First Technical Head. How much to ask for?

A friend of mine set up a small company (currently two employees). He started getting more work than he could handle so came to me asking for software to manage his clients and business process.

We have gone live with the system and he is paying me based on the throughput (~$600 per month). It saves him A LOT of time and means he doesn't have to take on any extra staff; in fact he's so happy with it that he wants me to work for him full time extending the software.

He can't afford to match my current salary (base $50,000), but has agreed to explore the option of sharing ownership of the company with me instead.

My question is how do we calculate a fair cut? And I will need at least little income to live on.

I estimate the company earns roughly $160,000 a year (before salaries and rent etc.) maybe a little less, hopefully this gives some indication of the value of the company.

I would be the first technical head in the company, and it is a very competitive industry that is turning more and more to technology.

I personally would ask for a mix of cash (you have to eat) ,stock up front , and stock purchase option and some multiple with a long expiry date.

The cash allows you to feel like you are not beign ripped off , over time if you don't receive any thing you will get disgruntaled. This helps pay your day to days and if you're ever out of pocket cause of working there (gas , lunch etc) this covers it.

The stock allows you to share in the risk and possibly gain on the upside if the company does well. The owner gets to save some cash and provide you with his version of paper money which benefits him in the short term. Of course he is giving up some future upside. But if he really needs you then this is an easy choice to make for him.

Stock option. This allows both of you to reduce risk and see benefit. If the company needs cash in the future you can buy some stock. It also allows you to wait to see where the company is headed before you get deeper invested.

As to the mix. What I do is calculate the companies worth , and how much I am worth. Lets say you get paid 50k a year doing software work at any given random job. and the company is worth $500,000.00 (3x 160k plus some good will) , I would ask for 30K in cash as a salary then 20k equivalent in equity paid each year you are working there. Promise to stay on for two years.

Ask for a stock option that can be executed at any time before and equal to the two years. Decided on the multiple and something that brings you up to 30% partner after its been executed (included the up front stock). You will have to pay for these but by that time you will know if its worth it or not, you are buying some risk reduction here. Also place a term on the options if you are fired or let go the options can still be purchased for some time period.

Do the math yourself based on what you want to get paid (what is fair for your work), what the company is worth and how the company values you. A mix is good cause it provides the company with options and it provides you with negotiating wiggle room.

GET EVERYTHING IN WRITING!

Ross Mann has a good answer in terms of the details. My feedback would be that it depends.

Here's my two cents that helps out with calculating some of the math. As far as your salary goes, you will have to decide what you are able (willing?) to live on. You shouldn't be making him pay for your retirement savings necessarily, and remember that even if you agree to work for only $XX,000 a year, that can easily cost 20%-30% more to the company in terms of taxes.

As far as a share of equity goes, it will really depend on what he plans to do with the company, and how realistic those aims might be. That alone will define the value of any equity to you, regardless of if it is 10% or 50%+.

If he just wants to scale the company up a little bit and run it for a while to grow it into a profitable business, then the value of your equity share will come from a portion of the profits. You will have to decide what it is worth to you to forgo salary and a reliable paycheck in return for lower regular payments and a higher possible value.

Here's how I would think of it... let's say they're earning the $160K a year you mentioned, and turning a 10% profit margin. That means there is $16,000 available before taxes to be reinvested into the business or taxed and then distributed to equity owners.

If you had a 20% share of the business, and management reinvested $6,000 -- and distributed $10,000 to the owners-- your payout on that would be $10,000 * 0.35 (tax) * 0.2 (your share) * 0.15 (your tax on dividends) = $105. Per year. There's plenty of room for growth in that if the company gets bigger--but you would need to see 10x growth in sales before your annual payout was $1,000. And 100x growth in sales (or higher profitability) before your annual dividend hits $10,000.

Be realistic about what equity in a venture like this is worth RIGHT NOW before you take the huge jump, and make sure that you're being compensated fairly.

It sounds like the company is already worth something: it is generating cash. This means, if you are given shares in the company, you will have to pay tax on them.

What I would suggest as the simplest arrangement is this:

1. You ask your friend to pay you, in cash, your true market value for your time.
2. You promise to reinvest some (most) of the cash in buying shares of the company.

As rough numbers, if the company is making $160,000 a year gross it will maybe be worth around $250,000 or so today. So if you reinvested $25,000 in buying shares you could buy 10% of the shares this year for half your salary, and take cash for the rest. Work for another year, and buy another 10% (or less if the value goes up).

I am convinced that the fairest way to do this for small companies is through a profit-sharing scheme. The idea is that the company, in a very transparent way, divides up a part of the profits (5-20%) among its employees. This scheme helps keep everybody's interests aligned in making the best, most profitable company they can and reduces the incentive for 'executives' to make some public maneuver to boost a stock price just prior to exiting (often at the expense of a solid long-term strategy).

For details of one I have a lot of respect for, check out Peldi's at Balsamiq.