Ask the Wizard

Brad and Jason have a great post up over on Ask The VC regarding the often asked first-time entrepreneur question How many shares should I create for my new company?. This is directly related to a couple of questions I've gotten lately from employees considering offers from startups that go like this (i'm combining a couple different lines of questioning into one set here):

I'm considering joining a startup that completed an A round financing. They have offered me options, and I'd like to understand the relative size of the options offer, so I've asked them about their pre and post-money valuation on the A round (which will tell me how much of of the company is owned by the investors already), and expected dilution in my equity as a result of a next round of financing. The company has not wanted to answer any of the questions in quantitative specifics, but responds qualitatively with "a good valuation" and "not much dilution". Is this reasonable? I will know the current valuation if I knew the exercise price and multiply it by total outstanding stock,right?

There are a bunch of things to say here. First, go read Brad and Jason's response to the "how many shares" question. Back already? Such a fast reader you are. Ok, let's dive into this set of questions in not necessarily any particular order.

The first question you really want answered when you're receiving an offer like this from a private company, and it's a question the company should be prepared to answer, is "what is the total number of authorized shares". If you are offered 100 options in the company, it doesn't really matter whether the company's valuation is 5 or 500 million dollars (if the company's public, all this is moot obviously. There are loads of mechanisms for valuing options in publicly traded companies). You don't really know anything about the size of your grant unless you know the total number of authorized shares, and they should be willing to let you know that information so you can determine the relative size of the grant. Without that information, the offer only amounts to "some options".

The valuation numbers are probably not going to be answered by a private company (they have multiple reasons not to go around touting the financed value of the company, not the least of which is employees claiming two years later that 'you told me the company was worth 50 million dollars'), but again, the answers to the valuation questions are secondary in my mind to the size of your grant. The first thing you really want to know is "what percent of the total authorized shares am I being offered".

In any case, you will not know the current valuation by multiplying the exercise price by the total outstanding shares. The options you are being offered are almost definitely options to purchase common stock. The investors on an institutional A round financing almost certainly have purchased preferred stock. Since the preferred stock is paid out in preference to the common stock on any liquidity event, the common stock is probably valued at a significant discount to the preferred stock. So that calculation isn't going to help you.

Once you know the percentage of authorized shares you've been offered, and you know the company's executed a 5 million dollar A round financing, how do you calculate the probable value of your options? The short answer is "you don't" or "the current value is around zero, subject to change", take your pick. The long answer is that your options aren't worth what a VC was willing to pay for their equivalent number in preferred stock. Your options are only going to be worth what somebody is ultimately willing to pay for common stock at some point in the future, and that price is only going to be determined on an IPO or sale of the company. Just like the founders, you need to decide whether you think your percentage of shares is going to be worth some potentially meaningful amount if the company is successful in the market. The only thing you can try to know with certainty is your percentage interest in the company against which you might guestimate reasonable comparable exits in the market and calculate your percentage interest in that exit, but even here, you are subject to unknown and potentially unknowable amounts of future dilution, preference multiples (in which the investors get 2x or 3x or more their investment back before any remainder is distributed to common), etc. A question you might ask the company vis-a-vis your percentage interest is whether the existing investors have any preference multiples (because this has the potential effect of reducing the common's interest in the company on a liquidity event), but again, even if the company answers this question with total transparency, it could be very challenging for you to understand or measure the implications to any reasonable degree.

The follow-on financing dilution question is important. Too few people understand the implications of follow-on equity financings, which is that everybody (probably including the existing investors if they don't invest in this round) gets diluted on any further equity financing. The trouble with specifics around this line of questioning is that the company isn't likely to have very concrete answers as to what future financings might mean for equity dilution, even if the market's supply/demand continues to function exactly the same as the present environment. One way of at least getting a sense of the magnitude/timing of potential dilution is to ask questions that help you understand how long the current financing is expected to last.

