How Giving Away Equity Makes You Rich

As a founder, the idea that to get investment you have to first give equity may freak you out. You have put a lot of effort into your company, and will continue to do the bulk of the work until the company is a success. All of the blood, sweat and tears will come from you. If the company fails, you are the one that loses the most. By a long shot. So it may appear idiotic to give away so much, so quickly.

This thinking is wrong. Owning equity in a company is only valuable if the company itself is valuable. Let me say that again, because it is important to understand. Your ownership of a company only makes you rich if the company itself is worth a lot. For example, owning 50% of a company worth $100,000 will make your portion worth $50,000. Owning 20% of a company worth $10 Million makes your portion worth $2 Million. But owning 100% of a company worth nothing makes your portion worth… nothing.

No problem, you are thinking. My idea, skills and talent are so great that I can create a valuable company without any outside investment. That way, when my company lists on the New York stock exchange I will keep all the profit. When that glorious day arrives, I will be as rich as humanly possible.

Great plan. Except one thing to remember is that startups take at minimum 7 years before you will be able to list on the public markets. That’s a long time to try to grow a company without the fuel of additional funding. Of course, there could be a scenario where you bootstrap your business, take on no investment, and grow its revenues year on year, making your profits through ingenuity and hard work. But in reality it doesn’t really work this way, especially in the world of tech where scaling as fast as possible, to beat out the competition, is a priority. The war going on between Uber, Lyft and other international competitors is an example of this.

Now that you recognise taking on investment is a requirement for success, allow me to explain how, paradoxically, the more equity you give away, the richer your get. Let’s say you start out by owning 100% of your company. As you haven’t sold any shares, the value of that company is zero, even if you are profitable. It may seem weird that a company that is profitable is worth nothing, but a company is a bit like owning a home. You can speculate that the value of your home is 500k, but you don’t know for sure until someone buys it and gives you the cash. That’s when you know it’s true value. As startups are more volatile than property, the speculation on its price is even more theoretical. So until you get your first investment, your company has zero value.

Then let’s say an accelerator then gives you something like 15k in cash and another 50k in services i.e. mentorship, deskspace, etc. for a total of 65k. In exchange they ask for 10% of your company. If they paid 65k for 10% of your company, that means that the other 90% needs to be worth an equal amount per percentage point. In other words, each portion of 10% has to equate to 65k. As there is 100% of a company, the total valuation of your company is 650k of which you own 90%. You therefore went from having 100% equity that was worth zero to 90% equity that is worth 585k, an increase of over half a million bucks. Pretty good, no?

A visualization of the equity division of your company. If you give an investor 10% of your company in exchange for 65k that means your remaining 90% is worth 585k.

Let’s take this a step further. One reason people join accelerators is access to the program’s investor network. The idea is, if you hustle hard and grow your company during the 3 to 5 months you are with the accelerator, you will be introduced to people who will give you additional cash. This investment is called follow-on funding. In fact, when talking with accelerators, you will hear statements such as ‘75% of our startups get follow-on funding’ or ‘on average our startups receive $500,000 in follow-on funding.’

If you joined the accelerator than after the program finishes you could expect to get around 500k in exchange for 20%. This number may freak you out again as you now have given away 30% of your company. But going back to the original idea of investment and valuation, let us do the math of how much your startup is worth after this second round of financing. If you give 500k for 20% of your company, that means that 100% of your company is now worth $2.5 million. You still retain 70% which is now worth $1.75 million. Happy?

To be sure you understand let’s summarize. At first you owned 100% of a company worth nothing and therefore your equity was worth 0. Then you owned 90% of a company worth 650k so your portion was worth 585k. Then a few months later, at the end of the accelerator, you now own 70% of a company worth 2.5 million and so your portion is worth 1.75 million.

I hope this illustrates the advantage of getting investment. The alternative would be for you grow your company on your own without the help of outside funding, but the chances of you achieving the same results are highly unlikely. Much better to take the investment, create a successful company and reap the rewards.