Working for equity at a startup
January 14, 2020
“Sweat equity is the most valuable equity there is. Know your business and industry better than anyone else in the world. Love what you do or don’t do it.”
What do you do when someone asks you to work for equity?
How you answer that question really comes down to three questions that you have to answer for yourself first.
Question 1: Can I afford to do the work and get zero return?
Working for equity is a risk and the reward needs to be more than just money.
Let’s face it, the most common return on an equity deal is going to be -100%. You’re going to get $0 for whatever work it is that you put into the project. Your return won’t be -100% every single time, but let’s assume that there’s a 90% chance that you’ll see zilch out of your time investment.
Do you really care about the founders and what they are doing? You want work that’s fun, interesting, purposeful, challenging, and where you can learn something.
If you have the cash flow to take those shots, then perhaps it’s worth investigating more deeply.
However, the temptation really occurs when the opposite is true.
When you have no cash coming in, then it’s tempting to think “well, this is something, and there’s a chance that it could lead to actual paying work.”
At the same time, you should be able to manage this work alongside your paying work. You wouldn’t put all your eggs in one basket. Working for equity is possible when you are earning cash directly from other work.
You are happy to have some high risk, potentially high reward work alongside regular income.
Because, time is precious. You only have so long to prove out whether or not the business can be profitable before you run out of runway and have to go back to get a job.
So, assuming that you can get through the first question, you must then ask yourself the second question:
Question 2 : Will this equity ever be worth something some day?
I have a MBA. From a top 10 school, even. And I had no idea how to value the plethora of ideas that were thrown out at me. Almost all sounded Good. With a capital G. Mostly, it was because they were in industry where I hadn’t a freakin’ clue what was good and what wasn’t, so if there was spin, it sounded Good.
Therefore, I was not an impartial evaluator of the potential of ideas. I was easily swayed, and I knew it.
Additionally, doing a proper market analysis of an idea is time-consuming. You have to research the market, the competitors, the financials, the cost of goods, comparative overheads, multiples, and a lot more before you can come up with a reasonable valuation for a company that is in its infancy.
After that, you have to discount your number heavily because of the other variables that come into play – luck, competency of the team, economic conditions, and potential competitors that aren’t yet even on the horizon. Naturally, looking at the company’s capitalization and valuation is a lot easier if it’s a venture-backed start-up, then you can have a look at the most recent round of funding that have determined the company’s valuation.
The best ideas in the world probably never got off of the ground because of a confluence of all of the other factors conspiring to cause failure.
As an entrepreneur, is that the best use of your time?
Or, would you rather be finding clients and customers who can pay you cold, hard cash right now for work that you can do or products that you can deliver?
Additionally, even if that equity is going to potentially be worth something someday, is it enough to be a game changer?
This is why the question would I do this work for free if money were no object? is the most important. If you find yourself making a purely money-based decision then it’s not the right opportunity.
Even if there is a high risk of getting $0 for your contributions, it’s important to value your work and define the right amount of shares of equity for you at the beginning of the collaboration.
Question 3: How to value it?
When you are working for equity instead of cash at a startup, if the founder wants your stock to vest, you should get “2x” the value of cash to account for risk.
Put differently; imagine you are going to work for 4 months full-time for equity, at the equivalent of a $120,000 salary. That’s $40,000 in “equity” in total, or $10k per month.
I like to then multiply that by 1.5x or 2x, to $60,000-$80,000 in total. The 1.5x-2x factor accounts for the risk in a startup that has no cash to pay you.
And then I like to pay that in stock based on either the last valuation of the company if there was one, or the next/first round if there hasn’t been a fundraising yet.
So if the company then raises at a $2m valuation, you’ll end up with 3%-4% of the company ($60k-$80k/$2m).
On a percentage basis, that may sound like a lot to the founder, at least, in retrospect if the company takes off. Contingent payments often seem expensive with hindsight.
But it is what it is, and it’s fair. And any other formula is sort of a wacky guess.
A variant is to get paid back in cash at the next fundraising, along with some lesser equity.
And note here there is no “vesting” per se, just a conversion based on months worked based on a hourly/weekly/month rate, converted to equity. Whatever you do get, is fully vested.
Let’s talk about it in the comments below!