I have always thought this is such a subjective question that it is almost impossible to give a right or wrong answer, UNTIL I recently read a blog post from back in 2007 by Paul Graham titled “The Equity Equation.” For a numbers focused guy like me, his simple equation to determine whether an investor is worth it or not is the perfect way to answer how much equity to give up in your startup company in exchange for investment.
The question is simple.
Will this investment improve the outcome of my company by more than the value of the equity taken by the investor.
Because I can’t explain this any more eloquently than Paul does in his article I have copied a section straight from his article below:
“Whenever you’re trading stock in your company for anything, whether it’s money or an employee or a deal with another company, the test for whether to do it is the same. You should give up n% of your company if what you trade it for improves your average outcome enough that the (100 – n)% you have left is worth more than the whole company was before.
For example, if an investor wants to buy half your company, how much does that investment have to improve your average outcome for you to break even? Obviously it has to double: if you trade half your company for something that more than doubles the company’s average outcome, you’re net ahead. You have half as big a share of something worth more than twice as much.
In the general case, if n is the fraction of the company you’re giving up, the deal is a good one if it makes the company worth more than 1/(1 – n).
For example, suppose Y Combinator offers to fund you in return for 6% of your company. In this case, n is .06 and 1/(1 – n) is 1.064. So you should take the deal if you believe we can improve your average outcome by more than 6.4%. If we improve your outcome by 10%, you’re net ahead, because the remaining .94 you hold is worth .94 x 1.1 = 1.034”
I love this because it is brilliantly simple. There is always going to be some push and pull when negotiating equity in a startup company. This simplifies the equation. If the entrepreneur does not believe that the investor will create more value than it is taking, then it is a bad deal. It is as simple as that. So no more worrying about how much cash flow a company might generate in 5 years and then discounting cash flows to present day value and then trying to come up with some arbitrary and incorrect valuation.
If this investment will take half of your pie, but makes the pie 4 times bigger, then you are left with a far bigger piece of pie than you had without the investment.