As Founders, when we give away equity determines how much we’re going to lose.
That’s because the equity game, and our job of holding on to it for dear life, is really about vulnerability. The more vulnerable we are, the more we give away. The stronger our position is, the more we retain. It’s really that simple, and yet, especially if this is our first startup, it’s hard to realize when we’re giving up too much too early.
There are really three moments in time where we have to really consider our timing and our approach — when we add cofounders, hiring early employees, and when we take on seed capital. What we often don’t realize is that there is a lot of strategy to when and how we pull these triggers, while a lack of strategy has massive costs.
Adding Cofounders Shreds Equity Fastest
There are tons of benefits to having cofounders, so let’s not debate whether we should have them (it’s up to you). But the cost of those cofounders gets amplified when we add them too early. If it’s our idea originally, we’re often best suited to wait until we have taken the idea as far as we can before we engage a cofounder. That way we have more leverage (and less vulnerability) in the discussion.
There’s a world of difference between saying “Hey I just had this idea 9 seconds ago, want to join me?” and saying “I’ve got the MVP of the product out there, I’ve found a few early customers, and I’m getting ready to start looking for capital.” The former gives us no leverage, and we wind up with the most expensive equity discussion of our lives (50% haircut) time and time again. The latter allows us to use our existing traction as leverage in the discussion (“this company already exists, you’re just joining it.”) which will far less likely result in a massive haircut.
Early Employees = Untested Investments
Next to Founders, overly (stock) compensated early employees are a massive drain on the equity pool for Founders. We tend to make this mistake easily because in the early days, we need help and we have no dough. When someone says they will develop our mobile app for “Only 15% of the company” we jump at the opportunity. 15% doesn’t sound like a lot and we just had our dreams fulfilled “for free.”
But 15% is a ton of equity. And more importantly, if it turns out we made the wrong hire, which is statistically the likely outcome since we have no idea what this company really is yet, 15% for someone who will have worked for us for maybe a year will be the most expensive equity we ever gave away. We have to think of every stock transaction like a capital raise. Would we give an investor 15% of our company for $50k of market value?
Hopefully not. So why are we so quick to give it to an employee? Even at small share grants, those shares add up, and before we know it we’ve lost a ton of equity without any way to put it back.
Taking Seed Money Way Too Early is Painful
Similarly, taking seed money too early is a huge miss. We only want to ask for capital when we have some sort of value leverage to use. Often this simply costs us some time, maybe 6-12 months. Yet, if you think about it, the time that we are using to invest in developing the product, attracting early customers, and building a case for the business model, is incredibly well invested with or without capital. Conversely, it’s wildly expensive to take on capital before we have leverage, only to do things that we could have done (figure out the business model) without capital.
The questions we should always ask ourselves are “How can I create the most amount of leverage before I raise? Have I exhausted every possible avenue before I have to get into a capital discussion?”
Similar to our discussions with cofounders, investors expect a different equity interest (or valuation) based on how far along startups have gotten. In the early days, six months of evolution in a startup can be worth 5-10 points of equity (or more). Remember, we never get that equity back, so those early investments will shape our net worth for the rest of our careers.