A programmer friend is building a very simple subscription as a service tool for me. He's calling it an "easy" job (2-3 months build time), and has agreed to work for a % of cash flow (profit) after the product roll-out, as well as a little equity in the company (which obviously, is worthless until it's live and income-producing).
I would love to hear from the community what % cash flow and % of equity you would advise to give an individual like this? It's totally open-ended. Initially I'm thinking 25% of cash flow and 10% equity. Is this too high?
I'm not going to give you numbers. Instead, I'll describe a hopefully rational way you can arrive at the numbers yourself.
First, you have to decide how much his work is worth. Let's say, for simple math, that in your area a market salary for such job is $90k/year. 3 months of work is worth $30k.
That, however, doesn't take into account risk. Let's say that there's 60% chance your business will fail i.e. won't generate any profits. In economics such value is called expected value and it would be $75k (X*(100-60)%=$30k, x = 30/0.4). So adjusted for risk of failure, his work is worth $75k.
You then need to estimate how much your company will be worth, how much money you'll be making. Both numbers are huge guesses. Let's say you value your company at $1 million and expect $400k cash flow. You can do simple math to figure out how to allocate that $75k among those 2 classes.
I'm not giving you the numbers because all the input numbers (salary in your area, probability that the company will fail, valuation, cash flow) are unknowable, even to you. They should be a result of negotiation between you and your friend i.e. both of you should agree on each number in order for both of you to feel they are fair.
Finally, I find the whole concept strange.
Equity in a privately owned business is worth nothing unless you pay dividends and dividends are equivalent to your cash flow scheme. You could give your friend 40% of your company and as long as you don't have an exit event (a sale to someone else or going public via IPO), you can keep all the profits to yourself by giving yourself a salary that is equal to all profits (as long as you retain unilateral decision making power, which you have as long as you have 51% or more ownership).
I'm not sure if both you and your friend are aware of that.
Also, I wouldn't do cash flow forever, because that's unlimited upside for your friend.
On the other side, you can screw your friend on the cash flow as well. Profit is an accounting term and you can easily drive profit down to $0 simply by paying yourself a salary that equals profit. That's probably not a concern for you, but should be for your friend.
What I would do: figure out expected value of his work (market salary adjusted for risk), double it to compensate for risk (expected value is "fair" by some metric but still carries a hefty risk of getting nothing for your friend and for you it's safe because you'll only pay it if you're successful) and structure payments to be from future profits, but not as a percentage of all future profit but as a cap, with some reasonable rules for how quickly you'll repay it.
I think you're spot on to lean toward giving up less equity and more cashflow. He's taking on a huge risk in that he may work hard for 3 months (or more if there's scope creep) and never see a dime, so you do have to keep the % of cash flow relatively high. Another reason this is smart is because if the service does take off, you'll have a great partner that's been with you from inception and you'll want him to be incentivized to stick around. Start with 25/10 and see where he's at. However, I would recommend not going higher than 30/15. If that's the case, consider looking at other options. Best of luck!