This is part of an ongoing startup advice series where I answer (anonymized!) questions from readers, like a written version of Smart Bear Live. To get your question answered, email me at asmartbear -at- shortmail -dot- com.
Employee-Investor writes:
I’ve been invited to join as startup as employee #1. They’re giving me a salary and an OK stock grant, but I want more stock.
I have $95,000 saved from a previous exit. I don’t need the money in savings because I’ve been making $150/hour as a consultant so my “plan B” is fine.
Should I invest my $95k at a $1m valuation to bring my total stock allocation into the double-digits? Or should I keep that money as an investment in my next venture?
Since make $150/hour, you probably think that’s what you’re time is worth. And the question is: Will you get enough of a return on that $95k to be worth it?
First I need to negate your assumption. Your time is actually worth $1000/hour. Go read that linked article so you truly believe this in your gut.
Once you understand this, the decision becomes quite clear, because the $95k is actually not your primary investment. The time you invest in this company is worth far more than the $95k.
Let’s do the math.
The $1000/hour thing is based on 100% risk with no salary, which is not your situation. So let’s re-do it:
Say you’ll make $75k/year salary but you were making $150k/year as a consultant, so your nominal opportunity cost of being with this company for four years is $300k. Assuming a 15% chance of success (like in the other article), you need a potential payout of at least $300k ÷ 0.15 = $2m on a successful exit.
Assuming you’re granted something like 2% in stock, the company would need a $100m exit in four years to cover that. That sounds unlikely. Bad bet.
But now let’s consider the $95k investment which brings you up to 10% in stock. Now your total investment is $395k. (See how the $95k is only 1/4 of your true investment?) Now you need a potential payout of at least $395k ÷ 0.15 = $2.6m, but with 10% of the company that’s an exit of $26m in four years, which sounds quite reasonable.
In short, your $95k investment buys you far more equity than your time does, whereas your time is much more valuable to you than your money.
So here’s the answer to your question:
If you believe this company has a good shot, you must invest your $95k, because it’s the only logical way to make the finances work!
If you don’t think the company has a good shot, you should not “work there but save the $95k” because you’re wasting your most valuable asset — your time. You’re better off spending time with your family and making a good living, or doing just enough consulting to fund a startup where you can own a big chunk of the company.
You might argue that you’re already putting yourself at risk by working at the company, so you should save your $95k as a cushion for your family. But actually you’re still doing your family a disservice, because it’s almost impossible for you to earn back the reward on your time. You’d serve them better by making $150k/year consulting at 20 hours/week and spend all that extra time with your family. Besides, if it all fails, you can make so much as a consultant — especially if you work the same hours of a startup founder — that you can put your savings back easily.
Of course the value of working at a startup isn’t just financial. It’s more fulfilling, more exciting, more fun, and nowhere else will you learn as much about as many things. That absolutely counts, perhaps even more than the potential for making money!
Add your advice to the discussion section!
14 responses to “Should I invest my savings in this startup?”
Nicely done.
I actually try to make people do the math on the exit based on their current salary – they often are discouraged when they see that there is no economic justification to taking the startup job.
I always say that joy in your work is valuable too, but you have to understand why you’re doing stuff.
_XC
The average outcome for any entrepreneur probably doesn’t fully compensate the time put in, so it doesn’t sound that far from starting your own company.
The answer would really depend on where you want to go. If you want to build your own wealth through a startup exit then you should invest in this or something else. On the other hand, $100k plus a few years of working at $150/hour and saving 40-70% of what you earn could give you enough to take bigger risks in the future (with a much higher probability).It’s all about the most efficient way to reach your own goals. Without knowing those, you can’t know if putting in time or money is the bigger risk. If you want to help this startup succeed, would the extra investment give it a boost? If you just want to profit from an opportunity, can you invest and advise without making it full-time?
Good advice, however, if it were me I would just ask for more stock to get me to the same level as if I had invested $95K and then keep the $95K for my cushion. That way if things don’t go well you can bail, preserving your opportunity cost. At $1M pre-money (these days) the company must be pretty small and you must be pretty early, so you consequently should be a pretty important hire. Change your status from “early hire” to co-founder and then work your _ss off to make it a success! If the existing founders don’t want to do that deal you have to scratch your head because either (a) the $95K is really important to them (a bad sign because if nobody wants to fund the company in this environment, it’s going to be a tough go whether you invest $95K or not) or (b) they don’t really think your contribution is that valuable. If it’s not that valuable, find another company where you can make a difference!
Josh, I totally concur…people soooo discount their time…when I tell people my rate is $495/hr they baulk, then I tell them that is a 50% discount..they laugh…then I say, OK..find someone else because I am working on my own company… People think $150K is fine, even less, you YOU can dictate the working conditions…being or creating a start up is so much more rewarding for much of the same reasons you listed..
This is horrible advice for a number of reasons.
1. Jason’s opportunity cost calculation is based on the notion that Employee #1’s current consulting income is the equivalent of a salary from a company. But anyone who has done consulting for any length of time knows that this isn’t the case. What you make is not what you net thanks to self-employment taxes. And everything can change overnight. If you have only one or two clients, it’s not impossible to see 40-60 billable hours a week, but your long-term risk is very high because the loss of a single client can obliterate your income. If you diversify your client base, however, you will always lose some percentage of your billable hours to ongoing business development.
