Understand Stocks and Options

Knowledge Sharing:
1. so if you own 51% of a company, you are said to own a controlling interest. You’re the boss
2. A Board has a legal obligation to act in its shareholders’ best interest, even if that interest is in conflict with their personal interest.
3. The CEO, in turn, operates the business at the pleasure of the Board; the Board appoints, compensates, reviews, and fires the CEO. If you own a share in a business, you’re the CEO’s boss’s boss.
4. A Board has a Chairman whose business it is to direct the meetings of the Board, but in
practice in smaller Silicon Valley companies this title is often given to the principal founder of a
company and is intended to signal to outsiders that this person sets the overall tone and direction
of the company rather than getting any special privileges.
5. A Board is usually composed of a small but odd number of members, to avoid a “tie” in votes.
6. It’s common for the lead investor in a round of financing to ask to have a seat on the Board, so a
typical configuration for a company that has raised two major rounds of financing from different
firms would be to have two seats appointed by Common Stock (usually the CEO and a founder
or someone loyal to a founder), one seat from the first round (Series A), one from the second
(Series B), and an “outside director” that has been agreed on by both the founding team and
investors.
7. A Board may also have any number of people who have the right to sit in on (but not vote in)
meetings: these people are called Board observers. Some investors, particularly those investors
who are not leading a round, may ask for observer rights, i.e. the right to appoint a person who
has the right to be notified about and optionally attend Board meetings.
8. While some portions of a Board meeting may be open to a larger audience (e.g. entertaining
reports from department heads about company progress), the Board may choose to enter into a
closed session and exclude all non-members other than formal observers and Board members.
This can be helpful for candid discussions of the company’s performance or legal issues.
9. Board members of Silicon Valley companies are almost never compensated with cash for their
service, since the Common representatives are often employees who are already paid a salary, and
the investor representatives are already paid by their firms.
10. In most cases the outside Board
member will be given a stock option grant, such as for ~0.5% of the company.
11. the spreadsheet that spells out exactly who has exactly what kind of ownership (or
capital) in the company is called a Capitalization Table, or cap table.It’s generally considered
extremely private / sensitive information, so if you’re working for a company and are curious
about the ownership structure, asking to see the cap table will probably be met with a groan and
a roll of the eyeballs, even by a relatively transparent company.
12. Ownership in a company is often called equity.
14. With a Board’s permission, the company can issue new stock, which is a lot like printing money:
it makes everyone else’s shares smaller as a percentage of the company. This reduction in
ownership is called dilution.
15. Shares that grant special rights are called Preferred Stock, although
what exactly those rights are can vary dramatically from one investment round to the next.
16. The first major negotiated sale of Preferred Stock is usually called a Series A, which typically
raises between $2,000,000 and $8,000,000 of funds, though there are smaller and larger
exceptions all the time and there’s no real legal definition for what a Series A round is or means.
17. Sometimes a very small first round of preferred (such as a round for $1,000,000 or less) will be
called a seed round or Series Seed, to save the Series A name for a later, larger round.
18. This is called a
liquidity event and it’s what all of your investors and employees are counting on.It’s the way
most people in Silicon Valley become very rich.
19. It may be worth noting that it’s common for key
staff in an acquisition (particularly the product and engineering personnel) to be given large
financial incentives to continue to work for the acquiring company for a certain “golden
handcuff ” period, often around two years. This is why you shouldn’t be surprised to read about
many founders leaving their acquiring company almost exactly two years after a sale.
20. The other common way for a shareholder to get liquidity is if the company gets permission from
the Securities and Exchange Commission (the SEC) to publicly sell its stock.
21. The SEC has a lot of
regulations to make sure that unsophisticated members of the general public don’t get defrauded
by companies selling ownership, so this is a long and difficult process and generally doesn’t make
a lot of sense in the U.S. unless your company has revenues of at least $50m/year and is growing
quickly.
22. When the company “goes public” and has an “Initial Public Offering” (IPO), it creates
some new Common stock that it sells to investment banks called underwriters that in turn sell
the stock to members of the general public or other investors
23. Interestingly enough,
it’s very difficult for a founder to completely cash out after an IPO as investors will see it as a bad
sign if the management team is uninterested in holding onto the stock in the long run.
24. Furthermore, it needs to be done in a very controlled way to avoid allegations that you’re timing
the sale of your stock based on things you know about the company that the general public
doesn’t. That’s called “insider trading” and is a good way to end up in jail.
25. Even
though this stock is technically liquid, if Bill tried to sell all of his stock tomorrow, the value of
Microsoft stock would plummet precipitously.
26. While an IPO or a buyout are the most common ways for founders and employees to gain
liquidity, there are several other ways starting to become more popular. Most of these “alternate
paths to liquidity” require the company to be doing very well ($10m+/year revenues, neardoubling
year-over-year, etc).
27. different people get paid in a different order when a company is sold; the order in which
people are paid is called seniority.
28. The total dollars of liquidity preference that
need repayment are called the company’s overhang.
29. For this reason, most deals in the Valley are
done at a 1x preference (except vastly smaller convertible notes, see below).
