exitEvery founder of a growth startup dreams of a big, successful exit — a sale of the company for millions of dollars. But that dream could be shattered if the investors are able to cause the company to be sold prematurely with proceeds only equal to or barely exceeding the investors’ liquidation preferences, leaving little or nothing for the founders. Such a proposed deal will almost always be opposed by the founders, believing that the company could achieve a much higher valuation if it remained independent for a bit longer. Whether or not such a deal gets consummated over the objections of the founders depends on state law provisions and negotiated contractual terms that combined will determine the one factor that ultimately matters: control over the deal process.

Background: Liquidation Preference and Investment Horizon

In a typical round of venture funding, the investors receive a liquidation preference, i.e., the right to receive first dollars (after creditors are paid) up to an agreed amount in any sale of the company. In a company’s first institutional funding round (typically designated as Series A), a liquidation preference of 1X plus annual dividends of 8% is “market”, i.e., the investors get an amount off the top equal to the amount they invested plus accumulated dividends before the common shareholders receive anything. Later rounds (Series B, Series C, etc.) may have liquidation preferences of higher multiples of dollars invested, e.g., 1.5X, 2X, etc. A more investor friendly variation is what’s called participating preferred, in which the investors, after receiving their liquidation preference, then share pro rata in the remaining proceeds with the common shareholders, often up to some maximum amount.

So if a VC is not sanguine about a portfolio company’s long term prospects, he may be happy to sell the company for an amount equal to his liquidation preference, particularly at a point several years into the investment. In this regard, the time horizons of founders and institutional investors are inherently in conflict. A venture fund’s limited partnership agreement will typically limit the fund’s life tomoney vs. time ten years, with the initial three years designated for sourcing investments and the remaining seven for exits. With certain exceptions, a fund manager is required to distribute any profits to the fund’s limited partners by the expiration of that ten-year period, which is why a VC’s investment horizon in any given portfolio company is typically three to seven years. Consequently, a VC will often favor a quick exit because it offers a higher risk-adjusted return, and eliminates further risk to their investment. In other words, the VC might believe there’s some likelihood the company’s valuation may increase, but why risk it if he’s entitled to his liquidation preference, particularly if the wind-down of his fund is imminent? Free of such timing constraints, a founder on the other hand would almost always prefer to buy more time, particularly when the company’s projections show an upward trajectory. The founder’s problem, though, is that acquirors will generally value a company based primarily upon historical data, and will either ignore or heavily discount projected metrics.

State Law

So in a sale of the company proposed by the investors and opposed by the founders, who determines whether the deal gets consummated? The starting point is state law. The corporate statute of the state of the company’s incorporation will dictate the minimum vote threshold needed from shareholders. Some state statutes are more protective of common shareholders (founders almost always hold common shares) by requiring approval of the common holders voting separately as a class, essentially a group veto, and/or may require a supermajority vote, which gives the common the ability to block a deal if they collectively own enough shares to prevent the majority from meeting the vote threshold. States that are less protective of common shareholders will require only approval of a simple majority of holders of all shares outstanding, without requiring a separate class vote. That’s the Delaware model. New York voting rightscorporations organized before 1998 must secure a two-thirds majority of all holders unless their charter provides for a simple majority (simple majority for post-1998 corporations), and a separate class vote is required to approve a merger if the shareholders receive stock of the acquiror or another entity containing attributes not included in the target’s charter for which the target’s shareholders would have been required to approve in a separate class vote under New York law.

Another source of state law that impacts control over the deal process is case law regarding a director’s fiduciary duty. Before a proposed acquisition even gets to a shareholder vote, it must be approved first by a majority of the target company’s board, whose actions must be consistent with the directors’ fiduciary obligations. These include primarily the duty of care (generally, the obligation to be informed and diligent) and the duty of loyalty (essentially, the obligation to put the interests of the company and the shareholders above a director’s personal interests and not have any conflicts). Shareholders have a right to sue directors for breaches of fiduciary duty, and common shareholders will have a stronger or weaker case in attacking approval of the sale of a company as a violation of fiduciary duty depending on how favorable a particular state’s fiduciary duty case law is to the common holders. Delaware fiduciary duty case law is regarded as board friendly.

Contractual Terms

Some of the most important terms negotiated by VCs in a venture investment are the ones impacting control, both at the board level and the shareholder level. As mentioned above, a sale of the company must first be approved by a majority of the directors. The allocation of board seats is determined by negotiation during each round of funding. Although a fair outcome would be for investors to receive board representation in proportion to their share ownership (e.g., two of five seats when owning 40% of the outstanding shares), the investors will often negotiate for and receive disproportionate representation on the board and sometimes even a majority. A typical board composition arrangement might be a five-person board consisting of two directors designated by the investors, two directors selected by the common shareholders and one independent industry expert mutually selected by the common holders and the investors. But if the industry expert is someone with whom the investors have a preexisting relationship, human nature is such that he will view the investors as a source of future opportunities and tend to side with them, thus giving the investors an effective majority.