2. Employee #1’s suggestion that he doesn’t need savings because he’s making $150/hour as a consultant is asinine. The appropriate amount of savings an individual should have is not based on current income; it is based on current obligations. These can very greatly (is Employee #1 living a frugal lifestyle or is he living like he makes $150/hour?) but regardless, it’s foolish to suggest that this individual leave himself with no savings so that he can own a greater percentage of illiquid (and perhaps arbitrarily overvalued) stock.
3. Employee-investor relationships aren’t all that common. There are good reasons for this, and while it’s possible there’s nothing to be concerned about in this instance, the fact that a company would contemplate taking a $95,000 investment from the person it wants to hire as its first employee for a near 10% stake is a big red flag.
4. Jason doesn’t speak to dilution and liquidation preferences, two huge issues. If Employee #1 invests $95,000 into his employer, he should assume that his investment will be diluted over time. If there is any chance the company will seek to raise money from professional investors, he should also assume that his potential gains upon exit will be limited by liquidation preferences, perhaps to a significant degree. In other words, a 10% stake and a $26 million exit would not necessarily equate to a $2.5 million gain here; it could actually be substantially less.
Bottom line: while Employee #1 says he’s making $150/hour as a consultant, the fact that he’s contemplating full-time employment hints that he isn’t as comfortable with his situation as his hourly rate might suggest. At the same time, he’s clearly not satisfied with the compensation package he’s been offered by his prospective employer.
The solution: Employee #1 should negotiate for a compensation package he’s happy with. If he doesn’t get what he wants/can live with, he should move on. Under no circumstances should he invest his life savings in the company he’d be going to work for.
The money under discussion was not this person’s “total life savings.” It was windfall from a previous company. This person was deciding whether to do his own startup or double-down in this particular startup.
If everyone followed your advice and never invested their savings in a startup, there would be almost no startups.
Jason,
“If everyone followed your advice and never invested their savings in a startup, there would be almost no startups.”
That’s a ridiculous assertion.
Let us be clear: we are not talking about an individual who is taking his capital to start his own business, and he is not an investor.
We are talking about something very different here: an individual who was offered a job at a startup and who is not happy with the amount of stock he was offered. Instead of negotiating for a better compensation package (which is a no-brainer), you are advising him to “double down” (note the use of a gambling term) by investing $95,000 of his own savings to boost his equity position if he believes the company has a “good shot” (whatever that is). Your justification is based on the belief that a 10% ownership stake would net this individual $2.5 million if the company is sold for $26 million in four years (a completely hypothetical exit scenario pulled out of thin air). You have not considered the effects of dilution and liquidation preferences, nor even the valuation being assigned to the company’s shares. You have also ignored the fact that most startups do not seek investment from their early employees, which is a huge red flag.
Finally, the individual in question wrote “I have $95,000 saved from a previous exit. I don’t need the money in savings because I’ve been making $150/hour as a consultant…” He did not write “I don’t need the savings because I have another $750,000 in savings.”
The use of one’s savings should never be based on the amount of income *currently* being earned, as income can go away overnight. The individual here could lose all of his clients tomorrow, he could be injured and unable to work, etc.
In short, to provide sensible advice about the amount one should invest, you need to know the amount a person actually has to invest given their obligations. That requires a more complete picture of an individual’s financial situation. Instead, you are providing guidance based on nothing more than speculation and hypothetical figures.
I spoke with this person for over an hour on the phone. The snippet above is a small summary to conceal identity and spark a blog post.
My previous response to you is, in fact, correct. He had already decided to risk that money on a startup. The question was: Do your own, or join one THAT HE ALREADY HAD JOINED, and was considering whether to continue.
Either staying with more % of the company, or starting his own thing, makes financial sense, but not just being an employee if you can make more money elsewhere AND you WANT to risk money for a big return.
You’re not wrong, actually, because I didn’t include all that context in the article! But this is in fact the case.
This is a new poster and not the ‘Guest’ above. Let’s ignore the fact that you are trying to win the argument by default by changing the situation on the previous poster. Under either the old or new scenario, the ‘Guest’ above makes the winning argument based on reason alone.
Additionally and not entirely unrelated, it’s worth reiterating Guest’s point that your numbers are completely bogus. The situation you’ve outlined values this company at $1.2M as of today. Maybe it is, but you haven’t provided us with any evidence for us to believe that this is the case. Does that seem reasonable from a company making its first hire? Odds are the company today is worth closer to zero than 1M. I think you probably would have mentioned something if this company had substantial traction already.
Also worth calling out is your assumption that this startup has a one in six chance of being worth eight figures in four years. Again, maybe you have information we don’t about this company. However based on normal expectations, this is completely ridiculous, again considering since this company is just making it’s first hire. You make the same assumption in your previous post. Garbage in, garbage out.
You’re just encouraging this person to gamble with their money because they are an employee. A better way to answer this question would be: if you had no connection to this company, would you spend $95K for 8% (the incremental equity in your example) of the company? If no, then don’t.
(1) The valuation was set by other investors. I didn’t “make it up.”
(2) He is already an employee, and not the only employee.
(3) It’s not the same if you’re not an employee. In one case you have visibility, some control, experience with the people there, deep knowledge of the product you helped created, etc.. In a random company to invest in, you usually don’t.
No, the question is: If you’ve already decided to be an employee here for the next four years, AND you want to get founder-sized returns, should you invest your money?
And the answer is: If you want to play the startup gamble, you need to own a reasonable % of the company, or else it’s just a job.
Under this logic isn’t the best decision to invest the $ and NOT work there?