Demystifying Stock Options and Preferences: Valuing Startup Equity
- 1. Demystifying Stock Options John Rodkin MD/GM @ Samsung Accelerator SF Eric Hanson Counsel @Wilmer Hale, Palo Alto
- 2. Agenda • Some vocabulary • Economic preferences, or valuation terms the media never mentions • Convertible notes and SAFEs • Some calculations (algebra heavy! ) • Q&A
- 3. A little bit about John • Engineering/JD/MBA Degrees • SerialVenture-backed Entrepreneur • Venture Capital Lecturer • LBO/PE/VC Experience • Small Business Owner
- 4. A little about Eric • Counsel in Corporate Practice Group of Wilmer Hale in Palo Alto • Venture Investments and Fund Formation: Over 100 venture transactions, representing issuers, venture venture funds and strategic investors, totaling an aggregate of well over $3 billion in transaction size. • Mergers and Acquisitions: Over 20 mergers and acquisitions, representing both buyers and sellers, totaling an aggregate of over $2.5 billion in transaction size, in transactions sized from $10,000 to over billion. • Capital Markets: Several capital markets transactions representing companies, underwriters and venture funds in connection with initial and follow-on public and 144A offerings. • Northern California Super Lawyers “Rising Star” 2013-2015 • Former software engineer, Electronic Frontier Foundation, the University of Washington and IBM’s T.J. Watson Research Center.
- 5. Why I Teach • There are a lot of sharks in this field • Know what you’re doing and the sharks won’t get you • I learned the hard way and am lucky to have had it work out 5
- 6. Valuation Basics • Valuation = what the company is “worth” • Preferred shares drive valuation • Common shares are what you have • You can’t spend valuation 6
- 7. Preferred Shares • Shares with special rights • Anti dilution • Control • Board seats • Preferred shares usually have special economic rights too • We’ll cover some economic preferences today 7
- 8. Venture Capital Deal Algebra • Pre Money? • What the company is worth pre-investment • = Number of shares before investment * share price (of preferred shares) • Post Money? • What the company is worth post-investment • = Number of shares after the investment * share price • = Pre + investment amount. Why? 8
- 9. Venture Capital Deal Algebra • Investor Ownership • = Investment / Post money • = Shares issued / total shares • Option pool is part of “total shares” • Valuation is implied • VCs pick percentage and investment 9
- 10. Liquidation Preferences • Downside protection forVCs • Their money comes out first, which is fair that they get their money back before you get paid • VC can pick: receive amount of liquidation preference or convert to common (i.e. looks like debt or equity) • All sorts of ways to adjust the preference • Multiples (Terrible for entrepreneurs, very rare) • Participation (next slide) • Caps • B round will do what you did in A – use that to keep preferences sane 10
- 11. “Participating” Preferences (or Double Dipping) • Get money back, then take pro rata share! • Both debt AND equity on the same investment • Expires in an IPO • “Cap” (or “kick out feature”) • After some limit, investor converts entirely to continue sharing in the upside 11
- 12. Participating (Liquidation) Preferences • VC Money comes out first. Then divide pro rata. • Example: Raise $100M at $300M post. VC owns 33% • Sale for $400M. • VC gets $100M + 33% * $300M = $200M. • Your company that was valued at $200M when you took the money only gets you $200M despite doubling in value • Much worse if you sell for $300M -> you only get $134M • Because it’s contract, all sorts of ways to adjust these numbers • Most common is to say thatVC only gets the preference until they get their original money back. • At $400M, then,VC takes 33% * $400M = $133M • Valuation is not the only important term! • With no participating preference, you end up with more on a $400M exit if the post is only $250M. (VC gets 40% = $160M, you get $240M) 12
