The Equity Equation
paulgraham.com
The Equity Equation
1–10 of 160 posts
Re: The Equity Equation
#2Was 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.
Re: The Equity Equation
#3Was 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.
Re: The Equity Equation
#4Was 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.
Possibly not the sole reason, but the first footnote leads on to this.
Re: The Equity Equation
#5Nice 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.
Re: The Equity Equation
#6Paul, 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.
Re: The Equity Equation
#7Even 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.]
Re: The Equity Equation
#8A 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.
Re: The Equity Equation
#9From 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.
Re: The Equity Equation
#10Even 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 s…
"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.