Terms I’ve learned about startup financing

In the past few days I’ve spent considerable amount of time going through different articles, blogs, and speaking to my friends who have raised money, established an option pool etc to understand  the various aspects of startup financing. Even though I’m not looking for any investor money at this stage, I thought it will be good to understand certain terminologies and educate myself. I’ve captured a lot of useful terms and what it exactly means in this article, I don’t claim the content to be original here, it’s just a curation of  best piece of definitions/explanations I’ve found while searching (you can see the references at the bottom). This will save me lot of time in the future, I don’t need to do the same exercise of searching and reading tons of articles to get to the points. I hope some of you might find this interesting.

Valuation

Lets start with valuation. This is extremely tricky one and there is no definitive guide to derive your company valuation, whether you are an early stage startup on stealth mode or you are generating some revenue.  It looks more of a guesswork than any scientific formula to derive your company valuation. I’ve spoken to few founders who raised funding, the more I speak the result are more obscure. I’ve come across founder currently doing $1m/annum valued at $20m and also a startup just begin their journey and making about $200k/annum still valued at $20m. It comes to factors like founding team, product, the market potential, investors confidence on the market and the team etc. It’s also common sometime you get x-multiples of your current revenue. Ex: $2m/annum might get you to $20-$25m at 10 to 12x multiples. Somehow you need to make the person who is either going to invest or an employee accepting an stock option to believe the valuation is approximately correct. Also, remember the valuation is analysis at that point in time and it will change over the course of the startup journey month on month.

Pre-money vs. Post-money Valuation

The difference between pre-money valuation and post-money valuation is simple. Pre-money refers to your company’s value before receiving funding. Let’s say a venture firm agrees to a pre-money valuation of $10 million for your company. If they decide to invest $5 million, that makes your company’s post-money valuation $15 million.
Post-money valuation = pre-money valuation + new funding

These terms are important because they determine the equity stake you’ll give up during the funding round. In the above example, the investor’s $5 million stake means he’s left with 33% ownership of the company ($5  million/$15 million).

Let’s consider a counterexample. Say the company was valued at $10 million post-money instead, implying a $5 million pre-money valuation. This means that the investor’s $5 million counts as half the company’s valuation. He comes away with 50% of the company in this scenario, rather than 33%. Given the difference in equity, you can see how important it is clarify between pre and post-money valuations when discussing investment terms.

Convertible Notes

When a company is young, quantifying its valuation is often an arbitrary, pointless exercise. There may not even be a product in hand, let alone revenue. But companies at this stage may still need to raise money. Convertible notes is a financing vehicle that allows startups to raise money while delaying valuation discussions until the company is more mature. Often notes convert to equity during a Series A round of funding.

Investors who agree to use convertible notes generally receive warrants or a discount as a reward for putting their money in at the earliest, riskiest stages of the business. In short, this means that their cash converts to equity at a more favourable ratio than investors who come in at the valuation round.

Capped vs. Uncapped Notes

As discussed above, convertible notes delay placing a valuation on a company until a later funding round. But investors often still want a say in the future valuation of the company so their stake doesn’t get diluted down the line. When entrepreneurs and investors agree to a “capped” round, this means that they place a ceiling on the valuation at which investors’ notes convert to equity.
So if a company raises $500,000 in convertible notes at a $5 million cap, those investors will own at least 10% of the company after the Series A round ($500,000/$5M).

An uncapped round means that the investors get no guarantee of how much equity their convertible debt investments will purchase, making these kinds of investments most favourable for the entrepreneur. Let’s consider a company that raises $500,000 in an uncapped round. If they end up making so much progress that they convince Series A investors to agree to a $10 million, this means that their convertible note investors are left with just 5% of the company, half of what they would get if they capped the round at $5 million.

Cap Table

The capitalization or “cap” table reflects the ownership of all the stockholders of a company — that includes the founder(s), any employees who hold options, and of course the investors. For most people to understand how much of a company they actually own, all they really need is the fully diluted share count, the broader breakout of ownership among different classes of shareholders, and a couple other details.  The fully diluted share count (as opposed to the basic share count) is the total of all existing shares + things that might eventually convert into shares: options, warrants, un-issued options, etc.

