Month: April 2012
Today’s post of the day comes from Micah Baldwin. Micah isn’t a VC – he’s an entrepreneur, CEO, and experienced mentor (he’s been involved in TechStars since the beginning.) He has a great rant titled Advisors Stop Screwing Startups. He makes several very important points about how advisors are screwing startups, why they should stop, and why entrepreneurs should take responsibility for 100% of their equity and be a lot more careful with it.
As a long time advisor for many companies, I’m a huge believer in “give before you get.” If you are an amazing advisor, your reputation should precede you. Be free – help – and when you are providing real value, entrepreneurs should give you something in return. But entrepreneurs, if the advisor asks for something up front, be skeptical. Sometimes its legit, but often it’s not.
Question: Most VCs commented that they can not fund current cap table where the CEO and COO would get 10% equity once fully vested while the current investors have 80%. We talked to our investors and they have agreed to rework the cap table, however, I would like to understand from you what should I change my cap table to?
More Context: I recently joined a very early stage company as their CEO. The company was founded by two people three years back who have funded it since inception to the tune of ~$200k out of which $60k is in loans and is on the books of the company. The rest of $140k are unbilled expenses. The company has ~1000 paying customers and in 3 years has earned ~$160k. Last years revenue was $52k. The company is still burning money to the tune of $24000 per annum. I am not taking a salary right now, but my salary (at 80% discount to my market salary) is getting accrued since January. Also, I have been offered 10% equity with 4 year vesting and 1 year cliff. At this point of time we are trying to raise ~300k at 2.4 mn pre money. Most VCs in India say we are too early stage for them and we have just started looking at angel investment as an option.
This is a tricky one because it’s not clear whether the two original founders are still active in the business. If they are, then the hired CEO and COO getting 10% equity each is probably not unreasonable given that the founders are separate from the investors. In the case where the founders are also the early investors, this doesn’t matter, as you can separate their contribution conceptually.
If the early founders are no longer involved in the company and you are effectively restarting the business, then this feels light given this stage. However, there is no standard situation. It ultimately a negotiation with the founders and with your new investors. It’s easy for an investor to say “this doesn’t work for me” – a logical response, if you believe they are interested, is “what works for you?” Basically, have them propose something and then work with the founders to see if you can get to a deal.
There are definitely cases where the early investors own too much of the company to make it fundable. For example, let’s assume the the early investors put up $200k cash for 80% of the company. These investors are not active in the company, but instead you and your COO are running it (from day 1). In that case, a new investor would look at it and say that the early investors ended up with too much of the company since they effectively got 80% for investing a mere $200k.
Finally, if you raise money, you should use the event to clean up the existing balance sheet. If you raise $300k, you don’t want the $60k loan outstanding (it should probably convert into equity) and you definitely don’t want the $160k of unbilled expenses hanging out there. In addition, your accrued salary shouldn’t be continuing to accrue or get paid out. One tool you can use to normalize the equity some would be to roll the existing $200k into the ownership that the founders have (e.g. they still have 80% but now have a cost basis of $200k and the loan + the unbilled expenses go away) and then you pick up additional equity associated with converting your deferred salary into equity (e.g. if you defer $135k over the year, you get another 5% in options post financing ($135k / $2.7m post)).
Question: I am one of three founders of a company. Up until now we have been bootstrapping the company from our own funds and working part time on the company while having full time jobs. However, we are now looking to raise some private funding and one of us will be transitioning to the first full time paid employee of the company. The question is, does being the first full-time paid employee affect that founder’s equity in the company? I can see two sides to this issue. The first is the founders that are not yet paid employees would think that the other is getting paid so FTE’s equity should decrease. The second is the found that is now a paid employee is putting themselves at higher risk as they left there prior job to go fulltime at the new company. How have you seen this structured in the past?
You do an excellent job of looking at both sides of the question. While the founder who is working full time for the company is getting paid and the other founders are not, the other founders presumably are still getting paid from the day jobs.
