In a previous post, we shared our approach to handling the salary variable in the salary vs. equity equation for compensating the entrepreneurs we select to be our co-founders. This week, let’s talk about the equity side.
A quick recap of the previous post: We allow the co-founders we work with to decide just how much salary versus equity they will take during the first few months of the company’s life. They pay themselves from the small amount of initial funding we provide ($20k), so it’s not a huge amount. If they need more money to make ends meet, they can opt to pay themselves a larger salary and take less equity. Likewise, if they can get by on less income right away, they can choose to take a larger equity stake.
Just how much equity should a co-founder get?
This has been one of the core questions we have spent the better part of a year debating. All this debate has resulted in an equity model designed specifically for a startup studio.
Startup studios, such as the model SPV uses, generate business ideas internally and then seek out entrepreneurs to bring on board as co-founders to help develop those ideas into successful companies. The goal is always to ensure the entrepreneurs we work with are properly incentivized and that their stake represents a significant part of the cap table.
How does a startup studio offer value?
Before you can understand our perspective on equity, you’ll need to understand the value we think a startup studio adds to a growing company versus the approach used by a go-it-alone “organic” startup. While an organic startup must build from the ground up, a studio-based company immediately benefits in a number of ways:
- The previous experience and reputation of its original founders
- Access to their network
- Vetted ideas
- Guarantee of early stage capital
- Lead investors
- Office space
- Support from a pool of talented contractors, including technical, design, marketing, legal, accounting, etc., all of whom are already familiar with our agile and lean startup processes.
Once you figure in these factors, we think the first twelve months of a company grown in a studio will be more productive than of a typical startup in three key ways.
1. Doing it right early on
Doing the right things early and, more important, figuring out what not to do: this is probably worth a post in and of itself, but our experience in angel investing and accelerating companies has demonstrated that for many first or even second time entrepreneurs, time management, focus and accountability are really hard. We really focus people on de-risking the most important issues first. We think this gets them to market faster (and time is money).
2. Efficient use of time
A first-time CEO (and we’ve all been there) spends time and effort building a funding network and pipeline. We shorten and de-risk this considerably. We let entrepreneurs focus on actually building product and a business.
Probably the most important aspect, as it relates to founder equity, is the fact that the startup studio model results in a higher valuation sooner than the norm because we are targeting big markets and the ideas are much more mature. We also de-risk much more of the business model before we build than most startups do.
Now let’s look at what this actually looks like in numbers:
*Chance of getting to Traction stage: 15%
*Chance of getting to Traction stage: 35%
If a startup studio adds so much value, how do you calculate a fair amount of equity for the entrepreneur who joins post-ideation?
We needed a starting place, so we started with the Series A financing in mind and then worked backward. We did a lot of reading, considered our own experiences, and polled recruiters and our friends in VC.
By the time a typical company has gone through the early startup phase with three or more founders, raised a little money from family and friends, raised a little more at seed, and then raised the Series A, entrepreneurs typically come out with significantly less than you might think.
Let’s take a scenario in which four people come together to found a company:
The four co-founders split equity equally amongst themselves (never a great idea, but it happens all of the time). So now the CEO has 25%. They raise $50k in an early Family and Friends round with 10% dilution, followed by a seed round of $400K with a 20% further dilution, meaning everyone gets diluted by at least 20%. Now the CEO is down to around 18%. Add the 15% ESOP pool and the CEO is down to roughly 15% and we haven’t reached the Series A round yet.
Obviously, the journey is different for everyone, and numbers may vary greatly, but it isn’t hard to see how a founder can quickly get below 20% before the Series A Round.
With a startup studio, the entire value proposition is based on the premise that ventures start out being worth more because they move down the validation path faster. As such, we landed on the notion that the co-founders in our businesses should get 17% equity in the venture before the seed round. With this model, which features a six-month cliff and three-year reverse vest, the co-founder will be in a similar position as they would be in a typical three- or four-person startup at the point of series A. The company’s chances of success will be significantly more certain and realized faster.
Some have suggested this will result in significant churn amongst entrepreneurs who will be unwilling to stay over the long term because we are taking too much up front and will leave when the going gets tough. That remains to be seen, but we’re optimistic that our process for selecting co-founders is rigorous enough to select the most viable candidates.
So how are we doing with this so far?
We have now funded five companies at the project phase (initial $20K). We have not had any “voluntary” churn, but we also have not been through particularly difficult times or seen how this plays out over the long term, so the jury is out in terms of how it will work in practice.
From a personal perspective, I have worked on opportunities as a “founder” where I had significantly less equity at the Series A round than our entrepreneurs will have, and I stayed (as did my management team) through difficult times and over the long haul. I believe company culture and how much you are valued and empowered has more to do with staying engaged than salary or equity (so long as both are fair).
We have also just finished our first cohort and were blown away by the quality and effort displayed by the twenty entrepreneurs that joined and the 100+ that wanted to join. We also feel that the five entrepreneurs in our projects are all A players, are working hard, and are passionate about their projects. The evidence certainly suggests our model doesn’t have a recruitment problem.
On the investment side, we have less data. Our first project is in the closing phase of seed funding and we are oversubscribed by about 2X on a seed round, which is above average in terms of the valuation and terms. This is due to a number of factors including the size of the market, the star factor of the CEO, and great timing.
That said, we have had a few potential investors balk, saying things like “When the going gets tough, the team will not be incentivized to keep rowing hard” or “The team needs more, and you will have alignment problems”. We believe if the team is good, the market is big, and the company is showing traction, then the pie is big enough for all involved.
All of this said, we reserve the right, as always, to revisit and tweak as more data comes in.