Quick case study: To give up equity or not

A colleague of mine contacted me to ask if he should give up a 30% equity stake in his company in exchange for about $10,000 services in kind (e.g. office meeting space, other support). (Numbers disguised to protect the innocent).

How do you think about an offer like this?

1. NEVER give up equity unless you have the opportunity to SIGNIFICANTLY increase the value of your company to your new partner. This means: major management or board talent, new technology, significant funding for ongoing operations. It rarely means a normal operating expense like meeting space.

2. If you do consider giving up equity, know the math:

a. What will be the value of the company in 3-5 years?

b. What is that value in today’s dollars at some appropriate rate of return. In this case, say that at a 15% discount rate over 3-5 years, the company is worth $100,000 in today’s dollars. The discount rate and expected value of your company are all determined via negotiation, so you should have a good sense of valuation (which I can get into later if anyone wants, or you can discover by getting a basic finance/valuation book).

c. Divide the value of the investment or contribution into that number. So $10,000 into $100,000 is 10%. That’s the maximum equity you should give up.

So in this case, here is my advice:

1. Don’t give up equity for meeting space. Instead, barter your services for meeting space. Equity is too valuable.

2. If you were to give up equity, in this hypothetical case 10% is about right.

Finally, you have to create a company that is worth something down the road. If a company is only “you” as an independent professional offering services, it won’t be worth anything. You need to develop a system that lasts beyond you, so someone sees value independent of the owner.

Free book: Jump Start HTML5 Basics

Grab a free copy of one our latest ebooks! Packed with hints and tips on HTML5's most powerful new features.

  • http://www.ptpnewmedia.com ptpnewmedia

    Here is a question along the lines of valuation. How do you sell your company. For example, your company begins to capture a large share of a market and the big boys don’t like it. They offer to buy you out and give you a three to five year non-compete.

    How do you make the decision of what to sell your company for and if it is even worth it. For example, you take the money and invest it into another venture or market. You could also consult the market you came out of but not provide the same kind of service (ie. web marketing).

  • http://www.crystalcleardesigns.com ccdesigns

    This is a great topic to get into Andrew. I especially like this part:

    Finally, you have to create a company that is worth something down the road. If a company is only “you” as an independent professional offering services, it won’t be worth anything. You need to develop a system that lasts beyond you, so someone sees value independent of the owner.

    A lot of people get caught up in producing web sites and not enough on producing a business for the potential of buy-out. The trick I guess is just finding that balance.

    Question: Is it out of the question to take a potential equity sharer on as an employee for at least a year before renegotiating their buy-in? To make sure they will truly add something to the firm.

  • http://www.developedsitesales.com Cutter

    One place to start in valuing your business is to take a look at simular businesses here: http://www.ibba.org/ — but just to get a rough guess.

    Ultimately I think it comes down to you. For some people $10 million today is better than the possibility of $50 million in 15 years.

    I understand there are some formulas used in pricing a business, but at the end of the day that isn’t what makes the final decision.

  • fleisc

  • Pingback: SitePoint Blogs » A bit more on equity and selling a company