Saturday, April 9, 2011
Earlier this year I was approached to join a social media start-up as a developer. I’m not going to get into any details about it except to say that I would’ve been developer #1, tasked with taking the software from zero to beta (and beyond, presumably). And the founder of this company had plans to go through what seems to be the standard-issue VC funding and growth process. So. Before receiving an offer for compensation, I knew next to nothing about how start-up economics work for developers (or, really, for anyone). I still am certainly no expert, but I tried my best to do my research and talk to people who know about this stuff — and a picture did begin to form in my head of how it works and of what metrics I should use to judge whether joining a start-up is worth my time.
I’m going to share that thinking with you, here. And the goal isn’t to share specific information about that start-up or what compensation I was offered: The numbers I’m going to use are not real. But my logic and thinking is. And if you’re considering an offer to join a start-up (or starting one yourself), I’m hoping this might be of use to you. At least for some perspective.
(Also: I’m fully expecting to come back to this post in a few years/months/days and think, “Christ, what a noob.”)
Here are my steps for deciding whether the opportunity to join a start-up makes economic sense for you as a developer (or any other hire, really).
1. Assess what your base yearly income is (or would be).
To start: I feel developers oftentimes undervalue themselves. If you know how to code or otherwise create using technology, you have something that’s immensely valuable right now. If you can sit down at a computer and make a thing, even if simple, and even if done in a clumsy way: That’s valuable. Many people in our industry cannot do that. And it’s not just valuable because you can do for yourself for free what someone else needs to pay for. It’s valuable because if you can manipulate technology, you can get dirty with the tools of the trade, play with them, and learn more about what possibilities they contain.
So, Mr. or Ms. Developer, the first (obvious) step when making a decision like this is to assess what you’re worth. If you’re already full-time employed, use that as a base. I work on contract projects, so my income fluctuates radically year-to-year. But let’s say you’re worth $100,000 per year as a full-time employee. (Again, this is not the number I chose for myself. But it’s a nice, round number that will be easy to plug-in below.)
On thing to think about, here: For my number, I factored in my income but I also kept in mind quality-of-life issues. As an independent developer I can take as many holidays as I want. I work at home with my cat. I can be very selective about the projects I take on and I can vary my income on a whim if needed. These perks are very important to me and I would need to be paid more that just my standard yearly income to pull me away from them. If you’re working a desk job you don’t care for in a cinderblock room with no windows and a single 40 Watt lightbulb to keep you company, you might adjust your numbers the opposite direction.
So: Pick your yearly value. $100k, for example.
2. Understand the offer.
Again, not using real numbers, here. My offer came in the form of a yearly salary plus options. Let’s pretend this was $3,000 per month (a low number designed more to help keep start-up employee afloat while the company gets its wings) and 3% stock options vesting over four years with a one year cliff (common vesting and cliff numbers). First, make sure you know some terms:
Vesting. This means you will slowly accrue these options over the course of four years. If you quit after two years, for example, you only get 1.5% of your 3%.
Cliff. This means you won’t accrue any options until a certain amount of time has passed. So in this case you would see no options until after one year, but on the one year mark, 0.75% of your 3% would immediately vest — your entire first year’s worth. Does that make sense? It’s a little weird.
And finally you absolutely must understand dilution.If you fail to factor in dilution, you run the risk of grossly overestimating how much stock you will have when your options vest. Dilution is this, in essence (again, using very round numbers for easy math): When a VC invests in the company, she usually doesn’t buy existing stock (as I understand it). She makes new stock, so your stock will be worth less. Say there are 10,000,000 shares. If a VC puts $10,000,000 into the company, they might add another 10,000,000 shares to the pool. If you had 3% of the company, you now own 1.5% of the company. You have the same number of shares, but now there are twice as many shares total. (Although hopefully your shares are each worth more!)
