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I currently work freelance as the sole software engineer for a small but promising startup company. I've been working with them for a several months, converting their "demo ware" software into something more robust and suitable to supporting the service they offer.

Understandably, they want to keep costs as low as possible and have offered me a share in the company in return for me reducing my freelance rate significantly.

I currently earn a good rate, but the salary they require me to drop to is office admin sort of money i.e. just enough to live on. The share on offer is 5%.

I'm interested, as the project does have promise, but the business is not turning a profit yet, and I believe that it will be at least 2 years before the 5% share is worth anything. In this time I will have sacrificed the best part of 2 years salary - and this is if the project succeeds.

I would like to own a share in a business such as this eventually. I really want to see the project do well, and don't like being the major cost to the company, but I don't feel that what's on offer is enough for me to make that kind of sacrifice.

Am I being short sighted? Does any one else have experience of this sort of situation that can advise me on the pros and cons of going ahead, or possible negotiation positions to make the deal more viable for me?

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Will the 5% be vested over time, and if so over what period? Can you make a counter deal offering part time service for that amount of money? Do they have any investors or plan to raise capital? Do you really believe in the idea of the company and would use the end product yourself? – Tilen Krivec Apr 2 '11 at 9:53
Also, is there a possibility of having your share diluted? – David Thornley Apr 2 '11 at 18:58
I definitely believe in the product, so that's a bonus. I guess there is a possibility of the share being diluted, as with a small share, I wouldn't have much say over further division of the company. – BombDefused Apr 6 '11 at 8:28

4 Answers

up vote 22 down vote accepted

I think the share might be way too low.

Let's say you sacrifice $50K of pay per years for 2 years, or $100K. Is $100K less than 5% of the current value of the asset and company? If not, then you are just cheap labor.

Here is a set of formulas I use to keep the discussion real:

  • What is the probability of success? Realistically 10%. So you have a 10% chance of recouping your $100K.

  • What is the definition of success? A local private (and successful) software company has been handing out options to employees for the last 20 years. They will probably never IPO. Will you participate in revenue sharing or do you get options? Options can be frustrating when the business is generating several millions a year, but is never put for sale so that you can get your money out. So I would opt for revenue sharing on top of options.

  • Even if everything goes well, you may be diluted by 50% by a couple rounds of financing. So now your stake is 2.5%. Then the company would have to be worth $4M just for you to recoup your cost.

In my opinion a 10% chance of recouping $100K should be worth $1M in case of success (i.e., you would never pay $100K for a lottery ticket with a 10% chance of paying $100K. You may if it has a 10% chance of paying $1M). For your 2.5% stake to be worth $1M, the company would have to be acquired for $40M. Is that realistic?

It depends. Do the founders have any experience is successfully launching a startup, and seeing it through acquisition, or is this their first time?

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Also, your point about cost to me vs probability of gain is a good way of looking at this. I think I need to look more at the numbers. – BombDefused Apr 2 '11 at 10:03
I disagree with these numbers, but only because they are understated. Imagine you had 10 such ventures (yes I know you can't, but imagine), on average 1 of the 10 would pay out. So you'd lose $1M gain the $1M. You shouldn't be looking to average out, rather be making some multiple. I'd say at least x3-5, so the company valuation needs to get to 120-200M in the above calculation now. – David Apr 5 '11 at 14:48
I edited your post lightly, in the hope of making it more readable. Some parts were a bit difficult, so please see the edit change set and revise if you don't agree. :-) – Jesper Mortensen♦ Apr 5 '11 at 16:46
1  
@David, I agree with you, in my opinion the numbers are understated. The odds of being alive after 5 years are ~10%, good success (>$50M) is more on the order of 2-3%. But good luck getting a founder to agree even with the conservative numbers above... – Tony BenBrahim Apr 11 '11 at 11:19
Great post, when you put it this way I'm glad I took the job with the larger salary and the smaller percentage. Startups are risky. – Ryan Detzel Apr 27 '11 at 17:51
up vote 12 down vote

First of all, your motivation is key. If you find the product especially interesting, and you have a long-term dream of doing a startup, then read further. Otherwise, decline politely.

Next: two years is way too long. Do not commit to more than 3 to 6 months of your life to a venture that doesn't pay the bills. If you love it, you can always extend.

Finally, the ultimate test for me would be: now that I would become a part-owner of this project, do the other people respect my opinion, involve me in the brainstorming, or am I just cheap labor to them?

Then decide.

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Thank you, some good points there – BombDefused Apr 2 '11 at 9:25
up vote 5 down vote

One of the best thought experiments is to suppose you had $100K, your salary loss, in the bank and the founders asked you to be an angel investor? Would you put the whole $100k into their company when you could use it to buy a house, buy bonds, invest in a mutual fund, or into any of the thousands of publicly traded companies in the US?

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Good way of thinking about it. Made me think of a program I watched last night on differences in responses if questions are phrased differently bbc.in/fptYCs (Sort of unrelated, but interesting!) – BombDefused Apr 6 '11 at 8:24
up vote 3 down vote

I just pulled the plug on a similar situation:

  • Promising Market
  • Sole Developer brought on to convert and upgrade an existing product
  • Offered Profit-Sharing and the promise of a big payday down the road

It was just a part-time gig.

However, I definitely put in my fair share of hours supporting/developing the product.

The pay was nothing in comparison to a contractor rate.

My biggest problem, and this may differ than your situation, was the leadership. I found I was repeating and re-repeating myself over and over again; explaining why something could or could not be done. I would get the "yeah, that makes sense" and then answer the same question(s) weeks later. There were also times I would exert strenuous hours to accomplish a task; only to have it sit in limbo for weeks at a time before any feedback.

That's just a couple of examples and may only apply to me. Since you've been working with them for months, you should have a good perception how they operate.

So, in addition to the excellent question Am I just cheap labor?, append these questions as well:

  • Does the company have good leadership?
  • Am I adding value to myself with the experience gained?
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+1 Thanks for sharing the experience, it's definitely relevant. – BombDefused Apr 6 '11 at 8:27

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