Founder: Hey Joe! How are you doing? Everyone here loved meeting you, and we would really love to have you on board as our investor! We really respect your expertise, and think this could be a great partnership. What do you say?
Investor: Glad to hear! Can you give me more details about how much money you’re looking for, and what I would be getting?
Founder: Sure. We’re looking for a $100,000 commitment, and in return, you would be getting 0.1% of the company.
Investor: In order for me to value your company accurately, do you mind sharing your financial books with me?
Founder: Unfortunately, we can’t do that. That information is classified.
Investor: You shared them with your earlier investors though?
Founder: Yes, but I’m afraid we can’t share it with you.
Investor: Ok. I guess we’ll just have to make do with the valuation from your most recent funding round. Can you share more details about that?
Founder: Sure. At our recent round 2 months ago, we were valued at $30M, post-money.
Investor: So, 0.1% of your company works out to $30,000… you’re asking me to commit $100,000 in exchange for $30,000 worth of equity?
Founder: No no no Joe. You’re not looking at it the right way. You can’t just value 0.1% of the company as being worth $30,000. No one has any idea where we’re going to end up in the future. How would you even value an early-stage startup like us anyway?
Investor: Well clearly you were able to agree on a valuation with your previous investors…
Founder: Yes, but that’s not the right way to approach this Joe. Startup outcomes are completely bimodal. Either we’re going to be successful, in which case your equity will be worth an astounding amount, even though you’re getting so little. Or we’re going to fail, in which case it will be worthless, no matter how much equity you have.
Investor: Well, I’m still concerned about the expected return for the risk I’m taking. And you still haven’t explained why you’re quoting me a valuation that’s so much higher than the valuation that you agreed to with your previous investors.
Founder: Look Joe, we’re looking for someone who believes in us and our vision. Someone who believes that we’re going to be the next unicorn. And when that happens, your $100,000 investment will grow into a cool $1M! Surely that’s a fair return on your investment? If you don’t believe in that vision, and if you aren’t willing to make sacrifices to be part of our team, maybe we don’t want you as our investor.
Investor: Well, I do believe in your vision and want to be a part of it. I just want to get the same amount of preferred stock that your other investors…
Founder: Hold up! Who said anything about preferred stock. I’m afraid only our other investors will be getting preferred stock, not you.
Investor: So you’re both quoting me a higher valuation, and I’ll be getting only common stock?
Founder: Not exactly. You’ll be getting options for common stock, with a strike price set to the company’s current Fair-Market-Value.
Investor: So when you guys eventually get to a liquidity event, I can then exercise these options and make money off them?
Founder: If everything goes well! We’ll need you to continue investing in us, every year, until we get acquired or go IPO. If at any point you decide that you don’t want to continue investing more money, you’ll have 90 days to exercise your options immediately. Otherwise, you’ll lose them forever.
Investor: But that’s so risky! Exercising those options is going to be very expensive, and that’s going to increase my risk even further because the stock is still illiquid! Not to mention that if the startup does become a unicorn like you were saying, I’ll get hit with a massive AMT bill that I won’t even be able to pay!
Founder: I think we’re getting ahead of ourselves here Joe. That’s all so far away! Who knows what’s going to happen 5 years from now. Most startups don’t grow that much you know. Let’s just finish the deal now, and if the need arises, the board can vote to change the terms of your options in the future.
Investor: And what if the board chooses not to? What if the startup does grow quite a bit, and I get hit with a huge AMT bill? My money would already be committed by then and I’d be SOL. Can’t you guys just replace this 90-day clause with a 10-year expiry, so that I wouldn’t have to deal with all these risks?
Founder: I’m afraid we can’t do that for you Joe. Besides, we want investors who are committed to us for the long haul. If you don’t want to keep investing in us for the next 10 years, maybe you don’t deserve to keep your equity. It would be best for everyone if we took away your equity and gave it to the people who are still with us.
Founder: … So, what do you say? Can we count on your $100,000?
Investor: Yeah… no. I think I’m going to go invest in Google instead.
If you’re taking a $X pay cut to join a startup, you’re really investing $X in them. Far be it from me to tell you how to spend your money, but make sure you’re happy with what you’re getting in return. Shout out to Adam D’Angelo, Sam Altman and Matt Mochary for fighting the good fight and bringing some rationality into these discussions.