Other key control rights negotiated for by VCs are so-called protective provisions, which give the investors a veto over major decisions, including a sale of the company. Here, the battle is over what transactions or decisions make the list, and what vote threshold is required within the class of preferred. But a veto is only a right to block, not a right to approve. It doesn’t give the preferred the right to compel the company to consummate a deal opposed by the requisite holders. That’s where drag-along rights come into play.

Drag-along rights give investors the power to require other holders to vote in drag alongfavor of a deal the investors are proposing, sometimes conditioned on board approval. If a sufficient number of shares are so encumbered, the investors can ensure that holders of a requisite percentage of the outstanding shares or close enough to it vote to approve a deal favored by the investors.

So Who Controls the Deal Process?

Putting it all together, investors are more likely to control the deal process if all or at least some of the following are true: the company is incorporated in a state that does not require a class vote of the common to approve a sale of the company, the state has fiduciary duty case law favorable to directors, the investors have an actual or effective majority of the board and the investors control the cap table either outright or through a combination of ownership and drag along rights. In limited cases, the common shareholders will nevertheless be able to negotiate for a share of the proceeds in sub-liquidation preference deals, getting the preferred to relinquish some of the amount they’re otherwise contractually entitled to. Such an outcome is more likely to occur where the investors are able to approve a deal at the board level, but the common shareholders have one or more of the other factors in their favor, such as ownership of enough shares to block the vote or the benefit of common shareholder favorable fiduciary duty state case law. Or sometimes, the VCs just want to sweeten the pot to create the appearance of fairness to preserve a good reputation. But the VCs will rarely just give anything anyway; they’ll likely condition any common shareholder liquidation preference carveout on the recipients signing a release.

Snap IPOThe just completed IPO of Snap Inc. has received enormous buzz and plenty of press coverage, mostly about its eye-popping valuation and offering proceeds, the big winners among the founders and early investors and the millennials who bought shares. But not nearly as much attention has been given to Snap’s tri-class capital structure and the nature of the shares that were actually issued in the IPO: the shares of Class A Common Stock sold in the IPO are non-voting. By its own admission, Snap may have pulled off the first ever IPO of non-voting stock.

Snap’s capital now consists of the non-voting Class A shares held by public investors, Class B shares snapIPO2with one vote per share held by early round investors, employees and directors and Class C shares with ten votes per share held by the founders. As a result of the Class C common stock that they hold, co-founders Evan Spiegel and Robert Murphy will be able to exercise voting rights with respect to an aggregate of 215,887,848 shares, representing approximately 88.5% of the voting power immediately following the offering. Consequently, Spiegel and Murphy, and potentially either one of them alone (see below), have the ability to control the outcome of all matters submitted to stockholders for approval, including election, removal, and replacement of directors and any merger or sale of all or substantially all of the assets.

Multiple class structures are not unusual, and several high profile companies went public with them in recent years. What’s unusual here is that whereas the shares sold in those other multiple class structure IPOs had at least some voting rights (typically, one vote per share vs. 10 for the founder class), Snap’s public offering shares have no voting rights. Technically, Delaware law would permit holders of Snap’s Class A non-voting stock nevertheless to vote with one vote per share on any proposal to amend the certificate of incorporation in any way that would adversely affect the holders of the Class A. For example, if a proposed amendment provided for the Class A to rank junior to the Class B and Class C with respect to dividends or acquisition proceeds, a Class A vote would be required and the holders of a majority of Class A shares could defeat that amendment. Such a proposal would be extremely rare, however, and the Class A holders would have no say in the much more typical matters of board elections and any proposed sale of the company.

Multiple share classes are especially useful to public technology companies because they give them the freedom to innovate without the constraints of “short termism” and also serve as a deterrence to takeover bids because of activists’ inability to manipulate the voting machinery for election of directors.

Snap’s Class A common stock will be its only class registered under Section 12 of the Securities Exchange Act, and because the Class A is non-voting, Snap will not be required to file proxy statements except for a rare case where a vote of the Class A common stock is required (see above). Nevertheless, Snap indicated in its S-1 that it will provide Class A holders any information that it provides voluntarily to Class B and Class C holders.

What makes Snap’s structure even more unusual is survivability and portability.  According to Snap’s S-1, If Spiegel’s or Murphy’s employment is terminated (which, because of their control, could only happen if they turn on each other), they will continue to have the ability to exercise the same significant voting power and continue to control the outcome of all matters submitted to stockholders for approval. A founder’s Class C shares will automatically convert into Class B shares, on a one-for-one basis, nine months following such founder’s zuckerbergdeath or on the date on which the number of outstanding Class C shares held by such holder represents less than 30% of the Class C (or 32,383,178 shares) held by such holder at the time of the IPO. Facebook, on the other hand, amended its certificate of incorporation so that Mark Zuckerberg’s majority voting control is good only while he is an executive at the company.