The bottom line for potential employees is that future dilution is going to be very hard to gauge, you just need to understand that the closer you are to startup mode, the more likelihood there is of significant dilution, for you and the founders and everybody else. The company should be willing to help you understand your current percentage interest in the company and some qualitative measure of the likelihood of future dilution. Beyond that, you're in the "leap of faith" pool with everybody else. If the company is unwilling to let you know what 100 shares equates to in terms of percentage interest in the company, I'd say that's a warning sign and you should ask lots more questions.

Posted by Dick at 02:35 PM | Permalink | Comments (3)

AKA The Wonderful Thing about Triggers…

The wizard hasn’t received many questions lately, which is very disturbing and embarrassing and I will chalk it up to summer vacations, but in the absence of actual questions, I’ve decided to invent some fans of the wizard. Question number 1 comes from an invisible Irish gentleman named Bernie in Wichita. Bernie writes, “Can you explain options acceleration? And when would I want to use it? And when wouldn’t I? And what’s single trigger vs. double trigger acceleration and how do you feel about those kinds of things?”

Those are great questions Bernie! Hopefully, I can at least get you to realize there's a lot to think about here. Let’s dive right in.

Most options plans for your employees have a vesting schedule the defines how the options vest (ie, when the employee can exercise them). Vesting schedules for tech startups all generally look like a four year vesting period, with 25% of the total options grant vesting on a one year cliff (ie, nothing vests for a year and then 25% of the options vest on the 1 year anniversary), and then the rest of the options vest at 1/48th of the total options every month for the next 36 months.

Now let’s say you’ve got this classic vesting schedule and you hire somebody named Bobby Joe after you’ve been in business for one month, and he gets an options grant equal to 1% of the total outstanding shares. He works hard at your company for 11 months, after which your company is acquired for an ungodly sum of money. The acquirer decides that they were buying your company because of it’s cool logo and they don’t need any actual employees so they are all terminated effective immediately.

Bobby Joe’s options are worth how much? If you answered “Bubkas”, “Zero”, “nothing” or laughed at the question, you are correct. Although Bobby Joe has worked at the company for almost the entire life of the company, he gets nothing and the person that started 30 days before him gets 25% of their total options value. Doesn’t seem fair. Or as Bobby Joe would undoubtedly say “I’m upset, and I will exact my revenge on you at some later date in a compelling and thorough fashion”

Enter acceleration. Acceleration in an options plan can cause vesting to accelerate based on some event, such as an acquisition. For example, you might have a clause in your plan that states that 25% of all unvested options accelerate in the event the company is acquired.

If Bobby Joe had acceleration like this, he’s happier. He may still not be as happy as the person hired a month before him who also accelerates and now has 50% vested (the first year cliff and the extra 25% acceleration), but it sure feels a lot better to be Bobby Joe in this scenario.

That brings us to single trigger, double trigger, full acceleration, partial acceleration, etc.

We’ll start with full vs. partial acceleration. Full acceleration means that if the accelerating event happens, 100% of unvested options are vested and the employee is fully vested. If you started your job last Wednesday, the board approved your options grant on Thursday with full acceleration, and the company was acquired on Friday, congratulations, you just vested 100% of your options….you are just as vested as Schmucky in Biz Dev who was employee number 2 and started 3 years and 10 months ago (although shmucky may of course have a larger total number of options than you).

Partial acceleration we already referred to; this is how we refer to vesting some remaining portion of unvested options, such as 25% of the remaining unvested options.

Ok so far? Good, we are coming to the fun part. Let’s say you bootstrap your startup that’s selling bootstraps on bootstrap.com for two years and then let’s say you have a 20% options pool that was created as part of an A round financing. Over the next 6 months you hire a whole bunch of people, you allocate 15 percent of the options pool, and an acquirer comes along. Do you think the shareholders (common and preferred) are going to be more excited about full acceleration or partial acceleration? Full acceleration dilutes the shareholders 15%, whereas partial acceleration only dilutes the shareholders…well, partially. As a variation on this example, let’s say you hired employee number 1 when you started bootstrapping and you allocate the same number of options to everybody. The guy who started last Tuesday is going to make just as much as employee number 1.

