Startup Equity 101 vs 5 01 13

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Fundamentals of startup equity with a focus on employe incentive grants, corporate structures and tax liabilities

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Startup Equity 101 vs 5 01 13

  1. 1. Startup Equity 101 Primerfor Founders and EmployeesMay 1, 2013by Jamie Lee@jieunjamiewith Ekaterina Mouratova, PLLCwww.mouratovalawfirm.comThursday, May 2, 13
  2. 2. DisclaimerHi! I’m not an accountant or a lawyer.The information contained herein and ensuing discussionshould NOT be considered tax or legal advice.The information is intended to help you get familiarized withgeneral concepts in startup finance, which may or may notapply to your situation.Thank you!Jamie Lee@jieunjamiejieunjamie.comThursday, May 2, 13
  3. 3. Startup Equity: More ART than SCIENCEbut still need to ASK questionsThursday, May 2, 13
  4. 4. Before joining a startup, ask•Is this the right team and company for my success?•What is my percentage of ownership?•What is total company capitalization?•How long is my vesting schedule?•What are tax implications?•What is the estimated valuation at exit?•What do I need to do when I leave?Startup Equity: More ART than SCIENCEbut still need to ASK questionsThursday, May 2, 13
  5. 5. Before joining a startup, ask•Is this the right team and company for my success?•What is my percentage of ownership?•What is total company capitalization?•How long is my vesting schedule?•What are tax implications?•What is the estimated valuation at exit?•What do I need to do when I leave?Startup Equity: More ART than SCIENCEbut still need to ASK questionsIf you’re a founder or employee,•Research market rate salary and equity comp•Read the partnership and employment agreements•Negotiate like a business person•Consult a lawyer or tax accountant (devil’s in the details)•Exercise your options early•Make 83b election ASAP for restricted stock grantsThursday, May 2, 13
  6. 6. High(1)High ReturnLow Risk(2)High ReturnHigh RiskLow(3)Low ReturnLow Risk(4)Low ReturnHigh RiskLow HighriskreturnStartup Equity: Think like an investorConsider the risk profile of your investment.Thursday, May 2, 13
  7. 7. High(1)High ReturnLow Risk(2)High ReturnHigh RiskLow(3)Low ReturnLow Risk(4)Low ReturnHigh RiskLow HighriskreturnStartup Equity: Think like an investorConsider the risk profile of your investment.Thursday, May 2, 13
  8. 8. High(1)High ReturnLow Risk(2)High ReturnHigh RiskLow(3)Low ReturnLow Risk(4)Low ReturnHigh RiskLow HighriskreturnStartup Equity: Think like an investorConsider the risk profile of your investment.Thursday, May 2, 13
  9. 9. High(1)High ReturnLow Risk(2)High ReturnHigh RiskLow(3)Low ReturnLow Risk(4)Low ReturnHigh RiskLow HighriskreturnStartup Equity: Think like an investorConsider the risk profile of your investment.Thursday, May 2, 13
  10. 10. High(1)High ReturnLow Risk(2)High ReturnHigh RiskLow(3)Low ReturnLow Risk(4)Low ReturnHigh RiskLow HighriskreturnStartup Equity: Think like an investorConsider the risk profile of your investment.Thursday, May 2, 13
  11. 11. High(1)High ReturnLow Risk(2)High ReturnHigh RiskLow(3)Low ReturnLow Risk(4)Low ReturnHigh RiskLow HighriskreturnStartup Equity: Think like an investorConsider the risk profile of your investment.Your startup is like your baby.But let’s face it, most of us won’t workat the next Facebook or Google.Thursday, May 2, 13
  12. 12. High(1)High ReturnLow Risk(2)High ReturnHigh RiskLow(3)Low ReturnLow Risk(4)Low ReturnHigh RiskLow HighriskreturnStartup Equity: Think like an investorConsider the risk profile of your investment.Your startup is like your baby.But let’s face it, most of us won’t workat the next Facebook or Google.Thursday, May 2, 13
  13. 13. High(1)High ReturnLow Risk(2)High ReturnHigh RiskLow(3)Low ReturnLow Risk(4)Low ReturnHigh RiskLow HighriskreturnStartup Equity: Think like an investorConsider the risk profile of your investment.Your startup is like your baby.But let’s face it, most of us won’t workat the next Facebook or Google.Thursday, May 2, 13
