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Founder equity 101 - How to Get it Right From the Start
From day one, it's crucial to put your company on the right path. With proper planning, you can avoid a number of common problems, such as cofounder disputes, tax issues, and cap tables that would make investors run for the doors. Startup equity is one of those things that most founders struggle with unless they have an MBA. On September 9th, 2020 at 10:00 am PDT Nicole Hatcher, Bret Waters, Brian McAllister, and Louis Lehot shed some light on the best practices and insights to apply when splitting equity for the first time. See the recording on YouTube channel #askasiliconvalleylawyer
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Founder equity 101 - How to Get it Right From the Start
- 1. FOUNDER EQUITY101: How to Getit Right from the Start September 9th, 2020
- 2. 2 © 2020 LouisLehot and L2 Counsel, P.C. Attorney Advertising Disclaimers: 1.We are not your attorneys. 2.This is not legal advice. 3.Past results achieved are not a guarantee of future performance. 4.Depending on your jurisdiction of viewing, this is attorney advertising.
- 3. PANELISTS Louis Lehot Founder Brian McAllister Principal BretWaters 4thly Nicole Hatcher Founding Partner
- 4. AGENDA 1. Founder EquitySplits 2. Types of Startup Equity 3. Who Gets What 4. Option Plans 5. Vesting 6. Cap Tables 7. 409A Valuations
- 5. 1. FOUNDER EQUITY SPLITS Considerations: •Contributions • Roles • Value-Add • Cash Compensation
- 6. 2. TYPES OF STARTUPEQUITY • Preferred Stock • Common Stock • Incentive Plans
- 7. 3. WHO GETS WHAT Fourgroups that typically get equity: • Co-Founders • Advisors • Investors • Employees •Others
- 8. 4. OPTION PLANS •Recruit and incentivize capital or talent • Range from 10 to 25% of initial equity
- 9. 4. OPTIONS PLANS (cont’d.) •Incentive Stock Options (ISOs) • Non-qualified Stock Options (NSOs) • RSAs / RSUs
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- 12. 7. 409A VALUATIONS • WhyNeeded? • When Needed? • How Long Is It Good For?
- 13. Bret Waters CEO www.4thly.com bretwaters@gmail.com Q&A For MoreInformation: Louis Lehot Founder l2counsel.com louis.lehot@l2counsel.com Brian McAllister Principal mblcounsel.com brian@mblcounsel.com Nicole Hatcher Founding Partner allenhatcher.com nicole@allenhatcher.com
- 14. FOUNDER EQUITY101: What Happens WhenThings Change September 16th, 2020 at 10 am PDT
Editor's Notes
- #6 Every startup will offer equity to some combination of those four categories. But not every startup is going to offer equity to employees; not every startup is going to offer equity to advisors; and not every startup is going to take on investors
- #7 What is the Difference Between Common and Preferred Stock? Common stock and preferred stock both confer equity in a company and generally come with voting rights. Beyond voting, however, preferred stock generally has significant rights that common does not have. Specifically, preferred stock generally has features that protect investors in scenarios ranging from sales of new or existing preferred stock to a change of control or liquidation event. These rights can include a liquidation preference, participation rights, pre-emption rights, right of first refusal, co-sale rights and redemption rights. Who Gets Which Kind of Stock When early-stage startups issue equity, there are generally two classes of people receiving shares: employees or founders and investors. Employees and founders typically receive common stock. Investors, on the other hand, generally receive preferred stock. Why Does the Common vs. Preferred Stock Distinction Matter? When a company is sold, all shareholders have access to a portion of the proceeds, but the allocation of proceeds depends both on the percentage of the company held and the specific rights associated with the shares held. Because preferred stock often features rights that confer economic preferences as compared to common stock, the specific features of the preferred stock issued by a company can significantly impact the allocation of proceeds in a liquidation scenario. In certain cases, common shareholders may be left with little or no returns after the required payments to preferred shareholders, especially in cases with participating preferred stock or multiple liquidation preferences. Non-Participating Preferred Stock vs. Participating Preferred Stock Generally, holders of preferred stock receive preferential returns. This means that they are paid back their initial investment plus some preferential payment before any other proceeds are disbursed. The extent to which additional funds beyond this preference is paid out to holders of preferred stock depends on whether the equity is non-participating preferred stock or participating preferred stock. Participating preferred stock takes a share of the proceeds from the deal along with common stockholders after receiving the preferential returns -- i.e., the preferred holder participates in the equity apportionment in addition to receiving its preference. Holders of non-participating preferred stock, however, only receive the preference plus any accrued dividends.