- 13. 13 Straight VC Percentage (no liquidation preferences (rare)) $0 $100,000,000 $200,000,000 $300,000,000 $400,000,000 $500,000,000 $600,000,000 $700,000,000 $800,000,000 0 1 2 3 4 5 6 7 8 9 10 11 vc share entrepreneur share EXITVALUE ($000M) CASHOUTTOEACHPARTY
- 14. $0 $100,000,000 $200,000,000 $300,000,000 $400,000,000 $500,000,000 $600,000,000 $700,000,000 $800,000,000 0 1 2 3 4 5 6 7 8 9 10 11 vc share entrepreneur share 14 Liquidation Preference Preferred gets first $100M. Only converts to common when 33% of exit is more than $100M EXITVALUE ($000M) CASHOUTTOEACHPARTY
- 15. $0 $100,000,000 $200,000,000 $300,000,000 $400,000,000 $500,000,000 $600,000,000 $700,000,000 0 1 2 3 4 5 6 7 8 9 10 11 vc share entrepreneur share 15 Uncapped Participating Preference Preferred gets first $100M, but also gets pro rata portion of remaining. No flat area. EXITVALUE ($000M) CASHOUTTOEACHPARTY
- 16. $0 $100,000,000 $200,000,000 $300,000,000 $400,000,000 $500,000,000 $600,000,000 $700,000,000 $800,000,000 0 1 2 3 4 5 6 7 8 9 10 11 vc share entrepreneur share 16 Participating Preference with 3x Cap When the cap is reached, there’s a band of equal returns for investor even with rising exit Notice: these flat bands exist where investor has a convert choice (see liquidation preference slide). EXITVALUE ($000M) CASHOUTTOEACHPARTY
- 17. 17 What is a “Convertible Note” • Investor loans the company money • The loan converts to equity at some price. Often at a discount to some future financing • May have a cap • Sometimes there is “warrant coverage” • Math on next slide
- 18. 18 Convertible Note Math • $1M convertible note at $5M cap, 25% discount, 10% warrant coverage • $5M financing at $10M pre, share price at $1 • With no cap, $1M / 75 cents = 1.33M shares. Plus 10% warrant coverage = $100K/$1 = warrants on 100,000 shares. • But with cap, $1M / 50 cents = 2M shares
- 19. 19 Are convertible notes good? • Pros • Don’t want to set valuation • Close small dollar amounts in several closings (“high resolution fundraising”) • Investors think it’s safer? • No board rights or voting • Cons • Gives too much in preference stack • Accrues interest • Can cause bankruptcy • Just kicks the can on valuation • Caps can be terrible – heads investor wins, tails entrepreneur loses
- 20. 20 SAFEs • Simple Agreement for Future Equity • “Evolution” of convertibles • Not a debt instrument • Preference adjusted to equal amount invested • Great for company. For investor? • Taxes?
- 21. 21 What drives messy terms? • Everybody wants a headline number • Attracts media, employees, maybe even customers • “It will never happen to me” • Why will your company not just go up and to the right? • Not every entrepreneur is a repeat player, most investors are
- 22. 22 Option Pool Shuffle • Options don’t get granted until board approves • VC has at least equal voting on board • Options don’t actually exist until granted • Media (and often entrepreneur) care most about headline valuation • So,VC can give higher valuation by making option pool larger
- 23. 23 Option Pool Shuffle Example Scenario 1 Post Money $10,000,000 Shares outstanding (prior to financing): 200,000 Option Pool 30% Investment amount: $5,000,000 After the financing: Common shares outstanding 200,000 Series A shares: 500,000 Shares reserved under option plan 300,000 Total Shares outstanding 1,000,000 Share Price $10 Scenario 2 Post Money $10,000,000 Shares outstanding (prior to financing): 200,000 Option Pool 10% Investment amount: $5,000,000 After the financing: Common shares outstanding 200,000 Series A shares: 250,000 Shares reserved under option plan 50,000 Total Shares outstanding 500,000 Share Price $20 • Even with all other terms equal, a change in the option pool doubles share price! • VC owns the same percentage!
- 24. 24 Key Takeaways • Many terms besides headline valuation matter • Work with a good attorney • Pick your investors carefully