My math on dilution (which more experienced friends have agreed with), is that a few rounds of VC funding might reduce your stake in the company down by 50%-75%. These are the real numbers I used for calculation. And, of course, numbers like these are wildly speculative. But to run the math, you will need to figure out what expected dilution you are comfortable using as an estimate. A 75% dilution means your 3% would actually be 0.75% of the company after several VC rounds. Granted, if you’ve gone through three rounds of funding, your start-up’s probably doing well and that 0.75% may be valuable. But you need to know what dilution means.
Finally, stock options I’m not going to get into the details, here, but be aware of what that means. It doesn’t exactly mean immediate ownership. Fred Wilson has much more elegant descriptions of how this sort of stuff works.
So: You’ve been offered $36k/yr with 3% stock options on a four year vest with a one year cliff. And you know what that means.
3. Understand the gamble.
You are making a gamble.
You are joining a start-up and will make significantly less money that you would otherwise make. For maybe a year or two. Possibly longer. And you’re a responsible adult, so you’re not just doing this for the sheer joy of working in a crazy start-up environment. The gamble must have a financial upside: If you do a great job and the cards turn up in your favor, you want a nice pay-off for your sacrifices today. That is the essence of entrepreneurship.
To understand this gamble, you must understand your investment and the nature of the possible pay-off.
My friend Jason Cohen made this argument to me when we discussed this:
Imagine you were being hired at your standard yearly income (see step #1 above — $100k/yr). The founder of the start-up would need to find an angel investor to pay for you. And that person would expect a return of 300% over three years of 1000% over five years to make it worth their while. But! In this case, you are being offered $36k/yr. So you’re, in essence, putting $64k of seed money into the company that first year. After one year, you will be down $64,000 from what you otherwise would have earned. So you want to see that investment grow. And you might as well use 300% growth in three years and 1000% growth in five years. Meaning, if there’s an exit in three years, you want $64k times 3: $192,000 return. If that exit’s in five years, you want to see $640,000 come back to you.
Big numbers can seem crazy or greedy or whatever, especially if you’re like me and used to smaller projects. But use them. Like I said, if you think you’re worth $100k/yr and they’re offering a base of $36k/yr — that’s a massive difference. Like, a couple or three new automobiles worth of difference. Do not give that up lightly.
In my case, there was also no guarantee that I would go up to my natural salary point anytime soon, so I doubled this first year investment to give myself a number that felt comfortable stretching over the course of three to five years. In this case, that would double your $64k investment to $128k. Which would make the return you’d like to see $384,000 after three years or $1,280,000 after five. Let’s knock this down to $300k and $1m even to account for the fact that you’re not putting this in as cash right at the beginning — it’s spread over time.
I know: These numbers aren’t perfect. You’re going to have to make your best estimates given the information you have. If you’re very confident in the idea behind the start-up, for example, you might be willing to accept a gamble with less pay-off. Or if there are other reasons to join such as getting exposure to an industry in which you’d like to work. But if you are going to invest yourself in this start-up project (especially if it’s as an employee), you need to establish what levels of returns your comfortable seeing in return for the gamble of time and money you’re putting in up front.
So: Let’s say, given the numbers I’ve been using so far, that you consider your risk to be $100k over the years you’d be working on the start-up and you’d like to see $300,000 after three years or $1,000,000 after five. And let’s say $500,000 after four years, when all of your options vest. I’m fudging the numbers down a bit to make them more round and just to pretend I’m factoring in some other stuff when doing this math.
4. Spreadsheet time.
Let’s plug all of these numbers into a spreadsheet and see where we’re at.
What this means:
Yearly Income: How much the start-up is offering you in salary.
Your Cost (4yrs): A ballpark of what you’re giving up in cash over four years to work at the start-up, based on the thinking described above.
Stock Options: What percentage of the company’s value in options are you being offered?
Dilution: The ballpark percentage of reduction in your ownership in the company after several rounds of funding.
Exit (mil): Let’s say the company has an exit right after all of your options vest — after four years. Let’s pretend it has exited at five different valuations, just to run some numbers.
