Archive for the ‘Equity’ Category

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Issues with Equity Misalignment

Q: In our startup we have 4 founders, two of whom are not full time.  We’ve all put in a good sum of cash thus far.  The two founders with the least equity happen to be the two tech founders.  Some of us feel that we made a mistake when allocating shares in the beginning – there is one founder in particular who does not do any work, and he has the second-most equity (the split goes like this: 32%, 26%, 10%, 7.5% with the rest for employees + advisors).  To me, it seems like any outsider would see this as a big disparity and wonder what happened, but one of our guys (Mr. 32%) seems to think that if we can get funding, the VC will correct this wrong.  I’m rather doubtful of that – what VC will want to fund a team that didn’t have the foresight to motivate the biggest contributors and keep them interested?  I’m looking to convince him that we need to fix our own mistakes before pursuing funding.  Am I off base?
 

A (Brad): You aren’t off base. Furthermore, this is a common problem and one of the reasons I strongly encourage every founding team to have four year vesting on their stock.

While some founders thinks this simply gives future investors a way to claw back equity in the future, it’s much more often the case that this protects the founders from each other, in cases like this or situations where one of the founders simply leaves.

In your case, you feel like the 32% founder doesn’t do any work. If your other two founders believe this also, the three of you should directly confront Mr. 32% right now. Don’t wait, don’t defer, don’t let more time pass. Deal with the issue – up front and directly. It’s an easy thing to solve – if you all agree (including him) that he should only have 15% of the company, then he can simply forgive (or give back – the mechanism will depend on how the company is structured) 17% of his equity. Then, each of you will end up with an increase of your pro-rata percentage of his equity.

If you have equity alignments early in your company, deal with them. Don’t let them fester.

Do My Early Stage Investors Own Too Much Of The Company?

Question: Most VCs commented that they can not fund current cap table where the CEO and COO would get 10% equity once fully vested while the current investors have 80%. We talked to our investors and they have agreed to rework the cap table, however, I would like to understand from you what should I change my cap table to?

More Context: I recently joined a very early stage company as their CEO. The company was founded by two people three years back who have funded it since inception to the tune of ~$200k out of which $60k is in loans and is on the books of the company. The rest of $140k are unbilled expenses. The company has ~1000 paying customers and in 3 years has earned ~$160k. Last years revenue was $52k. The company is still burning money to the tune of $24000 per annum. I am not taking a salary right now, but my salary (at 80% discount to my market salary) is getting accrued since January. Also, I have been offered 10% equity with 4 year vesting and 1 year cliff. At this point of time we are trying to raise ~300k at 2.4 mn pre money. Most VCs in India say we are too early stage for them and we have just started looking at angel investment as an option.

This is a tricky one because it’s not clear whether the two original founders are still active in the business. If they are, then the hired CEO and COO getting 10% equity each is probably not unreasonable given that the founders are separate from the investors. In the case where the founders are also the early investors, this doesn’t matter, as you can separate their contribution conceptually.

If the early founders are no longer involved in the company and you are effectively restarting the business, then this feels light given this stage. However, there is no standard situation. It ultimately a negotiation with the founders and with your new investors. It’s easy for an investor to say “this doesn’t work for me” – a logical response, if you believe they are interested, is “what works for you?” Basically, have them propose something and then work with the founders to see if you can get to a deal.

There are definitely cases where the early investors own too much of the company to make it fundable. For example, let’s assume the the early investors put up $200k cash for 80% of the company. These investors are not active in the company, but instead you and your COO are running it (from day 1). In that case, a new investor would look at it and say that the early investors ended up with too much of the company since they effectively got 80% for investing a mere $200k.

Finally, if you raise money, you should use the event to clean up the existing balance sheet. If you raise $300k, you don’t want the $60k loan outstanding (it should probably convert into equity) and you definitely don’t want the $160k of unbilled expenses hanging out there. In addition, your accrued salary shouldn’t be continuing to accrue or get paid out. One tool you can use to normalize the equity some would be to roll the existing $200k into the ownership that the founders have (e.g. they still have 80% but now have a cost basis of $200k and the loan + the unbilled expenses go away) and then you pick up additional equity associated with converting your deferred salary into equity (e.g. if you defer $135k over the year, you get another 5% in options post financing ($135k / $2.7m post)).

Does Being The First Full-Time Paid Employee Affect That Founder’s Equity In The Company?