30. Generally speaking, investors in startups come in four flavors: angels, angel groups, accelerators,
and VC firms.
31. Angels are mostly rich people (legally, an accredited investor is a person with $1m
+ in the bank, making $200k+/year themselves, or $300k+/year including their spouse) investing
their own money, directly
32. Most angels in Silicon Valley are entrepreneurs who
have built their own companies and who double as excellent mentors.
33. Angels usually have a full time job elsewhere, such as running their own companies,
though some “fulltime professional angels” do exist. Most of the best angels need to be
approached through someone they know instead of directly; this is principally because the very
most famous (e.g. Ron Conway) get thousands upon thousands of business pitches -- they have
basically given up on trying to filter all of these direct pitches themselves: you need to get
someone they know and trust excited, like a team they’ve invested in previously.
34. Angel groups try to act like professional venture firms but can often involve more paperwork for
less equity.
35. it can be excruciatingly difficult to eject an
overbearing or incompetent Board member.
36. That said, a great Board member can be an
invaluable asset: making introductions, closing deals, lining up more financing, discovering
potential acquirers, and dispensing crucial advice.
37. The most famous accelerator is probably Y Combinator, which
specializes in investing in young, technical founding teams
38. Recently, DST General Partner Yuri
Milner and Ron Conway announced they would invest $150,000 in every Y Combinator startup.
This was significant because it was in the form of a convertible note and had very favorable
terms such as no conversion “cap”, no discount, a 1x liquidation preference, and no demands of
a board seat or other involvement.
39. Venture capital (VC) firms are staffed by paid professionals whose full time job it is to invest
money into promising startups and help those startups quickly become worth a lot of money.
40. VC firms generally raise their money from enormous financial institutions like pension funds,
sovereign wealth management funds, university endowments, and very large corporations.
41. The entities that invest in a VC firm are called Limited Partners (LPs) because while they provide the
capital, they don’t actually get to decide what companies get investment.
41. That’s left to the General Partners (GPs or just “partners”), the full-time investment professionals at the firm.
42. GPs get paid an annual management fee of 1-2% (of the total fund size) plus about 20% of
any of the profits reaped from their investments (called a carry). The remaining 80% is paid
back to the LPs.
43. While the carry is distributed by seniority within the firm, it’s usually the case
that the partner who is managing the deal gets the lion’s share, so there’s a lot potentially on the
line for the partner who’s sitting on a Board.
44. When dealing with VC firms, it’s very important to know if you’re dealing with a partner
(someone who can actually make decisions) or an associate (also sometimes dubbed an
“analyst”).
45. If an associate calls you, keep in mind that part of their job is to sound really excited about your
company and that it is full of promise. But if there’s no partner involved in the deal, there is a 0%
chance of anything happening. Get a partner involved or don’t waste your time.
46. There are two common ways that a Silicon Valley company can raise money from investors: a
convertible note (debt) and a priced investment round (sale of stock) like a Series A Preferred.
47. Convertible notes tend to be smaller ($50k - $500k) and raised from angels or angel groups;
priced rounds tend to be larger ($500k - $5m+) and raised from VCs. As of early 2012, some
convertible rounds have expanded up to the $2m+ range, provoking some discussion of a
“bubble” in early-stage financing.
48. Convertible note investors are counting on you to build the company up with the cash they’ve
loaned and for you to grow to the point you need a Serious Institutional Financing, aka a Series
A round.
49. When such a financing happens, the debt (principal plus interest) “converts” to the
Preferred Shares of that round at a specified discount (usually 20-25%), meaning that it’s
exactly the same as if the company had paid the debt-investors back the cash owed and then the
debt-investors had immediately turned around and given the company that cash back to invest it
in the Series A financing round on the same terms as other investors, except paying 20-25% less
per share.
50. To avoid this risk, most convertible note investors will require a “cap” on how highly a company can be valued, typically
in the $4m to $8m range.
51. If the next financing round values the company at more than this cap,
then the debt converts as if the company was valued at this cap. This allows early investors to get
a fair share of the company in exchange for investing at an early stage of the company’s
development.
52. The astute reader will notice that neither the company nor the investor has to figure out how
much a company is worth to raise a convertible note round - the investor simply has to have
confidence that the company is likely to either sell or raise a round of financing in a reasonably
well-defined period of time. One of the hardest parts about raising financing is usually debating
how much the company is worth, so this can be a handy way around such infighting...but there’s
a catch.
53. So if the company proves unable to either sell or raise a
round of financing in the allotted time and does not have the cash to pay back the loan, the
courts could give ownership of the company to the creditors or allow the company’s assets to be
seized and liquidated to repay the balance owed. Yikes.
54. Convertible debt holders will also want semi-regular assurance that progress is being made
towards a financing round or a sale; the main point is to “bridge” you to a transaction, which is
why convertible notes are often also called bridge loans. But without bridging you to a
transaction it becomes a “pier”: a pejorative term used when noteholders are concerned that the
debt is going to come due without a financing or a liquidity event.