Full Vest: What are your options worth at that exit point, after this hypothetical four years. Which equals Stock Options minus Dilution (which leaves you with 1.2% options) multiplied by the Exit.
Gain $: What’s your profit? Equals Full Vest minus Your Cost.
Gain %: The percentage of return you would see in this case (to compare to the numbers an angel investor might want to see, as described above).
What you want to look at is Gain $ and Gain %. In this case, to get a good return on your investment, you’d like to see the company exit in the $30m-$60m range. $100m would be wonderful. A $10m exit would give you a terrible return, a mere $20k bonus after the years of risk you just took. These are your magic numbers. Given what you know about the industry and the start-up’s idea, do you think it can reach a $50m valuation? Is it even possible? Is it probable? Would you do this if there was a 10% chance of that? What about a 1% chance of that? We’re now in the range of questions only you can answer. This is where your professional judgment comes into play.
And be honest with yourself. My philosophy regarding optimism and pessimism is this: When you’re being creative and making things and throwing around ideas and making the business happen, be optimistic. Be joyous. Get excited. Have fun. Rock out. When you’re dealing with financial numbers you need to be realistic, sober — which for me means concentrating on the negatives. Being more pessimistic than I usually like to be. It can be a little uncomfortable, especially during negotiations when you have to talk with founders about dark crap like what happens if the business flat-out fails after a year.
So: Run that math. Think about the various possibilities and make your judgment about whether the gamble is worth it.
In my situation, I was talking to a founder who had essentially no code and no users and for whom I would be developer #1 and employee #1. So I didn’t factor in stuff like the current value of the stock options. Meaning: If the company were already worth $10,000,000, 3% of options could be considered to be worth $300,000 right from the start (a massive amount — I doubt a developer would get an offer like that, unless they’re someone really special). So be aware of that difference. But — it’s not hard to incorporate these numbers into the math above.
Also, I must say this once again: I’m a start-up business noob. I’m giving you my experience and I’m running through my rationale when understanding and making a judgment about my situation. If you’d like real advice, these are the two blogs which I read the most of and game me the most solid, usable information: Fred Wilson’s A VC and Jason Cohen’s A Smart Bear. Paul Graham has some good articles, as well.
I turned down the offer I received. Which saddened me because a friend was making the offer. But, the money had to be right before I could get on board. And I’ll be honest: I feel like solid developers in New York City at the moment have tremendous opportunities. There are plenty of jobs out there, if nothing else.
Also, y’know: I consider myself a pretty creative guy with an entrepreneurial bent. I haven’t started a company any larger than my one-person contracting biz, but I’ve got years and years of experience working independently. I’ve met all sorts of people and have had all sorts of experiences. Why not brainstorm my own idea? Why just take some small percentage of someone else’s? Especially if I’m doing all of the development, anyway: Why not fit it around my life and start with 100% equity in a project — no vesting, no cliffs. One could start a relatively small business and with a little pluck and luck possibly walk away with more cash than one would get taking the deal above with a company that eventually had a $50m or even $100m exit.
I think this is a strong argument for that kind of philosophy. I can’t say I’d never join a start-up like this, but I do think this is a very good argument for cultivating one’s own ideas and learning how to make them valuable rather than jumping in on someone else’s thing. I have a strong independent streak, anyway. I like working at home. I like small projects with at most a couple of people working on them. I prefer working with friends. I’m not a big fan of business for business’ sake: I like to make things. And I like to be able to say things I make are mine, not that they belong to someone else. These are my tendencies — very much non-economic issues which I had to consider when working out my decision on this issue.
Anyway. I hope this brain-dump helps someone out there. I am not an expert. So if there’s something wrong about my thinking, please let me know in a comment. I feel like I’ve just scratched the surface on this and I would love to know more.
Thanks for reading!
I'm Josh Knowles, a technology developer/consultant on a variety of mobile, social media, and gaming projects. I founded and lead Frescher-Southern, Ltd. I grew up in Austin, Texas and currently live in New York City.
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