- #8 Every startup will offer equity to some combination of those four categories. But not every startup is going to offer equity to employees; not every startup is going to offer equity to advisors; and not every startup is going to take on investors
- #9 What Is an Option Pool? An option pool is a way a startup company can acquire talented employees by offering them stock if the company does well enough to go public. Employees receive percentages of the option pool when they're hired, with the amount changing based on how early the employee joins the company and what their position within the company is. An option pool is a percentage of a company reserved for employees. New companies create option pools by setting aside common stock shares, and granting these shares to employees as a way to pull new talent into a startup. Option pools are also called employee stock option pool (ESOP.) Companies use option pools because: They want to offer an incentive other than money when they don't have much capital They want to give employees a reason to work hard enough for the company to go public (to make the pool worth something) People who start working for the company early usually get more stock in the option pool than people who join the company later. When a company has more employees, deciding which employees receive options can be difficult. Is there another way to inspire those employees to work hard? Is the money you save when offering the options worthwhile in the long run? How an Option Pool Works A Series A company sets aside a pool of outstanding stock. That pool is often 15-25 percent, but the exact percentage varies. The option pool is a percentage of the value of the company, not a percentage of the available shares. If a round of funding adds shares, shares are added to the option pool to keep it at the negotiated percentage of the company. Series A pools are usually large because: The company has the potential to build equity Shares of a young company aren't worth much To attract top talent, the company has to offer larger grants (0.25-3 percent) Once companies grant most or all of the pool, they need to expand it. Expansion usually happens during Series B, and might be 5-10 percent more outstanding stock. By Series C and beyond, adding 1-2 percent is sufficient. The later an employee is hired, the smaller their grant is, because: The smaller amount has a larger value as each share grows in value More capital has been invested in the business The business is less risky If the board votes to expand the pool between rounds of funding, that dilutes the existing shares. Startups also often split shares after Series B, usually into three or four. A company could go from having 10 million shares to 40 million shares. The shares created in the option pool during the Series B investments get added to the split shares. After Series B, experts recommend companies make a compensation committee to deal with option pools. The head of HR and two members of the board make up the committee The committee creates salary ranges and stock option plans for new hires They compare what the company is offering to the industry standard They create an option pool budget for the shares the company will give to each year's new hires Option Pool Shuffle The option pool shuffle is when the option pool gets valued in the pre-money of a company. Investors want the negotiations to happen like this, and many startup founders aren't prepared for it. Though option pool negotiations come during pre-money valuation, investors want the value of the shares to be in post-money valuation. Option pools can impact an investor's price per share, or just a founder's To create an option pool, you add shares to the already existing shares of a private company You figure out the price per share by dividing the pre-money valuation by the number of outstanding shares in the company Investors want the option pool to be separate from the shares they get by investing (preferred shares), so their shares do not get diluted thanks to the option pool If the option pool comes out of all shares, including the investor's, then that means the investor's shares are diluted, too
- #10 Types of startup stock options Stock options aren’t actual shares of stock—they’re the right to buy a set number of company shares at a fixed price, usually called a grant price, strike price, or exercise price. Because your purchase price stays the same, if the value of the stock goes up, you could make money on the difference. We’ll elaborate on this in part 2 of our equity 101 series. There are two types of employee stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). These mainly differ by how and when they’re taxed—ISOs could qualify for special tax treatment. Note: Instead of stock options, some companies offer restricted stock, such as RSAs or RSUs. Restricted stock is different than stock options and is treated differently for tax purposes. Stock option agreement While your offer letter might mention how many stock options the company is offering, you need to receive and sign the stock option agreement (also called an option grant) if you want to purchase your shares someday—just signing the offer letter isn’t enough. Stock option grants are how your company awards stock options. This document usually includes details like the type of stock options you get, how many shares you get, your strike price, and your vesting schedule (we’ll get to this in the vesting section). Your stock option agreement should also specify its expiration date. In general, ISOs expire 10 years from the date you’re granted them. However, your grant can also expire after you leave the company—you may only have a short window of time to exercise your options (buy the shares) after you leave. Make sure you know when your grant expires—if you don’t exercise your options before then, you’ll lose the opportunity to purchase them.
