1/(1 - n)

Paul Graham does some equity math for entrepreneurs trying to figure out if the dilution from a VC deal or an equity grant to an employee is worth it.

As usual, it's a good read.

Comments

[Steve Kane]

As always, here Mr. Graham is a thoughtful smart essayist, but in this case, I think he omitted a huge essential point:

Doesn't the amount of capital offered/invested have a big impact on the entrepreneur's calculation?

Sure I'd give up 6% of my pre-natal company for $1 million. But would I give up 6% for $1 thousand? No, of course not.

But Paul's essay suggests that in both cases the "added value" calculation is 1/(1-n).

Yet the ability to add 6.4% value at exit given $1 million is vastly different than if given $1 thousand.

Isn't it?

[jay]

For that component he does address what you're citing.

The idea was if giving up 6% of your company for $x was likely to increase the overall value using that formula.

Does that influx of capital increase the chance you will be worth 1.064 times your current value? 1.064 = 1/(1-.06)

That investment number needs to be what you base the likelihood against. It's just a metric with a fair amount of guess work still involved, not a hard and fast rule.

[Chris Neumann]

I feel bad for entrepreneurs who use Paul's formula. Fred, I disagree that it's a good read - I think it borders on disinformation. I think it vastly oversimplifies the process of deciding whether to take equity, and I think that Paul wrote it to serve his own interests in getting young entrepreneurs to take his low valuations. That whole model has worked beautifully for him, I'm surprised that more people haven't copied it.

[Peter Bell]

While in general I'm a fan of Paul Grahams writing, I don't think this was one of his more insightful pieces.

The financial part of the calculation is probably the least important part. What about the time taken to do the raise (assuming you didn't just get an unsolicited term-sheet emailed to you from Sequoia), the distraction of the pitch, the plan, handling the due diligence and the fact that you now have a backseat driver who is either going to stop you from driving off a cliff (making them worth way more than the financial story) or who (based on the portfolio problem: http://www.pbell.com/index.cfm/2006/10/28/The-Portfolio-Problem-Another-cost-of-capital) may end up driving you off a cliff in the change of goosing their overall return on the portfolio!

I think both the costs and the values of the non-financial factors leave the actual valuation math as a rounding error - especially in the early rounds, so I've got to agree with Chris. Disappointing from such an excellent mind.