Instead of comparing the equity of the first engineer with the founders, it is easier to compare how much his lower salary can buy him if he takes another job with full salary and invest the difference in the company as an angel investor. If there is an engineer whose salary is $120k/year and is joining a startup at $90K/year, he is taking a 30k/year loss. Let's say the startup has received $500K investment at the valuation of $2.5M. Since the startup has passed its valuation point already, its current value is somewhere between 2.5M and its future expected value.
Let's assume the prediction for valuation at the next round is $10M and there is 50% chance that the company gets there. This would make the value of the company about $5M at this point. This means that the engineer's discounted salary is worth about 0.6% equity (30K/5M=0.6%) for the company. Usually companies make the offer for 4 years worth of equity with a vesting plan. Again it is not correct to multiply 0.6 by 4 because the salary of engineer will reach to its market value after the next round of funding. It is fair to multiply it by 2x. This brings the total equity given to the engineer to be about 1.2%. I made a few assumptions here such as what the expected value of the startup would be in the next round of funding and how much the salary is lower than the market value. This calculation shows that the current amount of equity offered to the first employees is not that different from what it should be contrary to what the author of the blog post has suggested.
To offer a simple formula:
Y (expected equity of the first employee for the first year) = X (loss in income for the first year) / V (valuation at the next round of funding) * P (probability of the startup getting to the next round).
For our example:
Y = 30K / 10M * 0.5 = 0.6%
I know engineers often compare themselves to the founders and wonder why they should get so much less equity considering that they have similar skills and are putting equal effort into the company. One thing they ignore is that what founders have already put in. In most typical startups, the founders have been developing the idea at least for two years and have worked full-time on the startup for 6 to 12 months before receiving the seed funding. They have done this at the time that the possibility of getting to the seed funding round was less than 20%.
If we assume their market value was $120K/year, that means they each put in something about $120K at the time that there was less than 20% chance that the company would get to the point of $2.5M valuation. If there are two founders, this would be about $240K investment at the valuation of $500K (2.5M * 20%). That means the founders should get 48% in vested shares in the company. Instead they get all their share as unvested shares and have to work for the next 4 years in the company to earn them. Considering the remaining sacrifice they have to make, it is totally fair for them to receive 60% instead of 48%.
Let's assume the prediction for valuation at the next round is $10M and there is 50% chance that the company gets there. This would make the value of the company about $5M at this point. This means that the engineer's discounted salary is worth about 0.6% equity (30K/5M=0.6%) for the company. Usually companies make the offer for 4 years worth of equity with a vesting plan. Again it is not correct to multiply 0.6 by 4 because the salary of engineer will reach to its market value after the next round of funding. It is fair to multiply it by 2x. This brings the total equity given to the engineer to be about 1.2%. I made a few assumptions here such as what the expected value of the startup would be in the next round of funding and how much the salary is lower than the market value. This calculation shows that the current amount of equity offered to the first employees is not that different from what it should be contrary to what the author of the blog post has suggested.
To offer a simple formula:
Y (expected equity of the first employee for the first year) = X (loss in income for the first year) / V (valuation at the next round of funding) * P (probability of the startup getting to the next round).
For our example:
Y = 30K / 10M * 0.5 = 0.6%
I know engineers often compare themselves to the founders and wonder why they should get so much less equity considering that they have similar skills and are putting equal effort into the company. One thing they ignore is that what founders have already put in. In most typical startups, the founders have been developing the idea at least for two years and have worked full-time on the startup for 6 to 12 months before receiving the seed funding. They have done this at the time that the possibility of getting to the seed funding round was less than 20%.
If we assume their market value was $120K/year, that means they each put in something about $120K at the time that there was less than 20% chance that the company would get to the point of $2.5M valuation. If there are two founders, this would be about $240K investment at the valuation of $500K (2.5M * 20%). That means the founders should get 48% in vested shares in the company. Instead they get all their share as unvested shares and have to work for the next 4 years in the company to earn them. Considering the remaining sacrifice they have to make, it is totally fair for them to receive 60% instead of 48%.