Employee Equity: The Liquidation Overhang. We're five posts into this MBA Mondays series on Employee Equity and now we are going to start getting into details. We've laid out the basics but we are not nearly done. I am just starting to realize how complicated the issues around employee equity are. That's not good. It's like paying taxes. Everybody does it and nobody but the tax accountants understand it. Anyway, enough of that. When VC investors (and sometimes angels) invest in a startup company, they almost always buy preferred stock. For the sake of this post, I am going to talk about a simple plain vanilla straight preferred stock.
First, a quick bit on why preferred stock exists. In its simplest (and best) form, preferred stock is simply the option to get your negotiated ownership or your investment back, whichever is more. Now that we have that out of the way, let's talk about how this can impact employee equity. Let's keep going on the $50mm example. But that's not how the math works.
I know this is complicated. Employee Equity: Dilution. Last week I kicked off my MBA Mondays series on Employee Equity. Today I am going to talk about one of the most important things you need to understand about employee equity; it is likely to be diluted over time. When you start a company, you and your founders own 100% of the company. That is usually in the form of founders stock. If you never raise any outside capital and you never give any stock away to employees or others, then you can keep all of that equity for yourself. It happens a lot in small businesses. But in high growth tech companies like the kind I work with, it is very rare to see the founders keep 100% of the business. The typical dilution path for founders and other holders of employee equity goes like this: 1) Founders start company and own 100% of the business in founders stock 2) Founders issue 5-10% of the company to the early employees they hire. 3) A seed/angel round is done. 4) A venture round is done.
When the VC investment closes, everyone is diluted 20%. Employee Equity: Options. A stock option is a security which gives the holder the right to purchase stock (usually common stock) at a set price (called the strike price) for a fixed period of time. Stock options are the most common form of employee equity and are used as part of employee compensation packages in most technology startups.
If you are a founder, you are most likely going to use stock options to attract and retain your employees. If you are joining a startup, you are most likely going to receive stock options as part of your compensation. This post is an attempt to explain how options work and make them a bit easier to understand. Stock has a value. Last week we talked about how the value is usually zero at the start of a company and how the value appreciates over the life of the company.
If your common stock is worth $1/share and you issue someone an option to purchase your common stock with a strike price of $1/share, then at that very moment in time, that option has no exercise value. Employee Equity: The Option Strike Price. A few weeks back we talked about stock options in some detail. I explained that the strike price of an option is the price per share you will pay when you exercise the option and buy the underlying common stock. And I explained that the company is required to strike employee options at the fair market value of the company at the time the option is granted. The Board has the obligation to determine fair market value for the purposes of issuing options. For many years, Boards would do this without any third party input. They would just discuss it on a regular basis and set a new price from time to time. About five years ago, the IRS got involved and issued a rule called 409a. 409a puts some real teeth into the Board's obligations to strike options at fair market value.
As you might expect, 409a has given rise to a new industry. The vast majority of privately held companies now do 409a valuations at least once a year. You'd think this system would be better. Employee Equity: How Much? The most common comment in this long and complicated MBA Mondays series on Employee Equity is the question of how much equity should you grant when you make a hire. I am going to try to address that question in this post. First, a caveat. For your first key hires, three, five, maybe as much as ten, you will probably not be able to use any kind of formula.
Getting someone to join your dream before it is much of anything is an art not a science. And the amount of equity you need to grant to accomplish these hires is also an art and most certainly not a science. However, a rule of thumb for those first few hires is that you will be granting them in terms of points of equity (ie 1%, 2%, 5%, 10%). To be clear, these are hires we are talking about, not co-founders. Once you have assembled a core team that is operating the business, you need to move from art to science in terms of granting employee equity.
We have developed a formula that we like to use for this purpose. Senior Team: 0.5x. Employee Equity: Appreciation. This is the third post in an MBA Mondays series on Employee Equity. Last week I talked about Dilution. This week I am going to talk about the antidote to Dilution which is Appreciation, specifically stock price appreciation. When you start a company, on day one the stock is basically worthless. There are some exceptions to this rule such as a spinoff company where Newco is getting some valuable assets day one. One of the objectives of an entrepreneur is to steadily increase the value of the business and the stock price. At some point, the Company will generate revenues and earnings and can be valued using traditional valuation metrics like discounted cash flow and earnings multiples. Fortunately we have a marketplace for startup equity. There is a growing trend to finance the ‘seed stage’ of a startup’s life with debt, specifically convertible debt.
One thing that you need to know is that the price doesn’t always rise. Employee Equity: Vesting. We had a bunch of questions about vesting in the comments to last week’s MBA Mondays post. So this post is going to be about vesting. Vesting is the technique used to allow employees to earn their equity over time. You could grant stock or options on a regular basis and accomplish something similar, but that has all sorts of complications and is not ideal. So instead companies grant stock or options upfront when the employee is hired and vest the stock over a set period of time. Companies also grant stock and options to employees after they have been employed for a number of years. These are called retention grants and they also use vesting. Vesting works a little differently for stock and options. Vesting periods are not standard but I prefer a four year vest with a retention grant after two years of service.
If you are an employee, the thing to focus on is how many stock or options you vest into every year. Most vesting schedules come with a one year cliff vest. Vesting. In law, vesting is to give an immediately secured right of present or future deployment. One has a vested right to an asset that cannot be taken away by any third party, even though one may not yet possess the asset.
When the right, interest, or title to the present or future possession of a legal estate can be transferred to any other party, it is termed a vested interest. The concept can arise in any number of contexts, but the most common are inheritance law and retirement plan law. In real estate, to vest is to create an entitlement to a privilege or a right. For example, one may cross someone else’s property regularly and unrestrictedly for several years, and one’s right to an easement becomes vested. The original owner still retains the possession, but can no longer prevent the other party from crossing. Inheritance[edit] Employment[edit] Retirement plans[edit] The portion vested cannot be reclaimed by the employer, nor can it be used to satisfy the employer's debts. See also[edit] Employee Equity. One of the topics I get asked about most on MBA Mondays is "options. " But options are only one form of employee equity. I am going to do a series of posts on this topic over the next month of MBA Mondays.
I will start by laying out the logic for employee equity, going over some target ownership levels, and describing the various securities you can use to issue employee equity. One of the defining characteristics of startup culture is employee ownership. Employee ownership is such an important part of startup culture. While employee equity is "standard" in the startup business, the levels of employee ownership vary quite a bit from company to company. If the founders are the top managers in the company, then the typical "non founder employee ownership" will tend to be between 10% and 20%.
There are four primary ways to issue employee equity in startups: – Founder stock. . – Restricted stock. . – Options. . – Restricted Stock Units.