The Founder Dilemma: Risk, Equity Dilution, And Term SheetsBY: Cameron Keng | February 19, 2012
Startups are glamorized into overnight successes that roll over obstacles like a runaway freight train. This is the myth that every real startup founder hates and fights. Yet, the irony of the situation is that a founder needs this myth in order to secure funding and an eventual exit through either an initial public offering (“IPO”) or acquisition. Unfortunately, in order to get funded, sometimes a founder needs to create this myth.
No one knows the real number of successes or failures, but everyone knows that their chances are bleak. On average, 50% of small businesses in general fail within their first year according to the Small Business Administration’s statistics. It’s safe to assume that a startup has an even lower rate of survival.
Assuming that you successfully execute a sexy multi-million dollar exit, you need to realize that your portion of that “exit” is going to be less than 10% of the advertised sale. You need to ask yourself, do I want to work 3 to 5 years for the bleak chance to maybe earn $500,000 on average in salary and risk my entire future career?
Can you accept the risk of waking up tomorrow with poor health, a failed startup and a failed career? That’s a risk I accepted a long time ago for the right to my own freedom without having to listen to anyone. I’ve never regretted the decision, but that doesn’t mean that I sleep well at night either.
GroupMe vs Groupie Case Study: 2 Startups, 2 Group SMS Apps and 1 Exit
GroupMe and Groupie are two startups that started in New York City (“NYC”) working in the same tech space and mobile platforms with two very different futures. Both companies created a group text messaging system, where groups of friends could send SMS text messages to each other as if they were in a chatroom. GroupMe was provided investment funding and eventually acquired by Skype. Groupie was self-funded and bootstrapped, but has yet to have the same opportunities. This is a story of how 2 amazing companies with almost identical backgrounds can have such different conclusions. Genius and hardwork are the basic requirements for success, but sometimes it justcomes down to a bit of luck and serendipity. Are you willing to roll the dice?
How much funding did GroupMe get?
- $18,000 dollars by TechStar’s incubation program
- $850,000 dollars by various angels in the Angel round
- $10,600,000 dollars for their Series A round
- $11,468,000 dollars in total funding
How much equity did GroupMe give up?
- No idea.
But, the industry norm is the following:
- 8% equity is given to the incubator for $18,000 to $30,000 dollars in seed funding.
- 20% equity is given to the Angel investors for $500,000 dollars in angel funding.
- 25% equity is given to the Series A investors for $3,000,000 dollars in VC funding.
- 12.5% equity is put away to attractive early employees (CEO, CFO, COO and Engineers)
- 65.5% equity is given away or diluted by the end of the Series A round.
Assumption: GroupMe gave away at a minimum 65.5% of their company for $11,468,000 dollars based on standard market practices. Each round GroupMe went through was an amount above the standard model, so they likely gave up a substantially larger amount of equity in exchange.
Exit: GroupMe was acquired by Skype in August 25, 2010 for an undisclosed amount, but it was assumed to be about $43 million dollars by insiders.
Based on the assumption above, the founders of GroupMe received an exit worth about $7.4 million dollars for about 2 years work. Realistically, the average founder had 10% or less equity left in their company by the time they’ve exited. The real amount earned is closer to $1.5 million dollars per founder or $750,000 dollars per year in the company. That’s enough for a small apartment in NYC and a vacation from the last 2 years of backbreaking work.
GroupMe is considered by everyone as a success for the founders and their investors. But, you need to consider the risk that the founders of GroupMe took to start their company. A founder is considered unemployed until their company has a successful exit. If the founders of GroupMe failed to exit, then they would’ve had a 2 year black hole in their resume. The chances of them getting a job in this market would’ve been zero. Their entire future careers would’ve been stalled irrevocably.
GroupMe’s founding team was previously employees of 2 successful startups (Tumbler and Gilt Groupe). Their prior experience definitely helped gain credibility from investors for their initial investment round. GroupMe’s founders smartly capitalized on their relationships. But, this isn’t an advantage an average founder will have and is particularly unique to GroupMe.
Groupie was founded in 2009 by 2 smart and capable founders that bootstrapped their company. They’ve spent well over $50,000 dollars to develop their initial product and have spent an amount in excess of 6 figures to continue the development and maintain the service. Their business has been entirely self-sufficient through their own efforts and funding. Their product has had consistent viral growth since its founding to the point where they’ve gotten over 100,000 users and millions of messages per month. Their company has definitively been successful in the market, yet they still weren’t able to find investment funding.
Unlike GroupMe, Groupie’s founders didn’t have established relationships prior to their startup. Their limited funding makes it hard to grow at the same scale as GroupMe. Things might’ve been different had Groupie luckily closed an investment round. A small change could’ve meant all the difference. Maybe Groupie would’ve been the company that was eventually acquired instead of GroupMe.
You’ve got two equally talented companies with founders that are all equally tenacious and capable with 2 entirely different outcomes. The comparison is undeniable because they’re both in the same space, city and started around the same time. No matter how great a company’s product is, it doesn’t guarantee success. Even successful apps with growth don’t guarantee success!
Successful Exit Model
The model is based on the $43 million dollar exit above by GroupMe and industry standard practices:
- 5 year outlook based upon a VC’s fund cycle and the normal amount of time for a business to mature.
- 3% is the average salary raise for an employee in a Fortune 500 company.
- 1% is the current average return from the bank interest rate.