For these kinds of reasons, you will frequently see investors and others argue for partial acceleration. Options holders and those negotiating their employment of course prefer full acceleration. This can be the cause of lots of board arguments in the early going as you and your investors decide how acceleration will work in your company options plan (or with employees who want to negotiate additional acceleration on top of the existing plan). Hold this thought for a moment while we hop across town to learn about single trigger, double trigger, etc.

Single trigger acceleration simply means that there is one kind of event in the options agreement that triggers the acceleration of some or all options. Single trigger usually refers to an acquisition. Double trigger (and I suppose triple and quadruple trigger) acceleration means that there are multiple kinds of events that can trigger the vesting of options. Double trigger acceleration usually refers to a situation in which the options plan grants partial acceleration on an acquisition, and then further acceleration (perhaps full, perhaps additional partial) if the employee is terminated (eg, our first example where they’re buying the company for its logo and don’t need employees).

Now for the important piece of the conversation: What’s the best way to set up an options plan vis-à-vis acceleration? The idea behind double trigger acceleration is that as we saw in our bootstrap example, there are lots of interested parties that don’t particularly care for full single trigger acceleration. It is very employee friendly BUT not necessarily equitable and your investors will very likely raise their hands at every board meeting and ask if you’ve come to your senses yet if you’ve started your plan with full single trigger acceleration. We’ll see another reason to dislike it in a minute. So, along comes double trigger acceleration in which we seem to be creating a more ‘fair’ plan because partial acceleration makes the shareholders happy and the employees who’ve worked there for a couple years get a bigger piece than the guy who started Tuesday, while also providing additional consideration to any and all employees who aren’t offered jobs after the acquisition.

Here’s how I feel about all this, from number of options granted to acceleration: I’m for partial single trigger acceleration on acquisition (with no special exemptions for employees with super powers) AND an options grant program that objectively matches role and title to size of grant consistently across the organization. (eg, all senior engineers get 4 options, all executive team hires get eleventy-eleven options, you get the picture).

Why? Because any other approach misaligns interests and motivations. I know of one company (not one I started or worked for) that had full single trigger acceleration and the people at this company STILL hate the head of sales that got hired one month before an acquisition and made more than the hundreds of people who’d worked there for three years. Double trigger? Now you’ve got people who might WANT to get terminated if there’s an acquisition. Subjectively granting options quantities based on whatever the criteria of the day is? Always a bad idea and bound to end in tragedy and you regretting your whimsical approach to options grants.

So, at this point the astute reader thinks “this is all well and good, but you can just as easily have some employees who really take a bath if they’ve just left a very nice and respectable job to come work for you, then get terminated on acquisition a month later, and only get partial single trigger acceleration”. This is true. The answer is hey, they get partially accelerated, and I’d rather have generally equitable distribution of the deal. If you’ve got a reasonable Board of Directors, you can accommodate anomalies with performance bonuses or severance or whatnot instead of being locked into a plan with misaligned interests.

There’s another hidden issue with full single trigger acceleration that I mentioned earlier, and we can call this the “acquirer’s not stupid” rule. If your employees all fully vest on acquisition, how do you think the acquirer is feeling about your team’s general motivation level post-acquisition? They are not feeling good about it. No they are not. They are thinking “gee, we are going to have to re-incent all these folks and that’s going to cost a bunch of money, and you know where that money’s going to come from? I think we will just subtract it from the purchase price, that’s what we will do!”….so the shareholders get doubly-whacked…they get fully diluted to the total allocated options pool AND they likely take a hit on total consideration as the acquirer has to allocate value to re-upping the team.

My FeedBurner cofounders and I have done our options plans a bunch of different ways across a few different companies, even changing midstream once, and I think partial single trigger acceleration causes the least headaches for everybody involved in the equation (although it obviously provides less potential windfall for more recent hires).

NB: you should be very very clear when you hire people about how this works. Most employees, to say nothing of most founders, don’t really understand all the nuances in an options plan, and it’s always best to minimize surprises later on.

You want to sort as much of this out up front with your attorneys before you start hiring people. You want to avoid having “the old plan with X and the new plan with Y” and that sort of thing.

Thanks for the note, Bernie!

