

Ask HN: How do I manage equity and dilution in a lifestyle business? - lsc

I think the way it works in most startups is that you agree to an equity
split, and if one founder leaves, the company dies or you buy him
out and that's that.<p>The thing is, I run a lifestyle business.  I've pretty much poured
all my resources for the last five years into the thing.  I'm fairly
dedicated;  I'm not saying I'd never give up, but I think I've already
gone beyond what could be expected of any right thinking person.<p>Things are going fairly well now;  I mean, it is a growing market
segment with lots of investor interest, and I seem to have developed
something of a reputation.  I've got an office and an employee
now (not a misclassified contractor;  I'm doing it right.) and
I've got far more customer demand than I can meet at the moment.
I mean, it's not a big business, by any means;  but it's more than
a hobby and there's a chance it will become something that will
return significantly more than what a bay area sysadmin can get.<p>If you can read my tone above, I have very strong feelings of
pride and ownership.   I feel pretty uncomfortable cutting in
someone on ownership who will likely leave the company long before
I will.   The problem with simply buying people out as they leave
is that if I had the cash, I'd pay them in cash to begin with
rather than screwing with equity.<p>Up until now, I've just been paying people cash.  This has necessitated
a policy of finding people with potential who are new and training,
or finding people who are undervalued by the market for other reasons.
It has worked out fairly well for me;  I like training, and I think
I'm pretty good at spotting people with potential.  The crappy economy
means that lately I've been able to keep people longer than they normally
stick around.<p>The thing of it is, I know some people who are very good
who make fairly good money on the open market who are interested
in working for me.  I'm certain that hiring these people could
make my company much stronger, but the kind of cash I can offer is
just not going to cut it, not without a pretty good shot of equity.<p>Take, for example, a hypothetical person I want to hire who is
worth $130K in salary and benefits on the open market (around here,
that's a competent programmer, but nothing unusual.)  Say I can afford
to pay $30K a year so they can cover rent;  After a year, I've
got a $100K shortfall.   Assuming my company was only worth $200K
(my company is worth more, but not a lot more.  ISPs go foraround a years revenue plus value of any hardware, so we're not
talking emerging social network level price to earnings ratios.)
if I was to be fair, I'd give that person half the company.<p>Now, I understand that most startups won't give an employee
more than 5%, no matter how little the company is worth or how
much the employee is worth... I don't think that 5% of a $200K
company plus thirty grand is going to get me a years work from
a $130K person.   This whole thought experiment is an experiment
in being fair, and 5% is obviously not fair in that case.<p>If I give someone half the equity and the company grows at a
realistic (rather than an explosive) rate,  unless they are as
excited as staying on and working for free as I am (and I don't expect
that from a rational person.)  it's pretty much over.  I have a
choice between continuing to work for free on the startup, with
all the downsides of working for someone else and none of the upside,
and getting a real job with an immediate 400% pay raise.<p>Now, if growth exploded, that'd be fine.  we'd all be happy
and rich.   The problem is, what if we only boost the company
by another $100K?   I'm now stuck with half of a $300K company;
$50K poorer than I was last year, and now to move my own personal
net worth by a buck, I've gotta make the company $2 more valuable.<p>User maxawaytoolong pretty much sums it up for me:<p>"You just described how most startups end up. Even yc funded
startups that flop have to close up shop and the founders go
back to work at Facebook or whatever. There aren't any easy
answers to your questions."<p>the thing is, in the likely case of a reasonable growth curve, I
want the option of not shutting down.<p>There is precedent for this;  I know several funded but unprofitable
startups that have been funded and unprofitable for years.  They
keep going back for more funding, and because they have a very
compelling product, they get that funding.<p>Now, each time they go out for another round of funding, their
old investors are diluted by the new shares created to sell to
new investors.   Old investors let this happen because otherwise
the company would just die, and it's better to have a smaller part
of something than a larger part of nothing, and the newer investors,
well, they feel that just maybe, the company will take off without
needing another round.<p>What if I could apply this same process to people who invest labor
rather than dollars?<p>My thought is that every 6-12 months or so, we simulate another round
of funding.   First, we'd figure the difference between market rate
and what people actually got paid (I'm pretty sure I could do this
with anyone I'd be willing to work with... if it was a problem, we
could agree on those figures at the beginning of the term.)<p>We dilute all current stock by the amount of additional money we'd need to
pay everyone market rate, and distribute the new shares based on the
difference between a person's market value and the cash they actually
got paid.  (Obviously, we'd need to agree on 'market rate' and a formula
for calculating the value of the company ahead of time, but I think
these are small things.)<p>This would mean that every six months, anyone who was not working would
get diluted a little bit more.
======
answerly
> I think the way it works in most startups is that you agree to an equity
> split, and if one founder leaves, the company dies or you buy him out and
> that's that.