Snap’s capital structure has drawn some criticism. In a New York Times piece, Cal Berkley law professor Steven Davidoff Solomon referred to Snap’s IPO as “the most stockholder-unfriendly governance in an initial public offering, ever.” In the Harvard Law School Forum on Corporate Governance and Financial Regulation, Rob Kalb and Rob Yates of Institutional Stockholder Services cited a 2016 ISS study that showed that controlled companies had weaker governance standards and tended to underperform “with respect to total stockholder returns, revenue growth, return on equity, and dividend payout ratios.” And the Council of Institutional Investors sent a letter to Snap’s co-founders objecting to the capital structure and urging them to adopt a single class structure. While acknowledging that similar emerging companies with dynamic leadership and promising products have successfully raised capital despite having dual class structures, Snap’s structure is unusual in that the investors would have no voting rights and dual class company performance has been mixed at best.

When Google, Facebook and Under Armour went public, they each did so with a dual-class share structure that at least afforded public stockholders one vote per share. Nevertheless, each company subsequently requested stockholder approval for the issuance of a third class of non-voting shares. In each case, the purpose of creating a new non-voting class was to maintain founder voting control while simultaneously providing insider liquidity.

Despite the overall positive outcomes achieved by Google and Facebook for their stockholders, going public as a controlled company with an unequal-voting-rights structure is no guaranty for financial success. Groupon, Zynga and GoPro each went public with a dual-class structure, received poor ISS corporate governance scores indicating the highest levels of governance risk, and the share price of all three dropped precipitously since their respective IPOs.

Adding salt to the corporate governance wound, Snap is taking advantage of emerging growth company status under the JOBS Act, meaning that it is not required to comply with the auditor attestation requirements under Sarbanes-Oxley and the reduced executive compensation disclosure requirements and may delay adoption of new public-company accounting principles.

In the final analysis, investors will need to decide which Mark the Snap founders better resemble, Facebook’s Zuckerberg or Zynga’s Pincus. And looking beyond Snap, it remains to be seen whether other emerging companies adopt the Snap IPO playbook by launching IPOs with multiple-class structures that preserve founder control and give public stockholders little or no governance voice.

The cost of launching an Internet-based startup has fallen dramatically over the last 15 years. This democratization of internet-based entrepreneurship resulted primarily from two innovations: open source software and cloud computing. During the dot-com era, Internet-based startups had to build serversinfrastructure by acquiring expensive servers and software licenses and hiring IT support staff. So the first outside round of investment in an Internet-based startup was typically a Series A round of $3 million or more from one or more VCs. With the emergence of open-source software, however, startups for the most part were no longer forced to acquire software packages bundled with hardware. Another issue, though, was that startups had to acquire and maintain bandwidth to accommodate peak loads, resulting in expensive underutilization. But this all changed with the advent of cloud computing, which enabled entrepreneurs to launch an Internet startup with minimal upfront IT costs and to pay only for used bandwidth. In real dollars, the cost of starting up has declined from a few million dollars to a few hundred thousand dollars.

With the precipitous drop in the cost of launching an Internet-based startup came a significant rise in interest in seed investing by angels and early stage VCs. But the typical Series A document package (amended and restated certificate of incorporation, stock purchase agreement, voting agreement, cloudinvestor rights agreement, right of first refusal and co-sale agreement) is complex, time consuming and expensive to negotiate, and contains several economic, management and exit provisions that don’t become relevant until much later (e.g., if and when the company goes public). This level of complexity can be justified when a company is raising several million dollars, but not so for a seed round of a few hundred thousand.

The resulting pressure for deal document simplification has resulted over the last several years in innovative seed investment deal documents. Seed rounds are either structured as a simplified version of a priced Series A preferred stock or as debt that converts into the security issued in a next round of equity, typically at a discount. This Part I of a two part blog series on seed round investing will focus on priced equity structures; Part II will address convertible debt.

There are currently two alternative open sourced sets of equity seed round deal documents to choose from, each with the common goals of term simplification, cost reduction, transaction time compression and document standardization. Both feature terms similar to those found in a typical Series A deal, but stripped down from the robust set of economic, voting and exit rights usually contained in a Series A. The two deal document products are:

Series AA: Created by Cooley cooleyfor accelerator Techstarstechstarsfenwick
Series Seed: Created by Fenwick & West

The main terms of Series AA and Series Seed are as follows:

1X Non-Participating Preferred: Both Series Seed and Series AA feature 1X non-participating preferred stock, meaning on a sale of the company the investor must choose between his liquidation preference of 1X (i.e., one times his investment amount) or the proceeds he would receive on an as converted basis, but not both. In other words, the investor calculates which would yield the bigger payout and choose that one. On the other hand, participating preferred would give the investor two bites of the apple: first his liquidation preference, and then his share of remaining proceeds as a common shareholder on an as converted basis.