  14. 14. High(1)High ReturnLow Risk(2)High ReturnHigh RiskLow(3)Low ReturnLow Risk(4)Low ReturnHigh RiskLow HighriskreturnStartup Equity: Think like an investorConsider the risk profile of your investment.Your startup is like your baby.But let’s face it, most of us won’t workat the next Facebook or Google.Brave souls featured inRead Write’s “8 Real-World Stories Of WhyStartups Fail”Failure is like a badge ofhonor, and a greatteacher. Financiallyspeaking, it means noreturn.Thursday, May 2, 13
  15. 15. High(1)High ReturnLow Risk(2)High ReturnHigh RiskLow(3)Low ReturnLow Risk(4)Low ReturnHigh RiskLow HighriskreturnStartup Equity: Think like an investorConsider the risk profile of your investment.Your startup is like your baby.But let’s face it, most of us won’t workat the next Facebook or Google.Brave souls featured inRead Write’s “8 Real-World Stories Of WhyStartups Fail”Failure is like a badge ofhonor, and a greatteacher. Financiallyspeaking, it means noreturn.Thursday, May 2, 13
  16. 16. High(1)High ReturnLow Risk(2)High ReturnHigh RiskLow(3)Low ReturnLow Risk(4)Low ReturnHigh RiskLow HighriskreturnStartup Equity: Think like an investorConsider the risk profile of your investment.Your startup is like your baby.But let’s face it, most of us won’t workat the next Facebook or Google.Brave souls featured inRead Write’s “8 Real-World Stories Of WhyStartups Fail”Failure is like a badge ofhonor, and a greatteacher. Financiallyspeaking, it means noreturn.Yup, that’sme.Thursday, May 2, 13
  17. 17. Startup Equity: Owning a piece of the pieThursday, May 2, 13
  18. 18. Startup Equity: Owning a piece of the pieThursday, May 2, 13
  19. 19. Startup Equity: Owning a piece of the pieLet’s say your startup is likea pizza pie you and yourteam make from scratch.Individual slices are ownedby different people, but theteam’s goal is to grow thepie as a whole.As more people getinvolved and invest, yourslice may get skinnier, andthe pie bigger.This is calleddilution.Thursday, May 2, 13
  20. 20. Startup Equity: Owning a piece of the pieLet’s say your startup is likea pizza pie you and yourteam make from scratch.Individual slices are ownedby different people, but theteam’s goal is to grow thepie as a whole.As more people getinvolved and invest, yourslice may get skinnier, andthe pie bigger.This is calleddilution.“Employee ownership issuch an important part ofstartup culture. It reinforcesthat everyone is on theteam, everyone is sharing inthe gains, and everyone is ashareholder.”- Fred Wilson,AVC.comThursday, May 2, 13
  21. 21. Startup Equity: Owning a piece of the pieLet’s say your startup is likea pizza pie you and yourteam make from scratch.Individual slices are ownedby different people, but theteam’s goal is to grow thepie as a whole.As more people getinvolved and invest, yourslice may get skinnier, andthe pie bigger.This is calleddilution.Founders**55% Investors*25%Employee Pool20%*Hypothetical situation where investorshave bought a quarter of the pie.**If you own 51% and more of acompany, you own controlling interest.“Employee ownership issuch an important part ofstartup culture. It reinforcesthat everyone is on theteam, everyone is sharing inthe gains, and everyone is ashareholder.”- Fred Wilson,AVC.comThursday, May 2, 13
  22. 22. Dilution is part of lifeEach new issuance of stocks results in dilution of existing shareholdersDilution is inevitable part of company growth.Pre-dilution1% ownership100,000 sharesTotal shares outstanding:10M shares, $1/share$100,000Slice of a small pieSeries A funding2M shares issuedat $3/shareTotal $ raised:$6M .8333% ownership100,000 sharesTotal shares outstanding:12M shares, $3/share$300,000Skinnier slice of a bigger piePost-dilutionThursday, May 2, 13
