An Introduction to Stock and Options

by David Weekly

you own a share in a business, you’re the CEO’s boss’s boss.

In most cases the outside Board member will be given a stock option grant, such as for ~0.5% of the company.

With a Board’s permission, the company can issue new stock, which is a lot like printing money: it makes everyone else’s shares smaller as a percentage of the company. This reduction in ownership is called dilution.

Shares that grant special rights are called Preferred Stock, although what exactly those rights are can vary dramatically from one investment round to the next.

As a shareholder, your “illiquid” shares (called as much because you can’t turn them into other assets, like a house or movie tickets) thus become “liquid” cash. This is called a liquidity event

The first is to sell the stock on a private market (also called a secondary market) only available to sophisticated / accredited investors.

(all other things being equal, more shareholders equals more administrative burdens for companies).

Preferred shareholders would be paid their liquidation preference, in this case equal to the money they had invested and then participate in any remaining proceeds based on their percentage interest in the company, as if they had converted all their Preferred Stock to Common (assuming a 1-to-1 conversion ratio).

The total dollars of liquidity preference that need repayment are called the company’s overhang.

Angels are mostly rich people (legally, an accredited investor is a person with $1m+ in the bank, making $200k+/year themselves, or $300k+/year including their spouse) investing their own money, directly.

a great Board member can be an invaluable asset: making introductions, closing deals, lining up more financing, discovering potential acquirers, and dispensing crucial advice.

Accelerators are programs that generally provide a small (~$10k-100k), fixed amount of capital in a 3-6 month program in exchange for a small, fixed equity percentage of the company. They have the advantage of connecting founders with peers and providing helpful curriculum and access to quality mentors.

The entities that invest in a VC firm are called Limited Partners (LPs) because while they provide the capital, they don’t actually get to decide what companies get investment. That’s left to the General Partners (GPs or just “partners”), the full-time investment professionals at the firm.

GPs get paid an annual management fee of 1-2% (of the total fund size) plus about 20% of any of the profits reaped from their investments (called a carry).

if at the next financing round your company doesn’t get valued as highly and you have a “flat” or “down” round, all kinds of nasty provisions that protect investors’ rights can kick in. In many cases a new investor will demand a “recapitalization” - this is fancy-speak for tearing up the cap table and negotiating who should own what. Hint: if you’re a former or early employee, you’re not going to end up with much. The results can be unintuitively punishing: in one recent example, Gomez.com sold for several hundred million dollars and the founder made a few thousand dollars. He had left before the company had undergone a recap.

Some sophisticated entrepreneurs proactively draw up their own term sheets and present their own terms to a firm instead of waiting for the firm to present a term sheet. See http://techcrunch.com/2009/08/23/the-funded-publishes-ideal-first-round-term-sheet/ for an example.

I wish someone had told me that the term sheet is meant to be a discussion. You don’t sign the sheet without talking it through. In the process you can often get very substantial concessions on things that are important to you.

(A silly aside: I enjoy flying helicopters and scuba diving, both of which I might not have been permitted to do if I had agreed to a Key Man Insurance clause -- so I got my VC firm to remove the clause from the terms.)

Actually, there’s a long (4-10 week) closing process of finalizing the exact terms of the deal and the VC firm has the right to do some research on the company to ensure that you haven’t just been lying to them the whole time. This research process is called due diligence: if the firm gave companies money without verifying that the companies actually existed, they’d (rightfully) get sued by their LPs for negligence!

The story you need to tell when raising money is a delicate balance between clarity on how new funds could be very effectively put to work and the company doing just fine without that money.

And before you waltz into a financing, make sure you have a mentor, Board member, and law firm lined up to vet the term sheet in the requisite time period!

What a company can do, tax-free to the employee, is give the employee an option to purchase shares of Common stock at a price fixed when the board of directors approves the option, soon after their hire date. This is the strike price.

So as the employee passes their one year anniversary, they now have vested an option to purchase stock, but unless they do anything about it, they’re still not a shareholder. They can’t vote. They’re just an optionholder. To acquire stock, they still have to exercise their options to purchase Common Stock from the company.

So how does one avoid this “bear trap” of AMT when working for a startup? Well, there are two good answers. The first is that it’s a pretty reasonably good idea to do nothing.

The other good answer, and one that’s less well-known by first-timers, is to do an early exercise and immediately file an 83(b) Election.

This pool of unallocated options is usually mandated to be around 10-20% of the total shares outstanding at a major financing,

Sometimes a company can exhaust its pool, in which case it will have to ask for shareholder approval to grow it further. As employees leave the company, their unexercised options return to the pool.

People earlier on and taking a bigger risk (e.g. without a salary) should get much larger grants.

To walk through a specific example, let’s say you’re hiring your fifth employee, a senior engineer. (Seniority in this case should be more closely proportional to relevant raw skill than years worked.) Your company has raised $300,000 in seed financing from some angels and your product has just launched in public beta, though is pre revenue. Sheila has a relatively extensive network and some basic management experience. You don’t want to hire her directly into a VP/Engineering role but think she might be able to grow into it. Sheila is still paying off student loans, though, and will need to be paid at least $85,000/year while you and your other engineers are earning $60,000/year (the baseline for Basic Valley Survival Pay). The last engineer you brought on board, Fred, was quite junior but is turning out well - you gave Fred a 3% grant, but that was before you had shipped your product to critical acclaim. My advice in the above case would be to make a grant of 2% with a supplementary 1% grant at the point in time you do decide to make her VP/Engineering.