Antidilution Protection: Series Seed provides no antidilution protection. Series AA, however, has broad based weighted average antidilution protection. Most notably, antidilution protects the investor from the economic dilution resulting from down rounds. Weighted average is the type of protection that is more fair in that it factors in the dilutive effect of the actual down round (i.e., the conversion price doesn’t adjust all the way down to the lower down round price but rather takes into consideration the number of additional shares issued at the lower price relative to the number of shares outstanding), and broad based requires inclusion in the number of shares outstanding all outstanding options and options reserved for issuance (as opposed to narrow based which would not include options).

Board Composition: Both Series AA and Series Seed provide for boards consisting of 2 common and one preferred, except that Series AA conditions the preferred board member on the Series AA shares constituting at least 5% of the outstanding equity on a fully diluted basis.

Protective Provisions: These are veto rights in favor of the preferred. Series AA gives vetos over only changes to the Series AA. Series Seed includes vetos over changes in the Series AA, but also includes vetos over mergers, increasing or decreasing authorized shares of any class or series, authorizing any new class or series senior to or on a parity with any series of preferred, stock redemption, dividends, number of directors and liquidation/dissolution.

Right of First Offer on New Financings: Both Series Seed and Series AA give investors the right to purchase their pro rata share of new issuances.

Right of First Refusal: Series Seed gives investors a right of first refusal on shares held by key holders. Series AA does not.

Drag Along Rights: Series Seed gives Series Seed holders and founders the right to require common holders to include their shares or vote for any transaction approved by the board, by a majority of the common and by a majority of the Series Seed. No drag along in the Series AA.

So what standard Series A terms are missing from Series Seed and Series AA? Missing are dividend preference (not a big deal here inasmuch as the overwhelming majority of startups will not pay out dividends), registration rights and tag-along rights (also not a big deal inasmuch as founders rarely have an opportunity to sell their shares).

Overall, Series Seed and Series AA are worthy efforts to simplify terms and reduce transaction costs. There will certainly be situations, however, where investors will resist the weaker investor protections such as the absence of participating preferred and anti-dilution protection and stripped down protective provisions. Any effort to negotiate some terms back in will undercut the objective of diversification and simplicity.

Lane Becker, Former CEO of Get Satisfaction
Lane Becker, Former CEO of Get Satisfaction

The Founder of a $50 Million Startup Just Sold His Company — And He Didn’t Make a Dime”.  Such was the provocative headline of the Business Insider article last year reporting the sad tale of young entrepreneur Lane Becker and how he and his management team received none of the acquisition proceeds on the sale of Get Satisfaction, the company Becker founded.  Becker’s fate was not anomalous, and happens when the cumulative liquidation preference amount payable to investors exceeds the value of the company itself.  In this blog post, I’ll briefly explain the liquidation preference overhang phenomenon and discuss how to keep founders and key employees incentivized with a carveout arrangement.

Liquidation preference is a key term negotiated in venture and even seed stage investments. It’s the amount of money the preferred stockholders are contractually entitled to receive off the top on a sale of the company before the common stockholders receive anything.  The common stockholders receive only the balance after the liquidation preference is paid, and if the liquidation preference has a participating feature, the preferred stockholders also participate pro rata in that balance on an as-converted basis.

I have previously blogged here and here about how entrepreneurs often are too fixated on valuation and tend to overlook at their peril the impact that liquidation preference can have on the value of the entrepreneurs’ equity stake. A rich valuation could be completely undercut by a heavy liquidation preference stack.  For example, suppose an investor is proposing to invest $20 million at a pre-money valuation of $60 million for Series B preferred stock constituting 25% of the total equity on an as converted fully-diluted basis and includes a 2x liquidation preference.  The founder is giddy about the $60 million pre-money valuation and takes the deal.  The company had previously raised $10 million in a Series A round where the Series A had a 1x liquidation preference.  Two years after the Series B, the company is sputtering, challenged by competitors and investors and management alike believe the company may only be valued at $40 million, $10 million below the cumulative liquidation preference of $50 million (2 x $20,000,000 (Series B) + 1 x $10,000,000 (Series A)).  Founders’ and management’s common shares are essentially worthless and, consequently, they have little or no incentive to work hard and help the company succeed.

Prior to being acquired, Get Satisfaction was reported to have raised $10 million in a Series B round at a pre-money valuation of $50 million, bringing the total amount raised to $21 million. The purchase price of the acquisition was not disclosed, but it must have been less than $21 million for management to have been washed out (assuming a 1x liquidation preference).

In Lane Becker’s case, he had been terminated as CEO a few years prior to the acquisition of Get Satisfaction, which could happen when founders negotiate away control of their company. But what happens in the more typical scenario when founders are still the CEO or otherwise are employed by and managing the company at a time when the liquidation overhang looms, i.e., when the aggregate liquidation preference amounts exceed the company’s valuation?  What incentive does the common stock holding management team have to stick it out?  Cash compensation will rarely get management satisfaction (pun intended), either because startups seldom have the cash to do so or because cash compensation was never a motivating factor for key employees to begin with.  By joining a startup, talented employees typically sacrifice higher cash compensation they could earn with more established companies in favor of the upside potential that comes with equity they receive in the startup.  Hence, the drill would be to come up with a mechanism that simulates the upside potential of equity without that upside being negated by the liquidation preference overhang.