- 10% is the amount of equity assumed to have been retained at the point of successful exit. (This is considered very good)
- Promotions are provided on the 3rd and 5th year of your career (senior and managerial promotions).
- 46 years of employment based on your years between college graduation at 21 and retiring at 67 as the Social Security Administration’s age of retirement.
- Your startup has one technical and one non-technical cofounder.
- I will base the wages on the lowest average salary for their background for the sake of conservatism. The more you earn, the greater the cost of failure.
- Personal debt is assumed to be zero (uncommon)
- All income is shown at the present value to normalize the income.
- A non-technical co-founder
- Will forfeit $794,147 dollars in wages and raises.
- The present value of your successful exit is $4,091,302.
- Your net profit taking into consideration the opportunity cost is $3,297,155.
- That is $659,431 per year over 5 years.
- Total wages earned without a startup is $4,885,676.
- A technical co-founder
- Will forfeit $1,523,500 dollars in wages and raises.
- The present value of your successful exit is $4,091,302.
- Your net profit taking into consideration the opportunity cost is $2,567,802.
- That is $513,560 per year over 5 years.
- Total wages earned without a startup is $8,132,855.
What’s the point of this entire post?
- Being smart isn’t f%^ing good enough.
- Being smart is a basic requirement to even having a shot at doing a startup without having to fail on your face in the first week. People that succeed in this space don’t have the luxury of stupidity.
- It takes genius, hardwork and luck to succeed!
- Being smart, hardworking or a genius isn’t enough. Groupie was founded by two guys that will blow you out of the water. But, they haven’t achieved the same level of success as GroupMe because sometimes it takes a little luck to catch the right break you need to reach that next level. Groupie is still in the running and they know that survival is the first step to creating your own luck.
- These are two successful companies and only 1 has exited so far.
- GroupMe successfully exited and the founders bagged a salary of somewhere between $750,000 to $3,700,000 dollars per year.
- Are you ready to possibly sacrifice the next 3 years of your life to just finding out if you’ve got a real business?
- The average business will lose money during the first 2 years and pray to break even on the 3rd year. Most companies need 3 years to find out if they’re running a company or a dream running on hopes. You need to bite the bullet and ride the beast till the 3rd year to figure out whether you’ve got the real thing! Patience is painful virtue.
- Are you ready to wait 5 years to see if you can find an exit for your company?
- An average company that survives 5 years should’ve found a revenue stream and developed at least a minimum level of steady income. At this point you’ve got two choices. You can go for the long haul and aim big or sell. No one can say what’s going to happen in the weather tomorrow for sure, so there’s no point in me assuming anything about your business 5 years from now.
- Is the risk really worth it?
- Consider this. If you’re 21 years old or any age honestly, can you afford to be unemployed for 5 years? In the real world, self-employment is seen as unemployment by anyone hiring. Any skills you’ve developed previous in your past life have become non-marketable because employers will assume that your skills are archaic and you’re useless.
- The risk for someone just out of college is much lower than someone who’s had a career or been in the labor force. Having had a career means that you’ve risen to a management position after 5 years. Doing a startup and failing after 5 years puts you in an even worse position. , You’re not only going to have a hard time finding a job when you go back into the labor force, but you’re also going to take a demotion and pay cut.
- Is the chance to earn $750,000 dollars per year enough for you to risk your ENTIRE future? This 5 year gap will literally break the camel’s back in your career because the amount experience you’ll have will always be behind an entire generation in the labor force.
- If you’re going to do a startup you need to either love the shit out of it or know that it’s guaran-fucking-teed to succeed. Otherwise, I’d advise you to turn back now — fore you’ve been warned.
Do a startup because you love it. The road is painful, slow and depressing. If you’re in it just for the money, then it’s a hard journey ahead. Don’t assume that having a successful exit is going to set you for the rest of your life. This essay is definitely skewed toward the negatives. If this article can shake your determination, then you’re probably not meant to do a startup. I’ll be a lifelong entrepreneur because the gasps of freedom and accomplishment between the bouts of depression is more meaningful than a wage.
I wish you the best of luck and I hope that this has in some way prepared you for the long road ahead and the consequences you may face.
Cameron KengCam is a licensed Certified Public Accountant (â€œCPAâ€), Enrolled Agent before the Internal Revenue Service (â€œEAâ€), New York State Department of Education Business Teacher and future New York State Attorney-at-Law. Cam is co-authoring an Entrepreneurâ€™s Guide in Asia with Derek Sivers, founder of CDbaby and TED Speaker. He's been recently interviewed by Mixergy as a successful entrepreneur. His current project range from running and founding a nonprofit 501(c)(3) tax clinic for low-income families, the elderly and non-native english speaking immigrants to writing for awesome publications like techli. You can find him on twatter @cameronkeng. =)
Really immature understanding of how the business world works. While you're correct that founders walk away with less, the title of the post is misleading, as it's more about the risks that come with a failed startup. And that's where you just don't have a good understanding of how people get jobs. Connections, connections, connections. If you've been pounding the pavement for a year trying to raise money and promoting your startup, you should have a world-class Rolodex or you're doing it wrong. And that Rolodex can land you back in a cushy backup job.
The only question is: are you passionated about what your doing! Are you so inspired by the idea that the "whatever your product is" your product/service is a real benefit for the one who uses it that you must implement it? if yes, than you have pleasure every day you bring your project ahead! Because you love what you do because you love the people you wana do it for. And like that whatever end it takes you will have a huge experience and that is so valuable! So stop thinking about the money, that's bullshit!