Usually in these kinds of situations, the comp being paid is (or should be) modest – just enough so the full time founder can cover his basic living expenses. Assuming this is the case, I think you can comfortably separate out the equity as a separate concept. Specifically, whatever the equity splits are separate from the compensation should remain.
Now, the full time founder could make the argument that he should get more equity since he’s working full time for the company but the other two founders aren’t. This is a stronger argument if the founder working for the company isn’t drawing a salary.
Of course, the equity doesn’t necessarily have to be split three ways between the founders. However, if you can separate the compensation from the actual equity splits, you can usually have a more rational conversation.
Regardless, it’s never easy. Just have the direct conversation and keep working through it openly until you get to a happy place. If you can’t reach a consensus among the three of you, then you will have bigger problems down the road.
Question: How often do venture-backed start-up employees (let’s say non-executives) get stock option grants? Besides the initial grant when they start, how often do “re-up” grants come? Should they be expected after further funding rounds? After significant accomplishments/promotions? Never?
The short answer, at least in the US, is “most of the time.” It’s pretty standard for every employee of a VC-backed company to get at least a minor option grant as part of their compensation. Employees should expect these grants to vest over time (usually four years) and have a one year cliff (which means the person has to be employed for a year to have any of the options vest.)
Regarding the other question, it’s much more variable. In the previous post I talked some about “re-up grants”. In some cases, especially if there is a lot of dilution from a financing, there are occasionally broad grants across all employees post financing. However, in many cases, there aren’t, and employees should expect to take at least some of the dilution from subsequent financings, especially in up-round cases where the value of their underlying equity is increasing.
Additional grants occur on an employee by employee basis in two cases: (1) extraordinary performance (also referred to as a “spot grant” or “spot bonus”) or (2) long tenure – once an employee is fully vested (after year 4) they will often get an additional grant, although this will usually be much smaller than the original grant.
Question: I am considering joining a startup that is currently in the process of raising their next round of funding. I will be joining as a VP, reporting directly to the CEO, and considered an “executive”. Given the environment for this particular industry, it is very likely that the company will face a down round – perhaps as much as 50% of their last financing a year ago. What should I expect in terms of protection from both dilution and going under-water on my option prices given that I will be joining before term sheets and close of the round? Will my options be priced based on the previous round? Can I ask for some guarantees about % ownership and stock price post-funding?
Generally this is very hard to do. During your hiring process, you should address this directly with the CEO and ask him (a) what he thinks the prospect for a down round is and (b) if he’s willing to give you any guarantees on your stock position if one occurs. Most CEOs will say (a) I don’t expect there to be a down round and (b) no.
If you feel like you can negotiate then go deeper and ask for his word that if there is a down round you will receive an additional option grant that gets you close to your current granted amount. A great CEO will not commit to this – rather he’ll say it’s up to the team to increase value in the business regardless of external dynamics. If the team has performed well but the external dynamics have negatively impacted the value of the company (and subsequent financing), then it’s up to the board to consider additional option grants for employees in the content of this.
Some people will talk about the idea of being “trued up” in a subsequent financing. A long time friend likes to say “there is only 100% of a company to go around” so when someone gets “trued up” it’s coming out of someone else’s ownership. If a CEO commits to true you up in the future, recognize that it’s not a formal commitment unless it is documented as the CEO doesn’t have the authority to do this unilaterally (he’ll need board consent to do it.)
Now, let’s assume nothing has been committed to you up front and a down round subsequently occurs. In some cases, the company will grant additional options to make up some of the difference in dilution. This is rarely an amount that preserves your previous ownership as you should be taking some dilution, along with everyone else, as a result of the new financing. But – if the financing dilutes you 50% then a reasonable amount to expect would be an option grant that results in you only being diluted 25% to 33%. Of course, these numbers will vary a lot based on the actual financing.
If it’s a very material down round, in addition to granting new options, the company might reprice the existing options that are outstanding. This used to be difficult to do and have all kinds of weird accounting ramifications that tended to prevent this from happening. However, many of the rules have changed and all that is now required is a mildly tedious legal process.