Here’s a new company that has no outside investors, and existing stock allocated as follows:

If someone were offered 100 options, those shares would come out of the 1,000-share option pool, and so they’d own 100/10,000 or 1.0% of the fully diluted capitalization of the company.

I found couple of good resources for cap table here (venturehacks) and here (captable.io)

Common vs Preferred shares

Most startups have both common and preferred shares. The common shares are generally the shares that are owned by the founders and employees and the preferred shares are the shares that are owned by the investors. So what’s the difference? There are often three major differences: liquidation preferences, dividends, and minority shareholder rights plus a variety of other smaller differences. The biggest difference in practice is the liquidation preference, which usually means that the first thing that happens with any proceeds from a sale of the company is that the investors get their money back. The founders/employees only make money when the investors make money. In some financing deals the investors get a 2x or 3x return before anyone else gets paid. Employees typically get options on common stock without the dividends or liquidation preference. The shares are therefore not worth quite as much as the preferred shares the investors are buying.

Ownership

Any analysis of percent ownership in a company only holds true for a point in time. There are lots of things that can increase the fully diluted share count over time — more options issued, acquisitions, subsequent financing terms, and so on — which in turn could decrease the ownership percentage. Of course, people may also benefit from increases in options over time through refresher or performance grants, but changes in the numerator will always mean corresponding changes in the denominator.
This is something to keep in mind, a ownership of 5% equity in a business will not stay the same forever.

Original issue price, Conversion price, Exercise price

• The original issue price is just what it says: the price per share that the investor paid for its stock. This price tells us what various financial investors believe the value of the company was at various points in time.
• The conversion price is the price per share at which the preferred stock will convert into common stock. Remember, “preferred” stock is usually held by investors and has certain corporate governance rights and liquidation preferences attached to it that the rest of the “common” stock does not have. In most cases, the conversion price will equal the original issue price, however the two can diverge.
• The exercise price of employee options — the price per share needed to actually own the shares — is often less than the original issue price paid by the most recent investor, who holds preferred stock. How much of a difference in value depends upon the specific rights and the overall maturity of the company, and an outside valuation firm would perform what’s called a 409a Valuation (named for a specific section in the IRS tax code) to determine the precise amount.

Dilution

Dilution is a loaded word and tricky concept. On one hand, if a company is raising more money, it’s increasing the fully diluted share count and thus “diluting” or reducing current owners’ (including option-holding employees’) ownership. On the other hand, raising more money helps the company execute on its potential, which could mean that everyone owns slightly less, but of a higher-valued asset. After all, owning 0.09% of a $1 billion company is better than owning 0.1% of a $500 million company.

If the company increases the size of the option pool to grant more options, that too causes some dilution to employees, though hopefully (1) it’s a sign of the company’s being in a positive growth mode, which increases overall value of the shares owned (2) it means that employees might benefit from those additional option grants.

Let’s return to the example we introduced above, only now our company has raised venture capital. In this Series A financing, the company got $10 million from investors at an original issue price of $1,000 per share:

The important thing to keep in mind here is the magic number 100% is never going to change, it’s only the number of shares and corresponding price per share (value) going to keep changing constantly over the life of the company .

The fully diluted share count increases by the amount of the new shares issued in the financings; it’s now 20,000 shares fully diluted. This means the employee’s 100 options now equate to an ownership in the company of 100/20,000, or 0.5% — no longer the 1% she owned when she first joined. But… the value of that ownership has increased significantly: Because the price of each share is now $1,000, her stake is equal to 100 shares * $1,000/share, or $100,000.

Anti-dilution protections

While not all dilution is equal, there are cases where dilution is dilution — and it involves the anti-dilution protections that many investors may have. The basic idea here is that if the company were to raise money in a future round at a price less than the current round in which that investor is participating, the investor may be protected against the lower future price by being issued more shares.