Question: I am one of three founders of a company.  Up until now we have been bootstrapping the company from our own funds and working part time on the company while having full time jobs.   However, we are now looking to raise some private funding and one of us will be transitioning to the first full time paid employee of the company.   The question is, does being the first full-time paid employee affect that founder’s equity in the company?     I can see two sides to this issue.  The first is the founders that are not yet paid employees would think that the other is  getting paid so FTE’s equity should decrease.  The second is the found that is now a paid employee is putting themselves at higher risk as they left there prior job to go fulltime at the new company.    How have you seen this structured in the past?

You do an excellent job of looking at both sides of the question. While the founder who is working full time for the company is getting paid and the other founders are not, the other founders presumably are still getting paid from the day jobs.

Usually in these kinds of situations, the comp being paid is (or should be) modest – just enough so the full time founder can cover his basic living expenses. Assuming this is the case, I think you can comfortably separate out the equity as a separate concept. Specifically, whatever the equity splits are separate from the compensation should remain.

Now, the full time founder could make the argument that he should get more equity since he’s working full time for the company but the other two founders aren’t. This is a stronger argument if the founder working for the company isn’t drawing a salary.

Of course, the equity doesn’t necessarily have to be split three ways between the founders. However, if you can separate the compensation from the actual equity splits, you can usually have a more rational conversation.

Regardless, it’s never easy. Just have the direct conversation and keep working through it openly until you get to a happy place. If you can’t reach a consensus among the three of you, then you will have bigger problems down the road.

How Often Do Employees Of VC-backed Startups Get Stock Options?

Question: How often do venture-backed start-up employees (let’s say non-executives) get stock option grants? Besides the initial grant when they start, how often do “re-up” grants come? Should they be expected after further funding rounds? After significant accomplishments/promotions? Never?

The short answer, at least in the US, is “most of the time.” It’s pretty standard for every employee of a VC-backed company to get at least a minor option grant as part of their compensation. Employees should expect these grants to vest over time (usually four years) and have a one year cliff (which means the person has to be employed for a year to have any of the options vest.)

Regarding the other question, it’s much more variable. In the previous post I talked some about “re-up grants”. In some cases, especially if there is a lot of dilution from a financing, there are occasionally broad grants across all employees post financing. However, in many cases, there aren’t, and employees should expect to take at least some of the dilution from subsequent financings, especially in up-round cases where the value of their underlying equity is increasing.

Additional grants occur on an employee by employee basis in two cases: (1) extraordinary performance (also referred to as a “spot grant” or “spot bonus”) or (2) long tenure – once an employee is fully vested (after year 4) they will often get an additional grant, although this will usually be much smaller than the original grant.

Wenger: Presenting Option Grants to Boards

Today’s VC post of the day is from Albert Wenger (USV) and titled Presenting Option Grants to Boards. This is feedback I give to CEOs 98% of the time after my first board meeting. While there is no standard for how to present option grants, Albert lays out a very clear set of eight pieces of data he likes to see. The first four are the the columns in the spreadsheet and each employee / option grant are the rows. The next two are footnotes for options grants that aren’t standard. And the last two are contextual data that should always be included since board members are on multiple boards and won’t remember this from company to company.

Here’s are the eight pieces of data – go read the post for more details on why all eight are necessary.

Spreadsheet data:

  • Employee name
  • Title/role at company
  • Absolute size of grant in number of underlying shares
  • Percentage size of grant fully diluted

Footnotes data (for option grants that aren’t standard)

  • Special vesting considerations that differ from the plan
  • For refresh grants: how many options does the employee already have and how far are those vested?

Context data

  • Total size of option pool and remaining available pool (absolute numbers and percentages fully diluted)
  • Grant size bands by role (if you have established those already) — if not, include existing employees in similar roles for comparison (including their start dates)

Is Dilution Considered When Talking About Equity Ranges?

Q: When we talk about the equity percentage numbers for those directors and other early participants, are these numbers based on the total number of shares prior to a funding event or does the base share number include those allocated for investors as well? As the shares for future investors are hard to predict, I assumed that the percentage numbers we talk about here are before any dilutions, is that right?

A: (Brad) The answer is "it depends."  When we have written about equity and compensation in previous posts, we’ve tried to provide some context for the stage of the company.  When we’ve done this, you should assume that this does not include future dilution from other rounds of investment.