  23. 23. Employee Stock OwnershipTypically, total non-founder employee equitypool tends to fall between 10% - 20%.TitleOfTotal SharesCEO 5.00 - 10.00%C-level Executives 1.00 - 3.00%VP, Directors 0.50 - 2.00%Managers 0.25 - 1.00%Board Directors 0.50%Total capitalization = Total number of sharesissued by a company, including stocks and optionsCapitalization table = Spreadsheet that keepstrack of who owns what kind of ownership.Considered private and sensitive informationThursday, May 2, 13
  24. 24. Set you expectations right$ Cash CompEquity CompAt a smaller, younger, startup with less funding$ Cash CompEquity CompAt a bigger, more established company after several rounds of fundraisingThursday, May 2, 13
  25. 25. Startup Equity: Understand the Pecking OrderShareholdersBoard of DirectorsCEO•Board of Directors is legally bound to servein the best interest of shareholders.Thisresponsibility is called Fiduciary Duty.•Board of Directors sets general company policyand appoints, compensates, reviews and fires theCEO.•The lead investor in a round of funding usuallygets a Board seat.•CEO manages the company “at the pleasureof the Board.”Thursday, May 2, 13
  26. 26. Startup Equity: Common vs. PreferredWhogets them?Whatkind of rights?Whenare they issued?Whyare they issued?Howabout IPO?Founders, employees, some boardmembersOutside investors such asVCsAt incorporation and at the discretionof the Board of DirectorsWhen investors buy company shares.They usually pay a premium overCommon for Preferred. Named SeriesA, B, C, D, etc.To retain and motivate employees,in lieu of cash bonus, aka “Sweat Equity”To raise capital for company growth, etc.aka “Cash Equity”To attend shareholder meetingsCan include board seat, Preference,or the right to get paid beforecommon, right of first refusal, anti-dilution rights, right to convert toCommonEqual footing as Preferred Shares Preferred rights go awayThursday, May 2, 13
  27. 27. 1. Founders and founding members receivecommon shares. Special vesting schedule applies.2. Restricted stocks are issued to employees atearly stage companies while the value of stock isrelatively low.3. Stock options are the most common form ofemployee equity.You may have heard of the ESOP – Employee StockOption Plan and ISOP –Incentive Stock OptionPlanTypes of Common EquityApple Computer, Inc.Incorporated on Jan 3,1977Stock value: $0Thursday, May 2, 13
  28. 28. Restricted StockWhat yougetStock granted as a form of compensation with restrictions.Nitty GrittyOften the restriction is continued employment during period of time, uponwhich the shares vest. Or the restriction can be performance based.Legal & TaxFine PrintUnder the 83(b) IRS code, you can recognize “income” upon granting of stock.Income is difference between FMV and stock price, which are typically thesame. Meaning no income is recognized. Must be sent to IRS within 30 daysfrom day of purchase or grant of shares.Thursday, May 2, 13
  29. 29. Vesting Schedule4 year vesting with 1 year cliff is common.1 year cliff means you don’t vest duringthe 1st year. If you leave during this period,you leave with no equity.Unvested equity may be repurchased by thecompany and returned to the employeepool.Idea is to avoid a “hit and run” situation andto retain talented employees.Oops27.1%+1 mo.Day 1 1st year 2nd year 3rd year 4th year0% 25% 50% 75% 100%0 2,5002,7105,000 7,500 10,000VestedSharesGenerally, option strike price will not change throughout vesting schedule.Thursday, May 2, 13
  30. 30. Thursday, May 2, 13
  31. 31. (83B is beautiful)Thursday, May 2, 13
  32. 32. FMV Cost to EE(83B is beautiful)Thursday, May 2, 13
  33. 33. $0$25$50$75$1002013 2014 2015 2016Company XYZ Share PriceFMV Cost to EE(83B is beautiful)Thursday, May 2, 13
  34. 34. $0$25$50$75$1002013 2014 2015 2016Company XYZ Share PriceFMV Cost to EE100 shrs granted to EE at FMV of$1.00 with 4 year vest. EE files83B Election recognizing incomeof $1 (FMV) - $1 (shr price) = $0(83B is beautiful)Thursday, May 2, 13