Most anti-dilution protections — often called a weighted average adjustment — are less dilutive to employees because they’re more modest in their protection of investors. But there’s one protection that does impact the other shareholders: the full ratchet. This is where the price that an investor paid in the earlier round is adjusted 100% to equal the new (and lower) price being paid in the current round. So if the investor bought 10 million shares in the earlier round at a price of $2 per share and the price of the current round is $1 per share, they’re now going to get double the number of shares to make up for that, equalling a total of 20 million shares. It also means the fully diluted share count goes up by an additional 10 million shares; all non-protected shareholders (including employees) are now truly diluted.

Ideally, anti-dilution protections wouldn’t come into play at all: That is, each subsequent round of financing is at a higher valuation than the prior ones because the company does well enough over time, or there aren’t dramatic changes to market conditions. But, if they do come into play, there’s a “double whammy” of dilution — from both the anti-dilution protection (having to sell more shares, thus increasing the denominator of fully diluted share count) as well as the lower valuation.

Liquidation Preferences

The preferred stocks hold by the investors will normally come with liquidation preferences that attach to their shares. Simply put, a liquidation preference says that an investor gets its invested dollars back first — before other stockholders (including most employees with options) — in the case of a liquidity event such as the sale of the company.

To illustrate how such a preference works, let’s go back to our example, only now assume the company was sold for $100 million. Our Series A investor — who invested $10 million in the company and owns 50% of the business — could choose to get back its $10 million in the sale (liquidation preference), or take 50% of the value of the business (50% * $100 million = $50 million). Obviously, the investor will take the $50 million. That would leave $50 million in equity value to then be shared by the common and option holders:

Given the high sale price for the company in this example, the liquidation preference never came into play. It would, however, come into play under the following scenarios:

Scenario 1. If the sale price of a company is not sufficient to “clear” the liquidation preference, so the investor chooses to take its liquidation preference instead of its percentage ownership in the business.

Let’s now assume a $15 million sale price (instead of the $100 million) in our example. As the table below illustrates, our Series A investor will elect to take the $10 million liquidation preference because it’s economic ownership (50% * $15 million = $7.5 million) is less than what it would get under the liquidation preference. That leaves $5 million (instead of the $50 million) for the common and option holders to share.

Scenario 2. When a company goes through several rounds of financing, each round includes a liquidation preference. At a minimum the liquidation preference equals the total capital raised over the company’s lifetime.
So, if the company raises $100 million in preferred stock and then sells for $100 million, there’s nothing left for anyone else.

Scenario 3. There are various flavours of liquidation preference that can come into play depending on the structure of the terms. So far, we’ve been illustrating a 1x non-participating preference — the investor has to make a choice to take only the greater of 1x their invested dollars or the amount they would otherwise get based on their percentage ownership of the company.

But some investors do more than 1x — for instance, a 2x multiple would mean that the investor now gets 2x of their invested dollars off the top. The non-participating can also become “participating”, which means that in addition to the return of invested dollars (or multiple thereof if higher than 1x), the investor also gets to earn whatever return their percentage ownership in the company implies. The impact of this on other stockholders can be significant.

To isolate the effects of these terms, let’s first look at what happens when our Series A investor gets a 2x liquidation preference. In the $100 million sale scenario, that investor will still take its 50% since $50 million is greater than the $20 million (2 x $10 million liquidation preference) it’s otherwise entitled to. The common and option holders are no worse off than they were when our investor had only a 1x liquidation preference:

But, if the sale price were the much lower $15 million, the investor is going to capture 100% of the proceeds. Its 2x liquidation preference still equals $20 million, but there’s only $15 million to be had, and all of that goes to the investor. There’s nothing left for common and option holders:

Finally, let’s take a look at what happens when we have participating preferred, colloquially referred to as “double dipping.”