55. This also means that the legal expenses with
closing a convertible debt round tends to be low ($5k-$10k) vs a priced equity financing, where
costs can be as much as $50k for even a small $350k round.
56. This round would be described in industry parlance as “$100 on a $900 pre”.
57. Gomez.com sold for several hundred million dollars and the founder made a few thousand dollars. He had left before the company had
undergone a recap.
58. So while you can’t know the future,
you should have a lot of confidence that by the time you’re going to need more money, your
company will be worth a lot more than it is in this round.
59. I wish someone had told me that the term sheet is meant to be a
discussion. You don’t sign the sheet without talking it through. In the process you can often get
very substantial concessions on things that are important to you. Once you’ve signed the term
sheet, it’s going to be very difficult to undo what you’ve agreed to, so that’s absolutely the right
time to fight for what you want
60. One entity almost always has the responsibility to negotiate these terms with you - the lead
investor.
61. Actually, there’s a long (4-10 week) closing process of finalizing the exact terms of
the deal and the VC firm has the right to do some research on the company to ensure that you
haven’t just been lying to them the whole time.
62. The closing process involves a great deal of backand-
forth between your company’s lawyers and your investor’s lawyers about exactly what terms
the sale will be made on.
63. the deal’s not done until the cash is in the bank.
64. And let me tell you, it is a really incredible rush to see the number in your checking
account go from $14,213.87 to $2,114,213.87, especially if you grew up like me and thought
$14k was a lot of money. (We actually printed out our daily balance, circled it, and had it on our
Controller’s door for a few months after we closed.)
65. A maxim for financing is that it’s best to raise money when you don’t need it.
66. The story you need to tell when raising money is a delicate balance
between clarity on how new funds could be very effectively put to work and the company doing
just fine without that money. But if your company is a rocket ship and/or money printing
machine, you will have firms bending over backwards to give you money on any terms. (
67. (Google recently raised $3bn of debt even though they had $37bn of cash in the bank. Why? You guessed
it: they didn’t need it, so the markets bought their ten year bonds at a rate most governments
would envy.)
68. And before you waltz into a financing, make sure you have a mentor, Board
member, and law firm lined up to vet the term sheet in the requisite time period!
69. When you’re starting a company, you don’t have huge piles of cash. Even if you’ve closed a Series
A or Series B, you generally don’t have enough money to be able to pay people really generous
salaries. To give your employees compensation competitive with what they can get paid at a large
company, you’ll need to throw a sweetener into the mix...the same reason why you’re working
your tail off for pennies: equity.
70. Since the company wants the employee to stick
around for a while instead of quitting after a week, what’s commonly done is to have the
employee earn out (or vest) their stock purchase rights over a four year period
71. So companies set up a one year cliff, meaning
the employee will not earn the right to purchase any stock at all until their one year anniversary,
on which day the employee vests a quarter of their options, with further vesting of 1/48 of their
options every month thereafter until their four year anniversary
72. To keep employees from
waltzing out the door on their four year anniversary, companies usually provide supplementary
option grants (also four-year but usually with no cliff) that start a few years in. That way, an
employee is always earning more options. Supplementary grants have the advantage of taking
into account the employee’s actual performance at the firm.
73. One more piece of advice: doing an “early exercise” of an incentive stock option (ISO) is
riskier than if you exercise a nonstatutory stock option (NSO).
74. So in the old days, Boards classically priced Common at about a tenth of Preferred
75. If a company is found offering underpriced options to employees, both
the company and the employee could find themselves facing 20% fines -- and poor pricing could
also complicate later funding or acquisition diligence
76. The company should get shareholder approval to set aside a pool of options for future employees
to avoid having to ask shareholders to create new shares every time someone new is hired.
77. Only the Board of a company may cause new shares to be created; they are given this permission
by shareholders.
78. fully diluted basis. It’s a “guaranteed pessimistic” interpretation of
ownership because it includes unvested options, unallocated options in the pool, and Restricted
Stock
79. This means that one’s control as a shareholder is generally significantly
higher than the fully diluted ownership percentage would indicate
80. Once you’re playing on someone
else’s dime, it’s not your business anymore and it’s nearly impossible to unwind the investment if
things turn hostile. You’re pretty much in with them for the life of the company
81. It can be extraordinarily helpful for a company to have advice and mentorship from those who
have been down the startup road before.
82. so advisory shares usually vest over one or two years, often with a sixmonth
cliff. Since these are being given to non-employees, they’re not qualified for the special tax
treatment given to employee ISOs, so most advisors are given NSOs.
83. I’d suggest granting advisors 0.1% to 2% of your
company, depending on your stage and how critical the advisor is likely to be to the success of
your company.
84. This means that if your company gets acquired, all of the options you granted to
the advisor will be completely vested, as if time had skipped ahead, or accelerated, to the end
of the vesting period.
85. People earlier on and taking
a bigger risk (e.g. without a salary) should get much larger grants. Splitting ownership evenly five
ways or more is asking for trouble. People with relevant connections, insight, skills, and
experience should see that reflected in their grant size.