That mechanism is a bonus or carve-out plan that provides for a payout to carveouteligible employees upon a sale of the company or other liquidity events identified in the plan. A typical plan sets aside a pool of money whose amount is determined based upon a certain percentage of acquisition proceeds.  A well drafted plan would address certain issues related to calculating the proceeds upon which the payout is determined, such as assumption of debt by the purchaser, deferred payments, earnouts and contingent payments.  The relevant percentage may also be on a sliding scale, e.g., 3% on the first $100 million, 5% on the next $50 million and 7% on amounts exceeding $150 million.

Inasmuch as these plans are intended to provide value to common stockholders when the common is worthless, plans could (or should) consider the value of the common (i.e., when the purchase price exceeds the liquidation preference amount) as an offset to payouts and also set a ceiling on payouts. The plan could be structured either as a quasi-contractual commitment by the company in the form of a benefit plan or as a special class of common stock that would be issued to founders and key employees that would be pari passu with the preferred but have a separately calculated payout formula upon the sale of the company.

It’s never easy to take an entire business day out of the office, but the annual Cornell Entrepreneurship Summit is well worth it.  The 2014 edition, dubbed “Beyond the Horizon”, was no exception.  One thing that struck me about this year’s summit was that, unlike previous years, none of the entrepreneur speakers were Cornell alums, demonstrating that the summit has evolved from a Cornell entrepreneurship event to a Cornell event about entrepreneurship.  As to the speakers, here are some of the more memorable and meaningful takeaways for me.

Skybox CEO Tom Ingersoll
How did a startup succeed in creating a real-time Google-Earth?  Skybox Imaging CEO Tom Ingersoll asked the audience, “Have you looked at your house on Google Earth? Disappointed it was two years old?” Because satellites are so expensive to build and launch, most of the pictures that we see are of poor quality and years out of date. Until now. Skybox knew that real-time satellite imaging would require dozens of satellites, a prohibitively expensive endeavor with the cost of a single satellite being around $850 million.  So Skybox needed to find a way to build satellites for a fraction of that, and created a lightweight, nimble satellite in-house for about $10 million.  Ingersoll insisted that the key to Skybox’s success is in execution, and evoked the line mostly attributed to Thomas Edison (also a favorite of Steve Jobs):  “Vision without execution is hallucination”.  Ingersoll said that another key to Skybox’s success is that it has had a patient board of directors, which enabled Skybox to say “no” to Google twice, before finally agreeing to be acquired earlier this year.

If a company offered its employees unlimited vacation time, would anyone show up to work?  Return Path CEO Matt Blumberg revealed that when his company instituted that policy it experienced no higher vacation rates.   The author of “Start-Up CEO” said that his employees are encouraged to take as much time off as they can while maintaining high performance and achieving milestones.  “We don’t count the hours they work, so why should we count the hours they don’t?”

Sols CEO Kegan Schouwenburg

“We went from the cobbler to standardized mass manufacturing and now today we are going to change all that with digital manufacturing”, announced Kegan Schouwenburg, CEO of Sols Systems.  Sols captures a 3-D model of a patient’s foot, makes therapeutic adjustments in a web-based app and manufactures a final product with a 3-D printer.  Schouwenburg also demonstrated the direct to consumer version of the service where a customer can scan his or her own foot with a smartphone and order a custom fit insert.  “One super cool thing about digital manufacturing: no waste”, Schouwenburg said.

Despite recent mega-exits like WhatsApp, Tumblr and Waze, billion-dollar exits are rare, so much so that they’ve been designated the name of a mythical creature, a unicorn.  Every VC chases them.  “Birthing a unicorn is hard”, proclaimed CB Insights CEO Anand Sanwal.  Sanwal’s data shows that only one percent of exits are unicorns, while 72% are below $200 million.  Sanwal said that we may not be in a bubble yet, but valuations are “frothy”.  Although billion dollar valuations require lots of capital raising, some of the recent unicorns raised money late at higher valuations, or never, including Shutterstock and former Cornell Entrepreneurship Summit presenter Wayfair, and Anand said that “these are the companies we should celebrate”.

In Part I of this two-part series, I explained how a favorable pre-money valuation can be undercut by a large option pool baked into the pre-money cap table.  In this Part II of the series, I will concentrate on one other deal term that can serve to undermine a negotiated valuation:  liquidation preferences.  Failure to focus sufficiently on liquidation preference mechanics could also lead to a distortion of incentives and serious strategic issues down the road.

First, a simple scenario.  You’re a startup founder negotiating a $5 million Series A round with a VC and you agree on what seems like a generous pre-money valuation of $10 million.  The company issues the VC preferred shares constituting one-third of the overall equity of the company ($5 million/$15 million post money).  The company grows nicely over the next seven years and receives an acquisition offer of $30 million.  You can hardly believe your good fortune as you quickly calculate that you, your co-founders and angel investors will collectively reap $20 million (2/3 of $30 million).  But your lawyer takes a look at your charter and delivers the bad news: the common holders’ share of the proceeds is actually only $11 million.  What happened?    