In our $100 million sale scenario, the Series A investor not only gets its $10 million liquidation preference, but also gets to take its share based on its percentage ownership of the company. Thus, the investor gets a total of $10 million (its liquidation preference) plus 50% of the remaining $90 million of value, or $55 million in total. Common and option holders get to share in the remaining $45 million of value:

In the $15 million scenario, the common and option holders get even less. Because the Series A investor gets its $10 million in preference plus 50% of the remaining $5 million in proceeds, for a total of $12.5 million, only $2.5 million is left for the rest of the shareholders:

Employee Stock options

“Stock options” as typically granted give you the right to buy shares of stock in the future for a price which is determined today. The “strike price” is the price at which you can buy the shares in the future. If in the future the stock is worth more than the strike price, you can make money by “exercising” the options and buying a share of stock for the strike price.

Startup employees get stock options that typically vest over a four-year employment period, so if they choose to leave the company after four years (or at any time for that matter), they have only 90 days in which to exercise or forfeit the options. And that’s the catch: Exercising requires cash. Not only do you have to pay the company the exercise price for each share (because they are stock options, not actual restricted stock units), the IRS then taxes you at year end on the difference between the then-existing fair market value of the stock and the exercise price.

There are four groups of people who will own the company: investors, founders, employees, and former employees. When a company is first started, the CEO often puts aside a pool of common stock from which to grant employee options, generally around 15% of the company’s capitalization.

Over time, that pool shrinks as options are extended to new employees or as existing employees are given additional grants. The pool can be replenished when employees leave — either because they leave before their options are fully vested or because they don’t exercise vested options within the 90-day period that currently exists — so those options go back into the pool. When the pool gets exhausted altogether, the company will often ask shareholders to increase the size of the pool (i.e., getting them to approve an increase in the number of authorized shares the company can issue).

But, the pool can’t magically increase without impacting all existing shareholders, because 100% = 100%. If an employee owned 1% of the company before the pool increase and then the company increased the option pool by 10%, that employee now owns 0.9% of the company. Increasing the pool dilutes ownership. Just because a company can increase the nominal size of the pool to whatever level it wants, doesn’t change what the company was worth before it increased the pool.

Many early startup employees are generally okay with some dilution because, at least in theory, increasing the option pool to hire more people helps grow the company — which in turn hopefully increases the value of the company. So while an employee might own less of the company than before, he or she would rather own 0.9% of a company worth $1 billion than 1% of a company worth nothing. 1% of 0 is still 0 after all.

How Does a Employee Stock Option Work?

The following shows how stock options are granted and exercised:

• Contoso, Inc., hires employee John Smith.
• As part of his employment package, Contoso grants John options to acquire 40,000 shares of Contoso’s common stock at 25 cents per share (the fair market value of a share of Contoso common stock at the time of grant).
• The options are subject to a four-year vesting with one year cliff vesting, which means that John has to stay employed with Contoso for one year before he gets the right to exercise 10,000 of the options and then he vests the remaining 30,000 options at the rate of 1/36 a month over the next 36 months of employment.
• If John leaves Contoso or is fired before the end of his first year, he doesn’t get any of the options.
• After his options are “vested” (become exercisable), he has the option to buy the stock at 25 cents per share, even if the share value has gone up dramatically.
• After four years, all 40,000 of his option shares are vested if he has continued to work for Contoso.
• Contoso becomes successful and goes public. Its stock trades at $20 per share.
• John exercises his options and buys 40,000 shares for $10,000 (40,000 x 25 cents).
• John turns around and sells all 40,000 shares for $800,000 (40,000 x the $20 per share publicly traded price), making a nice profit of $790,000.
• To exercise an option, the option holder typically has to pay cash out of pocket for the exercise (very few companies allow “cashless exercise”).

Expiration and termination : Options typically expire after 10 years also typically in 90 days, which means that at that time they need to be exercised or they become worthless. Even if they are vested, you need to exercise them or lose them at that point.

Stock options – Mergers & Acquisitions

One of the most frequently asked questions about options is what happens to them if a startup is acquired. Below are some possible scenarios, assuming four years to fully vest but the company decides to sell itself to another company at year two:

Scenario 1. Unvested options get assumed by the acquirer.