Posted by Dick at 05:57 PM | Permalink | Comments (5)

I get so many search referrals to this blog with queries like "restricted stock vs. options", probably because i wrote a post titled "restricted stock vs. options", it's time to finally write about "restricted stock vs. options". This is a simple yet complicated topic, and I will undoubtedly leave out a bunch of stuff and get ten things wrong, but other than that, I hope this will prove helpful and enlightening. Please refer to Volume II of "Ask Dr. Phil, The Startup Years" for anything I might be leaving out here.

You can look up most of the basics like "what is restricted stock" or "what is an option" or "who shot JR" on the Google. I won't define terms here, I'll just talk about some pros and cons of when you might use restricted stock instead of options or vice versa and why. Big tip of the hat to Brad Feld and David Hornik who filled in a bunch of blanks for me on this.

When would you issue restricted stock instead of options? In a startup, one time that you might do this is very early on for a few executives or very early 'founder-ish' hires. The reason you might issue restricted stock instead of options generally has to do with tax treatment. The general deal with options is this - you get an option to buy stock at some price. The day you exercise that option is the day you start holding the stock. If you sell the stock before you have held it for a year, you pay income tax on the gain, even if you held the option itself for 4 years (and if you sell after you've held the stock itself for a year, you pay long-term capital gains). You can imagine lots and lots of cases in which the only time an employee would exercise their options is when they are about to turn right around and sell the stock, so in these cases, the employees are looking at income tax. Enter restricted stock. Maybe. Probably not though.

Restricted stock, on the other hand, is also really a stock grant that promises vested stock to the holder, but can work like so.....you're granted the stock, but it is restricted in that the company has a right to buy it back on the cheap according to a vesting schedule. So, the good news in this case is if you file a special 83b election with the tax man (more on this below), then the date the long term capital gains clock starts ticking is the date you buy the restricted stock (even though it is at risk over the course of the vesting schedule). So, good news is better clock ticking on long-term capital gains treatment and bad news is that you actually have to purchase the stock or pay tax now on a grant of stock that's priced below fair market value. So unlike options, you've got cash out of pocket on equity that's not going to be liquid, in all likelihood, for quite some time. One reason you might consider this approach more right at startup time is that the common stock hasn't yet acquired much/any value, so the purchase price or income tax can be next to nothin. You don't wanna have to buy $100k worth of restricted stock in shmucky.com only to watch shmucky.com go out of business 18 months later when the market for pre-washed online shmucks dries up or you quit, etc.

Is that all? No, that's not all. If that were all, the tax code and business would be simple, and you might see a lot more people getting restricted stock at startup time than options, and the chances of the tax code and company reporting requirements and so forth being simple are unlikely.

A non-tax restricted stock vs. options consideration for entrepreneurs and startups is that there are lots of issues involved with having too many stockholders. These range from things like inability to run as a pass-through entity like an S-corp if there are too many stockholders to things like requirements of x% of the stockholders on approval of mergers to all sorts of other reporting requirements that make it unattractive to have so many actual stockholders as opposed to options holders.

Then there's the tax kicker regarding why more companies don't just offer restricted stock grants instead of options to more people. This is the stay tuned for more bad news part that I mentioned earlier. Let's say the fair market value of the common stock is now $3 and you grant some employee 10k shares at zero cost to the employee with a four year vesting schedule. In order that the clock start ticking at grant time on the long term capital gains treatment, the employee files a special 83b election with the IRS. This election essentially says "i want to establish cost basis in the stock now and a gain (or loss) will be recognized only when i sell". As part of this, you then have to pay income tax on the difference between the grant and the fair market value now, at the time of grant. Six months later the employee quits or the company goes bankrupt and in either case the employee has no vested shares. Does the employee get to now claim a loss? What do you think the answer is going to be? You are right, the answer is no way, the employee is out the tax bill plus whatever they paid for the restricted shares.

So, ok, what if you don't file special election 83b? In that case, you pay no tax at grant time but only when the grant vests (more accurately, as each chunk vests). HOWEVER, at that time, you now owe income tax on the difference between what you paid for the stock and the fair market value at the time the stock vested. If the stock has appreciated, you now wish you'd been granted options. Very bad. Not good. Bummer. Since the potential tax liability on such stock could be massive if it really appreciates, anybody in their right mind files an 83b election, since that's kind of the whole point.

