It is common, especially in the startup stage, for small-business owners to give ownership shares of their company to key partners as a way to align everyone’s interests. Ownership equity is a powerful incentive for people who prefer a potentially larger payoff in the long-term versus a high salary or payoff in the present. But allocating equity in your business too casually or without a system can lead to the wrong people owning big chunks of your company. Famous technology entrepreneur and investor Paul Graham suggests that the formula 1 / (1 – n) can help you make better equity allocation decisions.
An example of this equity equation in use shows that it’s powerful and simple. Pretend that you own 100 percent of your current business and are thinking about bringing on another person. As part of that deal, you consider offering 25 percent ownership of your company as compensation. This means that in the above equation, n is equal to 0.25 and the equation equals: 1 / (1 – 0.25) = 1.33. So if the new person helps grow your company by more than 33 percent, then the deal is worth it for you. Otherwise, you need to offer a lower percentage of equity.
Assume that the new person actually increases the company’s growth by 50 percent, so the company’s shares are worth much more than if you hadn’t brought this person on board. In this example, your remaining 75 percent of the company increases by 50 percent, thus: 0.75 * 1.5 = 1.125. So even though you gave up a 25 percent ownership block in the company, the new value of your remaining shares is higher than the previous whole.
Using a spreadsheet and testing various inputs into the equation can help you settle on reasonable equity amounts to offer new business partners.