Evaluating Seed Startup Offers

August 28th, 2019

A friend of mine recently asked me how to evaluate early-stage (pre-Series A) startup offers. Being the first employee at a startup is widely lampooned (why take all the risk for a 20th of the payout?), but it’s not unreasonable. Sometimes, you’re just really excited about the team, industry, or product. That’s ok. Life isn’t just about money. But it certainly doesn’t hurt to think about it a little bit.

Seeds have become pretty big these days ($2-3m) at a valuation of ~$10m. A typical offer might be 1% of the company with a below market salary.

How do I value equity then? Say you’re taking a $50k paycut over four years (factoring in stock options you would get at a public company). Say the cost of exercising the options and paying the taxes is another $50k, so your total investment after four years is $250k. At 1% of the company, you’re “buying in” to the company at a $25m valuation. Yes, you’re getting some optionality (you can leave anytime, you don’t need to exercise any or all of the options), but I tend to think that that’s balanced out by the preferred shares investors always get. We could also discount against the market: the $250k you’re foregoing might otherwise be invested in the market. Over 8 years (roughly how long it takes for a liquidity event), might actually bring your investment to $400k and the implicit valuation 8 years hence is more like $40m.

In this hypothetical, the question becomes: is the expected value of the company 8 years from today at least $40m?

Ok, how do you think about expected value?

There’s usually three buckets for startup outcomes: failure, sustainablity, and victory. Failure is a $0 outcome for you. They shut the doors or there’s an acqui-hire but mostly to pay back the investors. Sustainability is the company is viable or even profitable, but never able to break out. Usually, it’s best to assume the current growth rate will remain linear, project it out 8 years, and then apply your industry’s revenue/gross profits multipler. Victory is the company has hit its goals, in both product, mindshare, and revenue. Think about each and what the company would be worth in each scenario. This is actually where talking to the investors are really useful. They usually have done the same math before putting money in. Also, ask for the pitch decks or at least the most important metrics you’d normally put inside a deck: user growth, revenue, retention, etc. You’re an investor after all.

Finally, it’s your turn. How likely do you think each outcome is? From that, you can calculate expected value. For our example, let’s assume the company has $500k in revenue today and adding about $100k a month in new revenue. Projected forward, you’ll have $10m in revenue and say other public companies in your category get a multiplier of 5x, making your sustainability outcome worth $50m. However, assume you’re able to hit some exponential growth curve and start grabbing a significant portion of the TAM, total victory is $1b. Let’s give 70% chance of zero, 25% chance of sustainability, 5% chance of victory. That implies a $62.5m valuation, which makes $40m investment a good deal.

Finally, this isn’t just a regular negotiation. You’ll be working here for years, so it’s important to have empathy for the founder’s perspective as well. Generally, founders create an equity pool for new hires as part of their seed round (say around 10%). Their current plan to hit the goals necessary to advantageously raise might be hiring 10 people at 1% each. If that’s the case, it might be better just negotiating for more cash.