their Google stock is pretty much equivalent to a dollar earned from their Loopt stock. Not quite equivalent, since there are non-tangible advantages for a VC fund to have many smaller success stories instead of one Google; but close.
As you point out in http://www.paulgraham.com/vcsqueeze.html, founders aren't "rational" in the sense of having the same approximately linear utility-of-money function as VCs: "... letting the founders sell a little stock early would generally be better for the company, because it would cause the founders' attitudes toward risk to be aligned with the VCs'. As things currently work, their attitudes toward risk tend to be diametrically opposed: the founders, who have nothing, would prefer a 100% chance of $1 million to a 20% chance of $10 million, while the VCs can afford to be "rational" and prefer the latter."
There's another reason to think that most people have concave utility-of-money curves: The insurance industry. If you buy house insurance, you are lowering your expected number of dollars (because even ignoring market friction, the insurance companies have to make a profit), but raising your expected utility.
You'll get rich, and you won't get heckled by a bunch of startup founders.
In any case, finance really doesn't interest me. I routinely tell Wall Street headhunters to stop bothering me because I would rather create something impressive than own something impressive. I'm not in this for the money.
Let's put it this way: How arrogant you are perceived as can be measured by how many times you say "I".
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...
I hope you'll consider posting this response up to your main site with a reference to my post clarifying my views.
seth levine
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.
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.]
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.
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.
http://www.foundrygroup.com/team.php
What a slimy move. It won't make any difference in the long run though.
What a shame!
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.
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.
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.
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.
My offer was ignored, BTW.
If they said yes to that, there'd be no need to apply, we'll all just show up at Graham's house every day.
But yeah, I can understand why they didn't go for it. It's turned out that yCombinator partner time is the scarcest resource in the Founders Programs. It makes sense to concentrate that where it's most likely to have the most effect, in the accepted founders. Which unfortunately doesn't include me.
This was for the first funding cycle though: at the time, nearly everyone harped on the money and not on the fringe benefits. Maybe Graham et al knew that partner bandwidth would be scarce, but I thought I was being clever by going for the part I really needed and offering to give up the part that didn't matter so much to me.
Waiving the cash suggests that you have your priorities right, but if YC believes in you, that money serves you both better in your pocket than in YC's, don't you think?
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?
Feel free to click and change change any of the assumptions as you guys fight it out :)
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/
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.
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.
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
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.
This is covered in other essays, e.g. http://www.paulgraham.com/guidetoinvestors.html
"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.
Incidentally, your specific claim that if you take VC money "you're not getting anything until the company is worth at least 10X" is false. Many VCs, including Sequoia, will let founders sell some of their stock on the way up for diversification. Such deals are usually kept quiet, but they're quite common.
"Many VCs, including Sequoia, will let founders sell some of their stock on the way up"
How very generous of them. They may deign to "let" you sell some of your stock. Come hither dumb hacker, trade that unencumbered stock for paper you don't even have the right to sell. And just to prove how generous we are, we'll let you keep 70% of the paper no one is allowed to sell (of course, we reserve the right to do whatever we please with our 30%).
Be in no doubt that they 0wn your ass, regardless of the percentage of your company they have. Hence why discussion of equity percentages makes no sense unless we're comparing the same class of stock.
http://www.nosnivelling.com/Paul Graham equity formulas.xls
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.