How much equity do investors need to take in a startup to make money ?

There are varying norms of how much equity investors try to take in a startup and it also changes from the stage of the startup that an investor tries to invest in. And it definitely varies significantly by Geography and Industry as well.

1. Accelerators / Incubators: YCombinator and TechStars (depending on location) take about 7% for approx. $100-120K.

500 Startups takes about 7% for net $75K.

Other incubator / accelerator programs take 0-5% for $0 + advice, or 5-20% for $10-25K.

2. Angel investors usually take sub-15% for up to $100K.

3. Seed Funds which invest less than usually in the $200-$500K will take between 15-30% equity.

4. Early Stage VC which invest $1-5M will usually take 20-30% equity.

Note 1: The above figures are as typical as possible in the sense that there are no established norms in the startup investment industry. There are exceptions and I guess some of them vary from the above figures by a wide range as well. Investment firm and individual investors and VC partners will continue to evolve their investment philosophies to differentiate themselves.

Note 2: We are not discussing later stage investment rounds because by then enough risk of technology and market has been resolved for the valuation of a startup to be more predictable. But at these earlier stages the equity to be taken by investors is more of a guessing game and there are no easy or straightforward right or wrong answers on how much equity do investors need to take in a startup.

The above figures have a quite range. And you could follow whichever norm. But if you tried to take too much equity then as an investor you lose out on the best startup teams and if you take too little equity you may fail to give a return to the limited partners in your fund. So how much equity should an investor aim for in the early stages of a startup ?

If you were manging a large hedge fund maybe you would distribute your risks (and money) over a balanced portfolio consisting of tech stocks, gold, bonds, real estate, etc. But venture capital (specifically in what goes for technology or tech enabled businesses) works differently because the returns come differently.

People tend to group investments into three buckets. Some (maybe 30-40%) startups fail and you lose your investment. Some (maybe 40-50%) kind of exist or you get an acqui-hire and basically the loss or gain is not significant i.e. approximately 1x. And your best (<10%) companies give you 3-10x.

But that kind of modelling of startup investments, particularly at the early stages misses the point totally if you are actually into investing. The returns from startup investments are unfortunately (or fortunately for some) skewed totally. The reality is that returns from equity investing in startups form a power law distribution.


~ From Peter Thiel's class notes

As Peter Thiel once asked Paul Graham about returns from investments into YCombinator Startups ~

Peter Thiel: Do Y-Combinator companies follow a power law distribution?

Paul Graham: Yes. They’re very power law.

So given how returns from early stage startup investments follow the power law distribution, how much equity should investors aim for in a startup?

Let's say you the startup is targeting a market niche M which can support a company with revenue size R in the best possible case. Now given R and the industry vertical this startup lies in you can find comparable multiples and assume that in the best possible scenario the startup will eventually spend X dollars and have valuation V and will take Y years to get there.

So here are the thumb rules you could try out to figure out how much equity E you should take for investing I dollars,

  1. If Y is too long i.e. (more than five years) for a startup to start dominating M then do not invest. (Unless you are John Doerr who can afford to make really long term bets)

  2. If R is not large huge (think $$$ billion) enough do not invest. The next round investors will not be excited enough.

  3. Investment I should ideally cover 12 months and at most next 18 months expenses. Never more than that.

  4. The best startups grow between 5-10% per week or about 10x-150x in a year approximately. And this kind of startup will get you the returns. So even at the lower end you can assume that the value of your investment will grow 10x every year in the best case. Though the next round of investment may actually happen at 2-5x increase in valuation only allowing future investors to get adequate returns as well. But given the fact that this is a top startup any single round will at most give away 20% equity, diluting you to 80% of E.

  5. You are at the most 5 years away and typically 3 years away from a startup to have reduced its risks of market and technology, after which the startup will raise the larger financing rounds which are more based on actual numbers or traction and less on guess work. So you need to plan only for the guesswork based dilution in this period. So assuming 5 years (will take the more conservative number) and assuming a round is raised every year you are diluted to 0.8 ^ 5 i.e. 0.3 * E.

So solve for 0.3 * E * V > 100 * I (targeting 100x return) and work in sync with the power law.

Let's take a real example to check if this theory works.

I particularly like Dropbox as a company.

YCombinator made a seed investment of $20K in 2007, so I = $20K

And by this time YouTube had already been bought at $1B by Google in 2006, and given Google's interest in storing consumer data (e.g. via Gmail service) we know that a consumer storage app or service would at least be valued more than $1B. And since we are talking about possible valuation in 2012 (five years later) we can assume that the markets would move so as to at the minimum give double the valuation for a hugely popular consumer storage service.

So V = $2B

Which gives us, 0.3 * E * 2 * 10^9 > 100 * 20 * 10^3

=> E > 1/300 or *YCombinator should have made money even at 0.33% equity in Dropbox.

Now let's look at how it played out.

Sequoia Capital did a seed VC round of $1.2M in 2007, followed by a Sequoia Capital + Accel Partners joint Series A round of $6M in 2008.

After four years in 2011, Dropbox had its traction + revenue numbers in place and did a Series B round raising $250M at a $4B valuation.

So by the time Dropbox achieved a valuation (in its Series B round) based on traction and revenues, YC equity would have been diluted twice (each time to 0.8 of its value) i.e. to 0.2% which would be worth about $8M by the Series B round.

YC invested in a total of about 60 companies between 2005 and 2007 (the batch Dropbox was part of) so a total fund investment of $20K * 60 = $1.2M

Assuming all other startups were a flop or at best gave 1x returns, and Dropbox was the lone (but huge) winner, YC would get an overall return of 6.67x on its fund investments made in 2005-2007 period.

I believe YC took 7% equity (not just 0.33% equity) in Dropbox in 2007 and made much more money.

Today they make 100+ investments in a single year and will try to scale up batch sizes as long as they can manage quality. It is important to make higher number of investments to be in synch with the power law. And as per the formula, they can easily afford to invest $120K per startup and still get great returns, like they do today.

Some additional points,

  1. It is not easy to figure out V i.e.future valuation in a market segment. At one point of time I believed that the Wireless HDMI market was at least a $1B market. So did many analysts and a large number of investors. But that market did not really exist and today WiFi technology serves all our wireless HDMI needs. Really important to understand why future markets will even exist.
  2. The number of investments should be larger for you as an investor, but at the same time important to ensure quality of the startup. Just throwing away money at more startups will not work.
  3. The key is to invest in and attract the best startups to you. For this your money needs to be smarter money. Partner with or invest through smarter people.
  4. YCombinator invests in a really wide range of startups trying to solve fundamental problems at times. You can reduce the dependence on the functioning of power laws by leveraging your indepth understanding of certain markets and investing only in startups operating in those markets.