However, there are no absolute guidelines.  For example, when you bring on an outside board director, whether it is at the Series A or the Series D, the stock option grant is usually in the 0.25% to 1.0% range.  While this is a wide range (see – there are no real rules) it gets more complex when a director has been with the company for a while and taken dilution from subsequent financings.  For example, assume a director joins at the Series A and gets a grant for 1% vesting over four years.  Three years later, the company has raised $30m and the directors grant now represents 0.3% of the company.  In some cases, the director would get an additional option grant to increase his ownership percentage (say – back up to 0.5%); in others he wouldn’t.  This is a function of the board, the investors, the entrepreneurs – all based on their view and assessment of the director’s contribution.

The same is true for employees.  Most employees will take the same dilution the founders take with subsequent financings.  This is relatively easy to deal with in the success case because the dilution is less significant and the value of the equity continues to increase.  However, in cases where the dilution is significant (e.g. a down round financing) employees need an "option refresh" – this is usually negotiated in the context of one of the financings.  In addition, as employees start to reach the point where their equity is fully vested (as they’ve been at the company for four or five years) there is often a refresh option grant.

There’s no simple answer.  And – any numbers we put on this blog are merely guidelines.  You mileage will vary dramatically with the situation.

What Happens to Unvested Options in a Merger?

Q: I work at a startup in the valley, and I’m wondering what happens to unvested shares in the event of acquisition? I.e., should I expect that they are canceled, accelerated, or stay on the same vesting timeline?

A:  (Jason)  The answer is “all of the above.”  Any of these are potential outcomes in an acquisition.  It really depends on the negotiating strength of the companies involved.  

Most “standard” employee option plans have a provision in it that says if the acquirer does not assume the option plan and does not keep the options on the same vesting schedule and other similar terms, they vest immediately prior to the close of the merger.  So in this case, they are accelerated.

However, there are plenty of times that the option plan is simply assumed by the new owner of the business.  Rarely, have I seen all of the unvested options be canceled with no payout to employees, as this would lead to the acquirer angering all of its new employees.

Note also, that when exercising options prior to the closing of a merger, one heavily negotiated item is who gets the exercise cash, the acquirer or the target company?  Usually, we see this go to the target company unless it’s a distressed deal.

Equity Comp in Turnarounds and Consolidations

Q: I thought i’d ping you on your thoughts regarding the non-cash compensation for key executives in strategic plays that aren’t strictly early-stage.. as an example, how would you structure your framework in providing equity comp to key executives in strategies involving turnarounds, consolidations and roll-ups etc.

A: (Brad): Equity comp for turnarounds / consultations / roll-ups for management and employees tend to be in the 10% to 20% range.  The structures vary widely, but they are usually some combination of stock, stock options, or a bonus pool based on performance.

It’s usually pretty easy to structure something that is fundamentally interesting to everyone in the success case although the style and approach of private equity investors tends to vary a lot.  Usually, the larger and less messed up the company is, the larger the base package tends to be.  This is counter-intuitive as you’d expect the most messed up companies to have the biggest upside for new management, but my observation (mostly indirectly, although directly in several cases) is that the patterns of comp tend to be more linked to the investors and their historical relationship with management (e.g. investors are more generous with either (a) people they’ve worked with before or (b) superstars that they want to work with.)

I’ve rarely seen situations where the non-investor equity ends up going above 20% in a turnaround or consolidation, but I’m sure there are cases where this has occurred, especially if management is founding the company and then bringing in investors.

Can Employee #1000 Get Rich Off of Stock Options?

Q: You’ve discussed the "typical" equity allotments for founders and senior management. But my question is about the perceived and real value (I presume they differ considerably in many cases) of stock options for employees beyond the first few dozen.  Do you have any historical perspective on whether options grants really drive wealth creation for any hires outside of early founders? Does "Employee #100" ever get rich off options? Does "Employee #1000"? At what point do stock options really cease being a major selling point for recruiting startup talent?

A: (Brad): While you have to define "rich", I’ll use millionaire as a proxy.  There are many examples of companies where the 100th employee made over $1m from stock options.  There are less examples of companies where the 1000th employee made over $1m, but there are plenty (Microsoft, Google, eBay, and Yahoo immediately come to mind.)

A successful company that manages its capital structure can always use stock options (or restricted stock) as a motivator.  The variance of outcomes decreases as the company gets bigger (e.g. it’s much easier to make a fortune as an earlier employee – but it’s also much easier to make $0 when the company fails) but in success cases the numbers can still be pretty large.

That said, if the valuation of a company gets ahead of itself at an early stage, stock options – especially in our new and exciting world of the 409a regulations – could end up having a lot less value because the strike price would be set unnecessarily high.