  35. 35. $0$25$50$75$1002013 2014 2015 2016Company XYZ Share PriceFMV Cost to EE100 shrs granted to EE at FMV of$1.00 with 4 year vest. EE files83B Election recognizing incomeof $1 (FMV) - $1 (shr price) = $0At end of 1 year anniversary,25 shares vested to EE.FMV rose to $5/shr.($5 - $1) x 25 shares = $100Don’t owe taxes until you sell.(83B is beautiful)Thursday, May 2, 13
  36. 36. $0$25$50$75$1002013 2014 2015 2016Company XYZ Share PriceFMV Cost to EE100 shrs granted to EE at FMV of$1.00 with 4 year vest. EE files83B Election recognizing incomeof $1 (FMV) - $1 (shr price) = $0At end of 1 year anniversary,25 shares vested to EE.FMV rose to $5/shr.($5 - $1) x 25 shares = $100Don’t owe taxes until you sell.After 2 years, 50 shares vested to EE.FMV rose to $25/shr.($25 - $1) x 50 shares = $1,200 value.Don’t owe taxes until you sell.(83B is beautiful)Thursday, May 2, 13
  37. 37. Stock OptionsWhat yougetRight to buy stock at strike price.You exercise your option when you buy stock.NittyGrittyBoard of directors sets the strike price based on fair market value (FMV) of commonstock decided by a 409aValuation.“At the money” means that FMV is equal to strikeprice (and not liable for taxes).Legal &Tax FinePrintOnce you exercise your option, you are liable for tax on the gain, or differencebetween FMV and strike price, as ordinary income*. Capital gains from stock heldlonger than one year is taxable as long term capital gains. Most companies requireoption holders to exercise within 90 days of termination.You may be able tonegotiate a “cashless exercise” or cash bonus to cover the exercise price.*unless the option is Incentive Stock OptionThursday, May 2, 13
  38. 38. Incentive Stock OptionIncentive stock options (ISOs), are a type of employee stock option that canbe granted only to employees and confer a U.S. tax benefit.The tax benefit is that on exercise the individual does not have to payordinary income tax (nor employment taxes) on the difference between theexercise price and the fair market value of the shares issued (however, theholder may have to pay U.S. alternative minimum tax instead).Instead, if the shares are held for 1 year from the date of exercise and 2 yearsfrom the date of grant, then the profit (if any) made on sale of the shares istaxed as long-term capital gain. Long-term capital gain is taxed in the U.S. atlower rates than ordinary income.**straight out of WikipediaThursday, May 2, 13
  39. 39. Thursday, May 2, 13
  40. 40. $0$15$30$45$60$75$902013 2014 2015 2016 2017 2018Company ABC Share Price and OptionsFMV ESOP ISOThursday, May 2, 13
  41. 41. $0$15$30$45$60$75$902013 2014 2015 2016 2017 2018Company ABC Share Price and OptionsFMV ESOP ISO100 options granted to EE at FMV of$10.00 with 4 year vest. Strike price isequal to FMV at time of grant, $10.This iscalled “At the Money”Thursday, May 2, 13
  42. 42. $0$15$30$45$60$75$902013 2014 2015 2016 2017 2018Company ABC Share Price and OptionsFMV ESOP ISO100 options granted to EE at FMV of$10.00 with 4 year vest. Strike price isequal to FMV at time of grant, $10.This iscalled “At the Money”25 options vested to EE. She can buy 25shares at $10 and realizes gain: (FMV $25 -Strike price $10) X 25 shares = $375This gain will be taxed. If she sells thoseshares, she will be taxed again for the gain.Thursday, May 2, 13
  43. 43. $0$15$30$45$60$75$902013 2014 2015 2016 2017 2018Company ABC Share Price and OptionsFMV ESOP ISO100 options granted to EE at FMV of$10.00 with 4 year vest. Strike price isequal to FMV at time of grant, $10.This iscalled “At the Money”25 options vested to EE. She can buy 25shares at $10 and realizes gain: (FMV $25 -Strike price $10) X 25 shares = $375This gain will be taxed. If she sells thoseshares, she will be taxed again for the gain.2 years in, management decide to incentivizethe EE with Incentive Stock Options. Similar 4year vest.At this time, FMV is $53, so strikeprice of ISO set to $53.Thursday, May 2, 13