Having said all this, when do restricted stock grants make the most sense for a startup? Again, they make the most sense in the early going, before the common has any real value at all, and even then only for a handfull of executives so that there aren't too many stockholders. The too many stockholders issues have little to do with transparency and everything to do with all the extra burdens heaped on companies with certain numbers of shareholders....burdens that startups don't need while they're trying to run fast and grow over the first several years.

Thus, you see some savvy executives who might come into a company in the very early days that understand the benefits of asking for restricted stock instead of options, and in those cases restricted stock can be a better deal for the executive and can make sense and this is not a ridiculous request. As you grow and finance the company and add more employees, however, options plans are more appropriate as they don't force employees to come out of pocket now with cash they might not be able to recoup later.

NB: I'm not referring in here to "Restricted Stock Units", which are another subject altogether. When you hear that companies like Microsoft have stopped granting options and started granting restricted stock, what they are really talking about is something called restricted stock units, which are a promise to grant unrestricted shares according to a vesting schedule, and you don't need to worry your pretty little head over those right now.

Clear as mud? Good. The Wizard is all about sleight of hand and misdirection. <Poof>

Posted by Dick at 03:37 PM | Permalink | Comments (5)

I hesitate to even start writing about options. They make my head hurt. Anything I write about options will likely be met with the ninety-one different opinions about options that have been forged by ninety-one different prior outcomes for ninety-one different people. Options are like bad tequila, you wake up in the morning with packing tape where your eyes are supposed to be and all you can think is "It seemed like such a good idea at the time when that guy said 'hey everybody, let's issue options!'". I think I'll start the options discussion with some discussion of rudimentary starter points and only dive into the murky depths later on.

StarterTopic #1: The options pool
You have started your company and you're raising capital. You have been fortunate enough to get a term sheet that says these nice people will give you 2 million smackeroos for 40% of your company, thus giving you a post-money value of 5 million smackeroos. You previously owned 100% of the company, so now the investor owns 40 percent and you own 60, right? Well yes, but just for now.

Your investor is likely investing 2 million with the hope that you are going to put some of that capital to work by hiring employees to flesh out your organization, and savvy employees are going to want some form of equity. Far more often than not, your investor's terms are going to mandate that you create an options pool from which to issue these new employees equity. Who gets diluted to create this pool? Nobody and Everybody. Let's say your financing mandates the creation of a 10% options pool just so we can keep the math simple (you should assume you will be creating something between a 10 and 20 percent pool, usually more like 15 or 20). Let's say that your investor owns 400 shares of preferred and you now own 600 shares of common. The way the options pool gets created is that you will now authorize another 111 shares of common that will be unissued.

Why didn't you just authorize 100 options, since 100 is 10% of 1000? because those authorized shares are part of the total equity now and 100 is not 10% of 1100. Capiche?

Do you now own a lot less than 60% of the company? No, you still own 60% of the company because those 111 authorized shares for options are unissued. If you sold the company tomorrow, those 111 unissued shares dissolve into the mist and there are 1000 shares of which you own 600. Once you start hiring however, you will start issuing shares out of this options pool and as those options vest over the years, everybody dilutes. Pay attention because this is the really easy part of options and we haven't even done our first tequila shot yet. We are still having chips and salsa, and everybody is looking at the menu.

Starter Topic #2: Acceleration
When you issue options to employees, you generally issue them along with some vesting schedule. The vesting schedule says simply that you can't exercise the option to buy these shares on day one, you become vested in these options according to the length of your employent with the company. A typical vesting schedule is something like a 25% 1 year cliff with an additional 1/36th vesting every month for the following three years. In plain English, this means that if you issue employee A 1000 options, then none of those options vest until the 1 year mark, at which point 25% of them vest. Then, every month after that for the next three years, another 1/36th of the remaining options vest every month, such that at the end of four years, the employee is "fully vested"; ie, they can exercise their option on all 1000 shares and become the proud owner of 1000 shares of common stock in the company. I guess that wasn't plain English, but it will have to suffice.