This means that, if someone is given the option to stay with the acquirer and choose to stay on, their options continue to vest on the same schedule (though now as part of the equity of the acquirer). Seems reasonable… Unless of course they decide this wasn’t what they signed up for, don’t want to work for the new employer, and quit — forfeiting those remaining two years of options.

Scenario 2. Unvested options get cancelled by the acquirer and employees get a new set of options with new terms (assuming they decide to stay with the acquirer).

The theory behind this is that the acquirer wants to re-incent the potential new employees or bring them in line with its overall compensation philosophy. Again, seems reasonable, though of course it’s a different plan than the one originally agreed to.

Scenario 3. Unvested options get accelerated — they automatically become vested as if the employee already satisfied her remaining two years of service.

There are two flavors of acceleration to be aware of here, single-trigger acceleration and double-trigger acceleration:

In single trigger, unvested options accelerate based upon the occurrence of a single “trigger” event, in this case, the acquisition of the company. So people would get the benefit of full vesting whether or not they choose to stay with the new employer.
In double trigger, the occurrence of the acquisition alone is not sufficient to accelerate vesting. It must be coupled with either the employee not having a job offer at the new company, or having a role that doesn’t quite match the one they had at the old company.

Note, these are just general definitions. There are specific variations on the above triggers: whether everything accelerates or just a portion; whether people accelerate to some milestone, such as their one-year cliffs; and so on — but we won’t go through those here.
Not surprisingly, acquirers don’t like single triggers, so they’re rare. And double triggers give the acquirer a chance to hold on to strong talent. Still, it’s very unusual for most people to have either of the above forms of acceleration. These triggers are typically reserved for senior executives where it’s highly likely in an acquisition scenario that they won’t — or literally can’t (not possible to have two CFOs for a single company for example) be offered jobs at the acquirer — and thus wouldn’t have a chance to vest out their remaining shares.

The simple way to think about all this is that an acquirer typically has an “all-in price” — which includes up-front purchase price, assumption of existing options, new option retention plans for remaining employees, etc. — that it is willing to pay in the deal. But how the money ultimately gets divided across these various buckets can sometimes diverge from what the initial option plan documents dictate as acquisition discussions evolve.

Pay attention to option pool shuffle

Option pool is a term used to refer to a chunk of equity reserved for future hires. The size of your option pool, as determined during a round of funding, has a direct impact on your company’s valuation and hence, your ownership.

This is because the option pool is often included in the pre-money valuation of a company. So let’s say investors agree to invest $2 million at a $10 million pre-money valuation, implying a $12 million post-money valuation. Option pools are expressed as a percentage of post-money valuation, so if the deal includes a 20% option pool, that means the pool is worth $2.4 million. Your $10 million pre-money valuation is now effectively a $7.6 million pre-money valuation. The investor isn’t taking a larger percentage as a result—they’ll still own 16.7% of the company in this case—but you will be substantially diluted because the option pool will come directly from management’s stake. So if you owned 100% and think you now own 83.3%, you’re wrong. That 20% option pool, reserved for future employees, means you now own 63.3% of company.

Vesting

A vesting schedule is imposed on employees who receive equity, and determines when they can access that equity.  This is useful because it means that if you give 5% of your company to a partner, that partner can’t just quit a couple of months later and keep the equity. A typical vesting schedule takes four years and involves a one year cliff.

The “cliff” means that none of the employee’s shares vest for at least one year. After that year, typically 25% of the employee’s equity is released, and the rest vests on a monthly or quarterly basis. The cliff is there to protect the company – and all the shareholders, including other employees – from having to give shares to individuals who haven’t made meaningful contributions to the company

References used:

• https://www.allbusiness.com/how-employee-stock-options-work-in-startup-companies-103450-1.html
• http://a16z.com/2016/08/24/options-ownership
• http://venturehacks.com/articles/option-pool-shuffle
• https://maxschireson.com/2011/08/23/startup-stock-options-explained/
• http://www.forbes.com/sites/jjcolao/2013/10/14/10-terms-you-must-know-before-raising-startup-capital/#3bc7c5642cd0
• https://www.allbusiness.com/how-employee-stock-options-work-in-startup-companies-103450-1.html