It is increasingly common for founders to have vesting schedules to prevent
this exact issue. If the founders have a four year vesting schedule and one
founder bails after year one, then they forfeit the un-vested equity.

>Now, each time they go out for another round of funding, their old investors
are diluted by the new shares created to sell to new investors.

Yes and no. It depends on the valuation. A previous investor's absolute
ownership percentage may decrease in subsequent funding rounds. But, if the
valuation increase outpaces the rate of dilution the previous investor winds
up ahead. For example, Peter Thiel's ownership in Facebook has been diluted in
subsequent funding rounds but the value of his investment has increased many
times over based off of the increased valuations.

>My thought is that every 6-12 months or so, we simulate another round of
funding.

This sounds overly complicated. Rather than the equity gymnastics, why not
implement a profit sharing program for your employees? This seems more
appropriate anyway since it sounds like you are focused on running this as a
lifestyle business for the long haul.

If you are set on providing equity, then why not just create a standard
employee option pool (i.e. carve out 10-20% of shares outstanding to allocate
employees)? With four year vesting you take very little risk.

~~~
lsc
>It is increasingly common for founders to have vesting schedules to prevent
this exact issue.

First, the likelihood of anyone besides me being here for four years is pretty
small... and next, well, then I've only pushed the problem out a few years.
Granted, someone having 50% of the company after four years is certainly more
fair than having 50% of the company after one year, but it's still very likely
a company death, if someone with 50% of the company leaves.

>This sounds overly complicated. Rather than the equity gymnastics, why not
implement a profit sharing program for your employees?

Do you have a link where I can read up on what profit sharing means and how
that differs from equity? I do not know these things.

>If you are set on providing equity, then why not just create a standard
employee option pool (i.e. carve out 10-20% of shares outstanding to allocate
employees)? With four year vesting you take very little risk.

Because 10% of my company right now is maybe twenty to thirty grand. If you
could get a job on the open market that paid $130K in salary and benefits,
would you instead work for some crazy guy for $30K cash plus another twenty
grand in equity?

~~~
answerly
>First, the likelihood of anyone besides me being here for four years is
pretty small...

That is the point. If your employee leaves before they have vested their
shares they don't get to keep them.

>but it's still very likely a company death, if someone with 50% of the
company leaves.

No, not necessarily. Founders of successful companies leave after several
years of service all the time (happened recently with Xobni, for example).

>Do you have a link where I can read up on what profit sharing means and how
that differs from equity? I do not know these things.

There are lots of resources if you just do a quick Google search. The basic
idea is that your employees would get a % of profits you generate in a given
year rather than equity.

>If you could get a job on the open market that paid $130K in salary and
benefits, would you instead work for some crazy guy for $30K cash plus another
twenty grand in equity?

No. Not because I wouldn't want to work for equity (I have done that before)
but because there doesn't be a clear path to liquidity of those options.
You've described this as a lifestyle business which typical means no imminent
source of liquidity for shareholders. This is why I suggested exploring a
profit sharing structure.

If you are saying that this is a business that can't support livable
compensation for employees for the foreseeable future, then I think there are
bigger issues though.

Sorry if I am not fully understanding what you are getting at.

~~~
lsc
>No. Not because I wouldn't want to work for equity (I have done that before)
but because there doesn't be a clear path to liquidity of those options.
You've described this as a lifestyle business which typical means no imminent
source of liquidity for shareholders.

Assuming the liquidity issue was solved to your satisfaction, would you work
for equity in a company where the valuation of the percentage of the company
you were earning plus the salary you were earning was 1/3rd of your fair
market value?