  44. 44. $0$15$30$45$60$75$902013 2014 2015 2016 2017 2018Company ABC Share Price and OptionsFMV ESOP ISO100 options granted to EE at FMV of$10.00 with 4 year vest. Strike price isequal to FMV at time of grant, $10.This iscalled “At the Money”25 options vested to EE. She can buy 25shares at $10 and realizes gain: (FMV $25 -Strike price $10) X 25 shares = $375This gain will be taxed. If she sells thoseshares, she will be taxed again for the gain.2 years in, management decide to incentivizethe EE with Incentive Stock Options. Similar 4year vest.At this time, FMV is $53, so strikeprice of ISO set to $53.When FMV falls under strikeprice, it’s called “under water”Thursday, May 2, 13
  45. 45. Startup Equity RECAP: More ART thanSCIENCE but still need to ASK and do theMATHThursday, May 2, 13
  46. 46. Startup Equity RECAP: More ART thanSCIENCE but still need to ASK and do theMATHBefore joining a startup, ask•Is this the right team and company for my success?•What is my percentage of ownership?➡ # shares you own / total shares issued•How long is my vesting schedule?➡ 4 years with 1 year cliff is standard•What are tax implications?➡Restricted stock: make 83B elections➡Option holders: liable for capital gains atexercise and when sold•What is total company capitalization?•What is the estimated valuation at exit?•What do I need to do when I leave?If you’re a founder or prospectiveemployee,•Research market rate salary and equity comp➡See appendices for references•Read the partnership and employment agreements•Negotiate like a business person•Consult a lawyer or tax accountantThursday, May 2, 13
  47. 47. Startup Equity: More ART than SCIENCEbut still need to do the MATH1) Ownership = # Shares Granted toYouTotal CapitalizationFormulas Example1) 1% = 0.1M Shares Granted10M Total Shares Outstanding2) Dilution Factor =(#Your Future Shares + Future Investor Shares)Total Cap. + #Your Future + Future Investor Shares2) 0.17% = (0.05M +2M)(10M+0.1M+2M)1% - 0.17% = 0.83% New Ownership3)Your Payday at Exit* =(Your Ownership X Company Exit Price)– (Total Exercise Price)3) $99K* =(0.83% X $30M) - ($150K)*Assuming $1 strike price,BEFORE taxes, very rough est.Thursday, May 2, 13
  48. 48. Sources- Andy Payne, Startup Equity for Employees: http://www.payne.org/index.php/Startup_Equity_For_Employees- Brad Feld, Blog archive on Term Sheets:http://www.feld.com/wp/archives/2005/08/term-sheet-series-wrap-up.html- Chris Dixon, The One Number You Should Know About Your Equity http://cdixon.org/2009/08/27/the-one-number-you-should-know-about-your-equity-grant/- Fred Wilson, MBA Monday Series on Equity: http://www.avc.com/a_vc/2010/09/employee-equity.htmlhttp://www.avc.com/a_vc/2008/11/restricted-stoc.html- How Stuff Works, Stock Options:http://money.howstuffworks.com/personal-finance/financial-planning/stock-options1.htm- Infochachkie, What The Heck Are My Startup Stock Options Worth?! Seven Questions You Should Ask Before JoiningA Startup: http://infochachkie.com/options/- Paul Graham, Equity Equation: http://paulgraham.com/equity.html- Pop History of DIg, Apple Rising: 1976 - 1985: http://www.pophistorydig.com/?tag=apple-computer-ipo- Startup Company Lawyer, What is an 83b Election?http://www.startupcompanylawyer.com/2008/02/15/what-is-an-83b-election/- Wealthfront, Manage Your Tech Career: https://blog.wealthfront.com/startup-employee-equity-compensation/- Wealthfront, The 12 Crucial Questions About Stock Options: https://blog.wealthfront.com/stock-options-package-valuation/- Wikipedia, Restricted Stock: http://en.wikipedia.org/wiki/Restricted_stockThank you!Thursday, May 2, 13
  49. 49. Appendix A: LLC v. C CorpThursday, May 2, 13
