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'm copying this pretty much verbatim from Matt Cutts' blog. I'm going to try to keep posting here with the same irregularity you've come to expect, and I have a couple looong posts queued up and just want to make sure that everybody understands that my thoughts are personal and mine alone, so ....

<copying from matt>
This is my personal blog. The views expressed on these pages are mine alone and not those of my employer.

Q: Did somebody tell you to write this?
A: No

Q: Why are you writing it?
A: Just in case. If I say something stupid in the future, it’s better to be able to point out that the stupidity is mine, and mine alone.
</copying from matt>

Posted by Dick at 03:40 PM | Permalink | Comments (1)