~~~
answerly
All things being equal between this theoretical opportunity and another with a
more attractive compensation structure, no.

If I believed that there was a longer term value to the equity that could make
up for the shortfall in cash compensation, maybe.

But, the specific case you've laid out leads me to believe that there isn't
significant growth potential in this business. Am I interpreting that wrong?

~~~
lsc
>But, the specific case you've laid out leads me to believe that there isn't
significant growth potential in this business. Am I interpreting that wrong?

It depends on what you call 'significant' - If we did everything right, we
could be bigger than slicehost and linode. Now, it's a long ways from here to
there, and the competition is tough, but that's the market.

My thought is just that, well, I've only managed to get this to a "it supports
me and only me" level, and while I think we can sustain 10%+ growth a month if
we don't screw it up (we sustain 10%+ growth on months when we don't screw it
up, and I strongly believe that if we quit screwing it up, we could
sustainability grow at that level for quite some time.) I'd like the option of
continuing even if we only end up with 30% a year growth, you know? because we
do screw it up. I went three months without adding new servers (I'm slowly
working through the waiting list right now) not only did I loose a bunch of
revenue, I hurt my reputation. I Look like some kind of amateur.

edit: I think part of what you are hearing is that I don't show "business guy"
confidence in places where my customers will see me. (Nerds, as a general
rule, hate that shit. Talking big means nothing. Show me.) Obviously, I think
the thing has potential for growth. I'm living off $30K year when I could
fairly easily be making 4x that working for someone else. I mean, the business
guy promoting this would have said we could go after amazon. (which, I admit,
is something of a stretch; at a minimum we'd need a giant wad of investment
capital.)

But my real question here was this:

If your time is worth $130K per year, and the company is valued at $200K (and
you assume that's a fair valuation) are you going to go work for that company
for a year for $30K plus 5% of the company (valued at $10K)?

I mean, I guess you can take issue with the valuation. (I mean, I've refused
to sell, more than once at what I think the market value of my company is.
With this growth potential, I think it'd be stupid to sell at 1x earning) but
still, this idea of giving a key employee 5% and expecting them to work for
dramatically below market wages seems kinda silly unless you think you have
'emerging social network' valuations.

------
rdl
Would you really call it a $200k company with a 409a valuation? You say "a
little more" -- definitely less than $500k or so?

I'd probably bail on a $200k company with 5 years of effort sunk into it, on
the principle of "throwing good money after bad", or at least try to shift it
into a different line of business, or try to get my involvement down to
5h/week while producing $50-100k/yr of revenue, and doing something else.

~~~
lsc
Yes, more than $200K, less than $500K if you are valuing it as 1 year revenue
plus hardware value (not hardware cost)

This is something I have certainly thought a lot about. in fact in 2007, i did
begin to walk, then I changed my mind,[1] in part due to new market realities,
and in part due to the recognition that I was doing it wrong, and that there
were much more reliable and economical ways to set up my system. In 2007, by
the same metrics, the place was worth probably not that much more than five
grand, which is really sad, considering that I personally dumped way more than
that into the company in 2007.

My main mistake in the first three years was to use 'enterprise grade'
hardware... used hardware, obviously, I couldn't afford the new stuff. The
thing is, 'enterprise' is great if you can afford to pay the support tax,
otherwise it's horrible. If you are relying on free support, use stuff that
other people use.

but the point is, irrational or not, I'm not walking away from this at this
point. Selling for one years revenue plus the value of a bunch of servers and
a reasonable job (all the acquisition offers I have gotten sounded like HR
acquisitions.) seems kinda silly when we grow by between 10 and 20% every
month that we have available hardware.

But you make a good point; it may be irrational to expect other people to
value equity in the company.

[1]<http://www.kuro5hin.org/story/2007/12/7/3649/26418>

------
lsc
well, thanks everyone, for talking with me about this. I think I might end up
taking the conventional route (small percentages w/ vesting that only matter
if we get big or some kind of profit sharing/bonus structure.)

It will mean that until I have more traction I won't be able to hire everyone
I'd like to hire, but after talking with some of those people, I'm not sure
that larger slices of equity would have made that big of a difference.