In most VC deals, the investors receive shares of preferred stock in exchange for their investment.  Although this form of security is usually associated with a whole range of economic, management and exit rights superior to common stock, the name preferred derives from one of the most important of these rights, namely the liquidation preference.  In its simplest form, the “liq pref” (as VCs often refer to it) is the investor’s right on a sale of the company to receive a certain amount of the proceeds off the top before the common holders receive anything.  In the real world, however, liquidation preference provisions are more complicated, so I’ll describe the typical variations and how they could end up impacting the acquisition proceeds waterfall in spite of the negotiated pre-money valuation.

The amount of the initial preference is usually not less than the amount invested, and is often a multiple of that amount, e.g., 1.5x, 2x, etc.  It’s also not uncommon for accrued but unpaid dividends to be added to the initial amount.  What happens next depends on whether the preference is participating or non-participating.  With participating preferred, the investor first receives the agreed-upon initial amount before the common holders receive anything, and then shares the balance of the proceeds (if any) pro-rata with the common on an as-converted basis.  With non-participating preferred, the investor does not share with the common after his initial preference amount.  But remember, preferred almost always has a conversion feature allowing a preferred holder to forego his preference and convert to common.  So with non-participating preferred, the holder has a choice to make, depending on what yields the most proceeds for him: either the preference amount, or his pro rata share on conversion.  With participating preferred, the holder generally does not have to make that choice; he gets the initial preference, and then he gets his pro rata share of the balance on an as-converted basis (but see below regarding capped participation).

In the above hypothetical Series A deal, the VC agreed to a $10 million pre-money valuation, thus receiving 1/3 of the overall equity, but also negotiated for and received a fully participating 2x liquidation preference with annual 10% cumulative dividends (payable on a sale).  The math works as follows:

 

Initial Preference                                             $13,500,000

            2 x $5,000,000            $10,000,000

            10% x 7 yrs.                $  3,500,000

 1/3 Participation                                               $ 5,500,000

            1/3 x $16,500,000       $  5,500,000

 Proceeds to Preferred                                       $19,000,000

 Proceeds to Common                                       $11,000,000

Companies will often try to limit the sting of the “double-dip” participation feature by negotiating a cap on the participation that follows the initial preference.  The cap is expressed in terms of a multiple of the investment amount, usually in the range of 2x to 3x, and the cap almost always includes the initial preference amount.  This is called capped participation, and participating preferred with no cap is referred to as full participating preferred. 

On the surface, both non-participating and capped participation seem better for the founders, but in practice both could lead to a distortion of incentives for the preferred and unintended consequences for everyone.  With full participation, the interests of the common and preferred will always be aligned; both classes will always be incentivized to seek the highest purchase price.  But with both non-participating and capped participation, there could be a range of prices in which the preferred have no incentive to seek a marginally higher price because within that range the common receive 100% of the marginal increase in price and the preferred receive no additional consideration. 

The two examples below illustrate this point.  Both examples assume a 1x liquidation preference on a $10 million investment, and a $10 million pre-money valuation where the investor is issued 50% of the equity.

EXAMPLE ONE: NON-PARTICIPATING

Acquisition Price

Proceeds to Preferred

Proceeds to Common

$10,000,000

$10,000,000

$0

$15,000,000

$10,000,000

$5,000,000

$20,000,000

$10,000,000

$10,000,000

EXAMPLE TWO: PARTICIPATION CAPPED AT 1.5X

Acquisition Price

Proceeds to Preferred

Proceeds to Common

$10,000,000

$10,000,000

$0

$15,000,000

$12,500,000

$2,500,000

$20,000,000

$15,000,000

$5,000,000

$30,000,000

$15,000,000

$15,000,000

 

Because neither of the above examples is fully-participating, the investor at some point will elect to convert to common and forego the liquidation preference, in each case at the point at which the purchase price is high enough so that the investor receives a higher pro-rata share on an as-converted basis than he’ll receive without conversion.  But notice that in each case there’s a range of purchase prices at which the investor stops receiving additional proceeds on the liquidation preference (on the lower end of this range) and before it makes economic sense for the investor to convert (at just above the upper end of the range).  In the first example, because there is no participation, the investor receives no additional proceeds between a $10 million and a $20 million purchase price (just above the latter being the point at which the investor would convert and take his 50% share).  So assuming the VC is looking to exit and the company receives an offer of $10 million, the investor would have no incentive to seek a higher price unless he believed the price could exceed $20 million.  Similarly, in the second example with a 1.5x participation cap, the investor would have no incentive to seek a price higher than $20 million (at which point he’s capped out at $15 million), unless he believes a $30 million price is achievable currently (above which he’d convert to common and surpass $15 million in proceeds). 