- #11 What is a vesting period? A vesting period is a length of time or a milestone that must be met before employees can gain ownership of their options. The lifecycle of an option usually looks like this: Grant: When you give an option grant to an employee (usually on their hire date). While you can include information about their equity compensation in your offer letter, you should also send them an official stock option agreement that spells out everything they need to know, like what type of stock they get, how many shares they get, and more. Cliff: When the first portion of the option grant vests and the employee earns the right to exercise their options. Many companies make the cliff the employee’s one-year anniversary and call it a one-year cliff. Fully vested: When all of an employee’s granted options have vested and are exercisable. (Many companies offer refresh grants when an employee vests all their options to continue motivating the employee to stay and help the company succeed.) Exercise: When an employee exercises all or a portion of their vested options. If your company is based in the U.S. and you designate us as your Transfer Agent, your employees can exercise directly on our site or mobile app. Sale: When an employee sells all or a portion of their equity stake. If you’re a private company, this usually only happens if you have a liquidity event, like a tender offer, or exit the private market by getting acquired or going public.
- #12 A capitalization table (or “cap table”) provides a record of who owns which pieces of a company. It tracks stakeholders’ percentage ownership, equity dilution, and the preferred or common stock in each round of investment. As companies scale, their cap tables grow and become more complex. As soon as founders are ready to distribute stock among co-founders, early investors, and employees, it’s important to make sure the cap table is accurate and up-to-date. A clean cap table will help you set your company on the right track, avoid a broken cap table, and reduce legal fees. All equity—including employee option grants, investor’s stock, and founder’s skates—is tracked in the cap table.
- #13 What Is A 409A Valuation And Why Do Startups Need It? The Internal Revenue Code Section 409A is meant to regulate how companies treat what’s called “nonqualified deferred compensation” that they give to their employees instead of a higher salary. A 409A valuation is usually performed to help new and existing companies set the current strike price for any employee stock options they choose to issue, and those options have to meet Fair Market Value shares or come in above it. It’s best to have an objective and qualified third-party provide the valuation, which usually means hiring an appraisal firm. Section 409A puts forth the guidelines that must be considered before the issuance of both shares and options, laying out the regulatory requirements involved. It was enacted in response to rampant pricing manipulations that occurred throughout the 90’s and the first half of the last decade by Enron and other large entities who often abused the previous method of setting the valuation internally. 409A is mostly meant to ensure that the proper federal income taxes are paid on deferred compensation plans, but it also ensures that company options are covered by the IRS safe harbor. Not complying will result in the federal government taxing you and your employees for that stock and slapping you with heavy fines, usually a 20 percent tax, as well as interest payments. It will not only make your employees extremely unhappy (to say the least), but it can also put the acquisition of your company in jeopardy. After all, what buyer wants to deal with the tax risk and indemnities you’ve incurred for not following the tax code? When Is A Good Time To Get A 409A Valuation? We understand that the last thing any startup wants to worry about is the taxes and legal side of running a business. It’s easy to let tax considerations slide when you have so many other things to worry about, like raising your new angel funding or venture capital. But every startup needs to think about tax law early in time to avoid confusion later. As with all things government related, it’s complicated and can impact or change your company greatly. How Do You Know When You Need A 409A Valuation? Let’s say, for example, that you want to hire top-notch talent with lots of experience, but you don’t quite have enough money to pay their current salaries. So, you offer them stock options and shares in the company instead—the nonqualified deferred compensation referred to in Section 409A. If a startup CFO wants to offer stock options or shares to employees, then the company needs a 409A valuation in order to comply with federal tax code regarding the strike price for those stock options. Usually, a startup CFO wants to put off their company’s valuation until after their Series A funding because many appraisal firms will charge around $5,000 for a 409A valuation, which is generally not worth it until the company has the funds to cover it easily. However, if your company is ready to create and grant good options to employees, then you’ll need a IRS 409A valuation to ensure that your option plans are covered by the IRS safe harbor. If you answer “yes” to any of the following questions, it’s time to contact Early Growth for a 409A valuation: Are you trying to value the common stock of a company? Do you plan to issue stock options and set your strike price? Have you raised a new round of funding since your last grant date? Are you looking to sell IP from one company to another? Has it been 12 months since your last 409A? How Long Is It Good For? The valuation is valid for 12 months after the Valuation Date or until a material event impacts the value of the company. Any new rounds of funding (equity or debt), major long-term contracts, change in business model, or increased regulation within the industry can impact the valuation of the company depending on the circumstances. The company’s position should be reviewed at each option grant, and this is something a valuation firm can help you to determine with a brief phone call.