David Cummings on Startups

Compounding Growth vs Investing Residual

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David Cummings

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Several weeks ago I was talking to a friend that’s thinking about making the entrepreneurial plunge. One of his main concerns was taking a big pay cut, especially when thinking about the bonus he expects to get at the end of this year since the year is going so well. Of course, that’s likely a red flag that he’s not risk-loving enough to dive into something, but you never know.

When talking about salary, I tried to make the point that compounding growth of equity is far superior to investing the residual of income less tax. I gave him the simple example of $100,000 in equity growing 40% per year vs an extra $100,000 income that you pay taxes on (assume 50% tax rate), then invested and earning 5% per year:

  • Year 1
    Equity -> $140,000
    Savings from Income -> $55,000 based on $50,000 + $5,000 from investing it
  • Year 2
    Equity -> $196,000
    Savings from Income -> $107,750 based on $57,750 + $50,000
  • Year 3
    Equity -> $274,400
    Savings from Income -> $163,137 based on $113,137 + $50,000
  • Year 4
    Equity -> $384,160
    Savings from Income -> $221,293 based on $171,293 + $50,000
  • Year 5
    Equity -> $537,824
    Savings from Income -> $282,358 based on $232,358 + $50,000

Again, this is example shows taking a $100,000 annual pay cut in exchange for a one-time grant of $100,000 in equity that grows at a rate of 40% per year. Without selling it and paying taxes in year five, the equity is worth almost double the value of saving and investing the residual income each year. Compounding growth is an amazing phenomenon.

What else? What are some other thoughts on compounding growth vs investing residual?

Comments

6 responses to “Compounding Growth vs Investing Residual”

  1. Baker Avatar
    Baker

    I like your point about the red flag of not being risk loving enough. I meet so many entrepreneurs who have an idea, they’ve tested the market on a small scale, but continue to do it part time because the thought of leaving an every two weeks paycheck terrifies them. The effects of compounding returns on equity more than offsets what you’re giving up, great example.

    Reply
    1. Izzy Green Avatar
      Izzy Green

      I can’t agree more! those who are not willing to give it 150% will never succeed. As I always say “you can’t build a business overnight, but you have to work through the night to build a business”.

      Reply
  2. Peter Franconi Avatar
    Peter Franconi

    David, you’re comparing pre-tax equity valuation to a post-tax earnings/savings calculation. To even the playing field, doesn’t it make sense to tax the equity after 5 years (assuming a successful exit) to have comparable figures? Small but important detail is that the equity must be true equity (and be applicable for the long-term capital gains tax) and not merely options (which will be taxed at the income tax rate). Is that correct?

    Reply
  3. Casey Cheshire (@CaseyChesh) Avatar
    Casey Cheshire (@CaseyChesh)

    Shouldn’t your equation factor in the risk of getting zero return from startup equity? No red flags here, just looking to see how the outcome would (or wouldn’t change) after adding that into the math.

    Reply
  4. Joe Koufman (@GumboShowJoe) Avatar
    Joe Koufman (@GumboShowJoe)

    Interesting article today in Business Insider: http://www.businessinsider.com/why-its-better-to-sell-a-startup-for-20-million-instead-of-200-million-2013-7

    Reply
    1. David Cummings Avatar
      David Cummings

      Great article Joe. I’m a fan of owning a larger percentage of a smaller exit.

      Reply

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