  50. 50. Appendix A: LLC v. C CorpType ofEntityLimited Liability Company (LLC) C Corporation S CorporationOwnershipUnlimited members. Membersown “units.”500 shareholders if private. Nolimit on shareholders if public.Up to 35 shareholders, one classof stock allowed.LiabilityMembers not liable for companydebts.Shareholders not liable forcompany debts.Shareholders not liableTaxesNo entity tax; profits and lossesare passed on to members.“Double taxation” Company istaxed as an entity. Shareholdersare also taxed.“Double taxation” Company istaxed as an entity. Shareholdersare also taxed.ManagementDesignated in OperatingAgreement. May be managed byMember or Manager.Managed overall by Board ofDirectors. Officers manage day today.Managed overall by Board ofDirectors. Officers manage day today.Thursday, May 2, 13
  51. 51. Appendix A: LLC v. C CorpType ofEntityLimited Liability Company (LLC) C Corporation S CorporationOwnershipUnlimited members. Membersown “units.”500 shareholders if private. Nolimit on shareholders if public.Up to 35 shareholders, one classof stock allowed.LiabilityMembers not liable for companydebts.Shareholders not liable forcompany debts.Shareholders not liableTaxesNo entity tax; profits and lossesare passed on to members.“Double taxation” Company istaxed as an entity. Shareholdersare also taxed.“Double taxation” Company istaxed as an entity. Shareholdersare also taxed.ManagementDesignated in OperatingAgreement. May be managed byMember or Manager.Managed overall by Board ofDirectors. Officers manage day today.Managed overall by Board ofDirectors. Officers manage day today.Thursday, May 2, 13
  52. 52. Appendix A: LLC v. C CorpType ofEntityLimited Liability Company (LLC) C Corporation S CorporationOwnershipUnlimited members. Membersown “units.”500 shareholders if private. Nolimit on shareholders if public.Up to 35 shareholders, one classof stock allowed.LiabilityMembers not liable for companydebts.Shareholders not liable forcompany debts.Shareholders not liableTaxesNo entity tax; profits and lossesare passed on to members.“Double taxation” Company istaxed as an entity. Shareholdersare also taxed.“Double taxation” Company istaxed as an entity. Shareholdersare also taxed.ManagementDesignated in OperatingAgreement. May be managed byMember or Manager.Managed overall by Board ofDirectors. Officers manage day today.Managed overall by Board ofDirectors. Officers manage day today.Thursday, May 2, 13
  53. 53. Appendix A: LLC v. C CorpType ofEntityLimited Liability Company (LLC) C Corporation S CorporationOwnershipUnlimited members. Membersown “units.”500 shareholders if private. Nolimit on shareholders if public.Up to 35 shareholders, one classof stock allowed.LiabilityMembers not liable for companydebts.Shareholders not liable forcompany debts.Shareholders not liableTaxesNo entity tax; profits and lossesare passed on to members.“Double taxation” Company istaxed as an entity. Shareholdersare also taxed.“Double taxation” Company istaxed as an entity. Shareholdersare also taxed.ManagementDesignated in OperatingAgreement. May be managed byMember or Manager.Managed overall by Board ofDirectors. Officers manage day today.Managed overall by Board ofDirectors. Officers manage day today.Thursday, May 2, 13
  54. 54. ACME, LLCAnnual net profit: $100MNo corp taxAppendix B: LLC Tax Passthrough•Members taxed for ACME’s profit (or loss) proportionately•Members receive K1 tax form (and tax assistance from entity,depending on terms of agreement)A:10%$10MB:10%$10MC:80%$80MTax Liability Tax LiabilityThursday, May 2, 13
  55. 55. ACME, Inc.Annual profit: $100MCorp tax: $35MNet profit: $65Mdividends paid out to shareholders(taxed on individual level)Appendix C: C Corp “Double Taxation”•Both ACME, Inc. and shareholders taxed•No tax assistance from entity to shareholdersdividends dividendsThursday, May 2, 13
  56. 56. Appendix D: Recommended Online Resources• Check out Anonymous Startup Salaries, Stock Options and Equity on Ackwire.com• Check out Fred Wilson’s Cap Table Template on Google DocsThursday, May 2, 13
  57. 57. Appendix E: Recommended Online Resources• Check out Patrick McKenzie’s Salary Negotiation: Make More Money, Be More• Check out David Weekly’s An Intro to Stock OptionsThursday, May 2, 13

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