McStartup

Andy writes:

Hi Jeff. A friend has started a limited company here in the UK. It is a software startup with an idea, a technical specification, and a non-functional prototype, but no money. There is one client lined up at present. As far as I'm aware he hasn't secured any funding yet.

He wants me to join as a first employee developing the software with him, paying in equity rather than a salary. I think the amount offered is very low and would like your opinion.

Projections are as follows:
Year 1 £13k sales, £15k grant, £130k investment, £57k expenses
Year 2 £462k sales, £330k expenses

Authorised Shares: 10,000
Initial Issue: 6,621

He values the company at £800k

For working 6 months as a Lead developer he is offering 250 shares.
For investing £20k, becoming a director, and working as CTO he is offering 662 shares.

For the first two years directors would not take a salary, but would live off drawings.

I think firstly that the valuation is high given the figures, and secondly that the equity offered is low considering I would be a first employee playing a vital role in developing the product.

Do you agree, or do you think I am being unreasonable?

As you've described it here, I would say what has been proposed to you is, to put it bluntly, completely ludicrous.  Now, that said, I don't know a lot of the details here, but I'll walk you through some of my thoughts based on what I see in your question.

The authorized share number, as I've addressed in an earlier post, is not really an important number.  The board of directors can increase that number at any time, so it's not worth worrying about at this stage of the game.  What does matter is effectively "Who owns what, today?"

In your numbers here, and based on the fact that this is the very earliest of early stage startups, I'm going to assume that the other partner is who owns all or almost all of the 6,621 shares.  If you come aboard, and it's just you and him, and you get 250 shares, then the new total outstanding is 6,871.  Your 250 represents 3.6% of the company.  At first blush to me, that seems obscenely low for someone that's going to work for 6 months without getting paid.

There are other factors - if this guy is bringing a large sum of money to the table, then that is worth a whole lot more than your working for free.  Of course, if that were the case, you probably wouldn't be working for free, in which case we wouldn't even be having this discussion, so I'm assuming this is not the case.

There's also the issue of how long has he been working on this, on a full-time equivalent basis?  Time is worth a lot in a startup, and if he's been working on this full time for a year, and now wants to bring you aboard, that's a lot different than if he's been working on it every other weekend for a month, and wants to bring you on board.    Even here, 3.6% seems very low to me, but a 50/50 split would be very high, if he'd been working full time for a year.

Something for you to consider is the future dilution due to funding requirements.  If this company were to need to go the route of venture capital (which based on your projections, it would not, but for the sake of illustration I'll go through it), you'd be looking at 40-50% dilution for your first round of funding, and 20-30% for your second, if needed.  If that were the case, your 3.6% is going to end up looking more like 1.5% when all is said and done.  Seems wrong given that your partner would be looking at more like 30-40% ownership after all that.

There is also the issue of what is the company worth today, which factors in whether you put in 20k or you raise several 100k in investment capital.  The proposed valuation of 800k is interesting -- ask yourself this question -- if I wrote him a check for 300k right now and asked him to walk away, would he do it?  If so, then 800k is too high.  It's kind of a silly exercise, because getting a check to walk away and getting investment are two different things, but if you can find the point where the answer is "no, he wouldn't walk away for that" it could be telling.  If he'd be willing to walk away for 100k today, then saying the company is worth 800k on the same day seems a bit of a stretch. 

In a traditional venture funding scenario, a CTO hired after initial funding might well end up in the 3-5% ownership range, depending on a lot of factors, and probably a full market salary to boot.  He's asking you to be at the low end of that range pre-funding, when all the risk is on you two and with no salary.  I would say that's quite off. 

I'd be happy to take look at some additional info and give you a more specific recommendation, but I would say from what I know right now that the "fair" split would be somewhere between 50/50 and 70/30 as a very broad range.

Hope that helps!