The foregoing phenomenon has been referred to by commentators as the dead zone or the zone of indifference.  I’ll call it the “range of indifference” just to be different.  Once the VC is in the range of indifference, he has no incentive either to negotiate for a higher price, or to defer a sale altogether to build more value in the company.  Even if the investor believed the Company may be worth 50% more in two years, he would have no incentive to take that risk because he’d receive no additional proceeds from the higher price.  The common holders, of course, would have the exact opposite set of incentives and would seek either to negotiate for a higher price or to continue to build value in the company in the hope of selling for a higher price down the road.  This distortion of incentives resulting from the range of indifference actually gets even more complicated as the company completes additional rounds of funding and particularly when an investor in a later round such as a Series D has priority over earlier rounds of preferred.

In any seed or early stage round negotiation between a company and a VC, one of the first and most contentious issues to be negotiated is valuation.  A company’s pre-money valuation will determine how much equity will need to be issued to the investor for any given amount of investment, and thus on its face would appear to be the most critical term in any term sheet.  But as I will show in this two-part series, a favorable pre-money valuation can be undercut by a large option pool baked into the pre-money shares outstanding and/or by a generous liquidation preference.  In this Part I of the series, I will concentrate on the option pool.

VCs almost always insist on a pool of options to be set aside for grants to key employees, both to recruit new talent and to retain existing talent. Startups and emerging companies are typically cash poor and thus have no choice but to use stock as compensation currency.  Options (or restricted stock) also serve to incentivize the management team with the chance to ride the upside potential of the company.  The existence of an option pool in and of itself is not controversial; the way it’s structured can be – if founders are paying attention.

Option pools are typically expressed as a percentage of the post-money shares outstanding on a fully-diluted basis, usually in the range of 10% – 20%.  So if the post-money number of fully-diluted shares (i.e., outstanding shares plus all shares that are subject to options and other rights to acquire shares) before adding the option pool is one million, a 10% option pool would consist of approximately 112,500 shares (112,500/1,112,500 = 10%).  So far so good.

Where the option pool gets interesting is in its impact on price per share of the VC’s investment, which in turn dictates the number of shares and the percentage of total equity to be issued to the investor.  Price per share is calculated by dividing the pre-money valuation by the pre-money number of shares outstanding, typically on a fully-diluted basis.  The issue then is what constitutes “fully-diluted”, i.e., which rights to acquire shares are included in calculating the total number of “fully-diluted” shares.  Should the options to be included in total shares be limited only to those that are outstanding (in other words, those that have been granted but not yet exercised), or should it be viewed more broadly to include options that have been authorized but not yet granted as in the option pool to be agreed upon with the VC?

If option pool shares are included in the pre-money fully-diluted outstanding, the price per share will be reduced and more shares will get issued to the VC.  Accordingly, whether or not the option pool gets baked into the pre-money fully-diluted outstanding shares is an issue with real consequences, as it determines whether founders get diluted disproportionately or just pro rata with the VC.  If the shares in the option pool are included in the pre-money fully-diluted shares, the founders get diluted disproportionately by the option pool shares; if the option pool is excluded from the pre-money shares outstanding, both founders and the VC get diluted proportionately.

VCs will almost always include the option pool in the pre-money shares outstanding.  A typical term sheet submitted by a VC will contain a provision on this point as follows:

“The purchase price per share is based upon a fully-diluted pre-money valuation of $[_____] (including an employee pool representing [__]% of the fully diluted post-money capitalization).”

Most entrepreneurs obsess on the portion of the foregoing sentence preceding the parenthetical; they should focus on the parenthetical as well.  Simple illustration: Assume a pre-money valuation of $4 million, one million shares outstanding, a VC investment of $1 million and a 15% option pool.  Now assume the company is sold for $10 million (the liquidation preference impact on valuation will be explored in Part II of this two-part series).  The difference in outcomes is illustrated in the charts below:

Pre-Money Valuation $4,000,000
Founders Shares   1,000,000
VC Investment $1,000,000

Scenario 1:  No Option Pool

Founders Shares 1,000,000   (80% post)
Price per Share $4 ($4,000,000/1,000,000)
VC Shares 250,000 ($1,000,000/$4) (20% post)
Proceeds per Share $8
Proceeds to VC $2,000,000
Proceeds to Founders $8,000,000

Scenario 2:  Option Pool Not Baked into Pre-Money

Founders Shares 1,000,000   (68% post)
Price per Share $4 ($4,000,000/1,000,000)
VC Shares 250,000 ($1,000,000/$4) (17% post)
Option Shares 220,588 (15% x 1,470,588 = 220,588)
Proceeds per Share $6.80
Proceeds to Employees $1,500,000
Proceeds to VC $1,700,000
Proceeds to Founders $6,800,000

Scenario 3:  Option Pool Baked into Pre-Money

Founders Shares 1,000,000 (65%)
Price per Share $3.25 ($4,000,000/1,230,769)
VC Shares 307,692 ($1,000,000/$3.25) (20% post)
Option Shares 230,769 (15% x 1,538,461 = 230,769)
Proceeds per Share $6.50
Proceeds to Employees $1,500,000
Proceeds to VC $2,000,000
Proceeds to Founders $6,500,000

As indicated above, the consequence of the option pool getting baked into the pre-money shares is that the founders get diluted from 80% to 65%.  In absolute dollar terms, the result becomes more dramatic as the proceeds on the sale of the company increase. The VC, however, remains at 20%.