Options agreements can vary wildly. Consult your physician thoroughly regarding all of this stuff. I mention it only as a prologue to acceleration.

The notion behind acceleration is that you may have employees who don't want to wait no stinking four years if something exciting happens to your company, like it is acquired or there is some change of control. There are different kinds of acceleration, but you will generally hear terms thrown around like "single trigger" and "double trigger". I'm really over-generalizing now, but single-trigger acceleration generally refers to a situation in which the options agreement states that all of the employee's options vest on a change of control, while double trigger may state something like "50% of unvested options vest on change of control and the other 50% vest on termination after change of control".

I won't go into my various opinions about acceleration here, largely because opinions about options are so frequently colored by what happened to you in the past or at the very least "what happened to me the last time I was issued options", and it's different for everybody, but suffice it to say that you want to nail down your company's approach to acceleration in the early going, have a definite philosophy and point of view about it given the different potential outcomes, and then try to maintain a consistent policy within specific groups of people as you grow the business and add more people. By "within specific groups of people" I mean that you might have one acceleration policy for external board members and another for employees, but try to have a consistent policy for employees and a consistent policy for BoD, etc. Acceleration is obviously dilutive to the existing shareholders but it's employee friendly, so you have to figure out what works for your company. Your investors will have strong opinions about this as well.

As with just about everything I write about here, there are 19 more things to say about acceleration, but this is a good start, and I really just want to lay the groundwork for an eventual discussion about issuing options vs. restricted stock.

My head already hurts, and we haven't even started talking about pricing, IRS 409A, and tax treatment of ISOs vs NQSOs.

Posted by Dick at 09:48 PM | Permalink | Comments (3)

Some great comments here right off the bat. Frank asks on a previous post,

"I am just now hiring a COO (really a co-CEO). My first hire. What are the equity amounts offered to a key non founder at the early stage (Pre Launch)? I have read 5% to non founding CEOs, and 1% to COOs. In our case, he and I will be joined by no more than a couple senior execs in the next year. Thanks for any advice."

As you might expect, the first and most important answer is "it depends", but I'll throw out some quick thoughts.

1. If your company is pre-funding and pre-revenue, which it sounds like you may be, then a single point sounds pretty darn light for a COO. Don't forget this person's going to get diluted on financings along with you and everybody else.

2. The 5% to non-founding CEO's can be the kind of equity package that a non-founding CEO might get after a round or two of financings. Again, if you're pre-launch, pre-revenue and this person along with the founders are going to form the core of the mgmt team, you could easily be thinking 4-5% for this person, some people would say more is fine too. The dynamics change dramatically as you raise money, make headway in the market, etc., but don't get caught up in hoarding founder equity at the expense of getting the right team together when you're still pre-launch. The key is to remember that this person's equity is going to dilute with everybody else's on future financings.

3.I have no idea what Canadian equities law is, and I frankly don't know US equities law that well, but note that if you haven't raised capital yet and you're pre-revenue, then you can very possibly issue this person common stock or restricted stock (instead of options) without the normal tax consequence since the stock has no perceived value yet . This is a topic for an entirely separate post, but when your stock is "worthless", there are some real benefits to restricted stock over options. Again, caveat emptor, there are loads of pros and cons to options vs. restricted stock, but something to consider at this stage (and I'm not a lawyer, if your erection lasts for more than four hours after hiring the COO, please consult your physician, and so on and so forth).

I'll say something that will become a common theme here. Founders that worry about keeping as much of the equity as possible are not thinking about things correctly. Owning 5% of a billion dollar company is better than 40% of nothing (yes, yes, owning 40% of a bilion dollar company would be best. I've only had an audience for two days and you're already predictable!). If you're only offering a point of equity to somebody that's coming into one of the most senior positions in the company pre-funding, pre-revenue and pre-launch, you aren't going to attract the best person for the job. The right person will prefer more equity and less salary, and a point is *probably* not close to the right number.

Hope that helps. Need to do a post on options vs. restricted stock. Lots to say about that.

Posted by Dick at 03:34 PM | Permalink | Comments (4) | TrackBacks (0)