As between the VC and the founders, the VC actually has the better argument here.  The pre-money valuation is predicated on a management team capable of successfully implementing the business plan.  If the founders themselves do not constitute a complete management team, any equity needed to recruit talent should come out of their basket.  The pain to the founders could be mitigated by limiting the option pool to a reasonable level.  As a general rule, the pool should be just enough to cover the grants expected to be made until the next funding round.  The founders should endeavor to present a credible plan showing how many options the company will need to grant to satisfy its recruiting and retention needs up to that next round.

The other way to approach all of this is to treat the pre-money option pool placement as an alternative to lowering the valuation.  In the above example, by putting a 15% post-money option pool in the pre-money calculation, the VC was essentially asserting that the company is effectively valued at $3.25 million, not $4 million.  But the term sheet will not say “the effective pre-money valuation is $3,250,000.”  That’s for the founders to figure out.

My next blog post will explore the other major valuation buster, liquidation preference, which could have an even more dramatic effect on the founders’ bottom line.

 

Your startup was launched only a few months ago and your co-founder has just informed you that he’s leaving.  It hits you that your co-founder just walked out the door with 50% of the equity in the company.  Oops.

Founder breakups are not uncommon, but what happens to the exiting founder’s stock will depend on whether or not the founders had agreed in advance on a vesting arrangement.  Essentially, vesting of stock means that all or a portion of it effectively gets “earned” either over time or upon achieving milestones or a combination of both.  The purpose is to align incentives: encourage founders to remain with the company and avoid the unfairness inherent in walking away with unearned equity.  The arrangement is typically effectuated with the right of the company to repurchase the individual’s unvested shares, usually at some nominal price.

Background

So if the company could be given the right to repurchase unvested shares for a nominal amount, why not just issue the shares at each vesting interval instead of issuing them all at the outset and then repurchasing shares that haven’t vested?  The answer is that issuing shares subject to vesting creates a significant tax planning opportunity for the shareholder.  Shareholders are typically better off being taxed when shares are least valuable, i.e., at or within a short period following formation.  Although shares issued under a vesting schedule are subject to a substantial risk of forfeiture and would therefore generally be taxed as they vest, shareholders can choose to be taxed at the time of issuance, i.e., when the shares are valued low, by filing a simple Section 83(b) election with the IRS.

Another reason for founders to agree to subject their shares to vesting is that VCs will typically insist on it at the time of their investment in order to incentivize founders to stay, and VCs are more likely to agree to preexisting vesting arrangements if they are reasonable.

Vesting arrangements involve several variables, each of which should be considered based upon the unique facts and circumstances of each case.  The three main variables are vesting schedules, repurchase price and acceleration.

Vesting Schedules

 Vesting schedules can be either time based, milestone based or a combination of both.  Careful consideration should be given to immediate vesting of a portion of the shares allocated to a founder to the extent that founder has made any significant pre-issuance contributions to the startup.  Vesting schedules should also be driven by founders’ expectations of their respective efforts going forward.  The most common arrangement is four-year vesting with a one-year cliff, meaning that 25% of the individual’s total share allocation vests after one year, with 1/48th of the total shares vesting every month for the next 36 months.  Of course any significant pre-issuance contribution by a founder might justify vesting a certain percentage right away.  Milestone-based vesting (e.g., some percentage of shares vest upon the development of a prototype) might be appropriate for a founder who is being relied upon to focus on development of the company’s technology.

Repurchase Price

Under any vesting arrangement, the company has the right to repurchase any shares that have not yet vested at the time of termination of employment.  The repurchase price in most vesting arrangements is some nominal amount per share (e.g., $0.0001 per share), which is intended to be the amount paid by the founder, regardless of the nature of departure.  Arguably, upon terminations by the company without “cause” or by the founder for “good reason”, the vesting agreement should provide for repurchase at fair market value at the time of repurchase as determined by the board of directors in good faith or as otherwise determined by the parties.

 Acceleration

Founders usually negotiate for accelerated vesting upon an acquisition or change of control of the company.  Investors resist this on the theory that it would make the company a less attractive acquisition candidate inasmuch as a buyer will want to know that key employees will continue to be incentivized to remain with the company at least through some transition period.  A compromise here would be something called double trigger acceleration: unvested shares would vest automatically if the founder is terminated (typically without cause) within some period of time, usually six months to one year, following a change of control.  Most acceleration provisions call for vesting of 100% of unvested shares upon the triggering event.  A better approach might be to equate the percentage of acceleration with severance.  If the individual is entitled to severance of 50% of base salary upon a termination following a change of control, perhaps the vesting of 50% of unvested shares should be accelerated.