Why You Need to Understand Preferences, Dilution, for VC-backed companies
Why isn’t my 2% worth $2 million?
Not long ago, I was speaking with the founder of a very successful mobile gaming company about some misconceptions he had seen when their company was sold. He said that there was a lot of misunderstanding amongst even their key employees about how much their stock was worth.
Let’s say that his company was sold for $100 million. He had a key employee that had, let’s say, 2% of the company, so he naturally assumed his stock was worth $2 million. It seems logical, right?
Wrong. This is a Startup Myth — like most myths, it’s not entirely wrong, there is a kernel of truth. After all, 2% of $100 million should be worth $2 million. But the actual distribution of funds in the sale of a company vary significantly.
As I thought about it, even many founders, angel investors, and advisors, in addition to employees, fall into the same trap.
The actual way in which money gets distributed in an acquisition is complicated enough that the lawyers put together a detailed spreadsheet that shows what happens to the consideration and how it gets parceled out across the various shareholders, often over time. They even have a special term for it: a waterfall spreadsheet.
Many things impact how this “waterfall” looks: the legal structure of the acquisition, the legal structure of the company, whether there is an earn-out, the size and nature of the company’s liabilities, and but the most important factor from the point of view of founders and employees is usually the preferences
By unpacking this myth, we can get not only get into these issues, but explore misunderstandings about options and vesting that many employees of startups have.
Startup Model: Waterfall in a Windfall: Money Distribution in an Acquisition
Let’s ignore the legal structure of the company for now, (though we will talk about that another — whether it’s an asset sale or a stock sale has big tax consequences).
Assuming that there is money to be distributed for shareholders, it will flow roughly as in Figure 1: Waterfall model for shareholders.
I say roughly because any company may have multiple variations of preferred stock (Series A, Series B, Series FF Preferred, etc.) and founders may or may not have vesting. Also, if it’s an asset sale then the company will get the money and pay off any debts and amounts owed to vendors (the company’s liabilities). After that’s done, any money that is left will be distributed to shareholders, again roughly following the waterfall illustration in Figure 1.
Let’s look at this waterfall in stages:
Preferred Shareholders. Preferred shareholders are the first to get money. Usually preferred shareholders have “preferences” that are equal to the amount they put in (plus some interest calculation). Generally these are investors who have put cash into the company, usually angel investors and venture capital funds (though sometimes this includes other corporate investors as well). More on preferences in the section below.
Common Shareholders/ Founders. If there is money leftover after paying the preferred shareholders, then money gets distributed to the common shareholders. The lion’s share of these go to the founders, with some amount (usually 10%-20%) reserved for employee options. I have listed the option-holders separately from founders, even though they both get common stock. The difference is that founders usually will get some amount of money per share as long as the acquisition amount is greater than the preferences, while option-holders may or may not exercise their option depending on the price per share.
Common Shareholders/Optionees. Employees are usually option-holders, and they will usually “exercise” their options only if the price per share being paid out is greater than their “exercise strike price”. More on options and the considerations such as vesting below.
It’s important to note that in many acquisitions, there is no money left over after the investors are paid back (or in the majority of startups, the investors don’t ever get all of their money back). Although I have listed these as a waterfall, usually what happens is that the decision points (D1) and (D2) are made, and then all shares (preferred A, preferred B, etc.) are converted to common and options are exercised, leaving only common stock for the acquirer to buy.
Point (D1) asks if the acquisition price is greater than the total preferences. If so, then there will be money left over after preferred shareholders get paid back for founders and employees and other common shareholders.
Point (D2) asks if the purchase price per share is greater than the strike price for optionees. As I said previously, most employees will get options to buy stock rather than actual shares. It only makes sense for employees to “exercise” their options at strike price $X if they can turn around and sell the shares to the acquirer for more than $Y (which is greater than $X).
A Not So Sil.ly Example
Let’s start with an illustrative example that we’ll carry through this chapter to explore who gets paid what when a company exits — you’ll see that the flow of funds looks slightly different depending on the exit scenario — that is, whether it is a good, mediocre, or bad exit.
Let’s say, Sil.ly, a cool Silicon Valley type startup, is founded by three friends — Larry, Moe, and Curly, and they each get 3 million shares. At the founding, this means that each owns 33%, of the company, as shown in Figure 2.
Founders, Vesting, Options, and Outstanding Shares
Before we continue, let’s deal with the issue of Founder vesting. What if the company didn’t do anything else and Curly decides to leave the company and do something else. Should he still have the same number of shares as Larry, Moe, and Curly?
This is why VC’s often insist on vesting for founders. It makes good sense to vest the shares over a period of time — let’s say 3 years. That way each founder can be sure that if one of the other founders leave, they will end up with less shares than those that “stick it out”. This is an interesting way that founders can end up with a higher percentage or lower percentage than they originally had. Let’s suppose that it’s a 3 year vesting and after 1 year, Curly leaves. In this case, he would have vested 1/3 of his shares, or 1 million. While the other two founders are still vesting, we consider their stake to still be 3 million each.
Figure 3 shows what happens — in this case, the two remaining founders theoretically own 43% of the company each (up from their 33% initial stake), while Curly has 14% of the company. Of course, this is assuming no other shares have been issued.
Options For Employees: Vesting, Strike Price, and all that Jazz
Getting back to the myth, let’s look at employees. Employees usually receive options to buy stock at a certain price (called the exercise price). Let’s suppose the company allocates 10% of its stock for the employee option pool, then the total cap table might look like Figure 4, where the founders (assuming Curly is still there) have 9 million shares, and 1 million shares are allocated for the option pool.
We say that the fully diluted share count would be 10 million shares, and of this fully diluted share count, 10% is allocated for options and 30% are allocated for each founder.
However, if the company were to be sold today, before the company had actually hired any employees or given them any options, the reality is that the options are unallocated, so the number of outstanding shares is actually 9 million, and the founders would still own 33% of the company each.
Let’s suppose that Marco Polo is hired as VP of Sales, and he is offered (being a very experienced salesman) 2% of the company, which would be 200,000 shares.
As I explained before, employees don’t actually get shares, so Marco would really get options to buy 200,000 shares out of the 1 million shares in the option pool. Marco would vest those over a 4 year period (typical for employees in Silicon Valley) with a 1 year cliff. A 1 year cliff means that Marco vests no shares over the first year, but on the anniversary of his start date, he gets 25% of his stake (or options on 50,000 shares) vested, and then usually they vest monthly or quarterly beyond that point.
So, if the company were to be sold for $10 million, how much would Marco make? 2% of $10 million would be $200,000, right?
Wrong. You have to go through the waterfall to figure it out. Marco has options on shares so he would have to buy the shares at the exercise price of his options, and then sell them. So what is his exercise price? It depends on the strike price and how many shares he’s vested.
About the Strike Price
The “strike price” is usually set by the Board of Directors based on the FMV (“fair market value”) of the company and is usually reset each year or each time there is a new financing event. This strike price is also called the 409(a) valuation.
Let’s suppose, for arguments sake, that when Marco joins, the strike price for all employee options is set to $.30 (or 30 cents) per share. Since the fully diluted share count is 10 million, this means roughly that the valuation of the company at the FMV is $3 million (10 million shares * $.30 per share).
This means that if the company is sold for $10 million, then its stock (assuming a stock acquisition) is being sold for $1 per share. Since this is more than the $.30 per share that Marco needs to pay, he will make the difference between $1 per share (acquisition price) and $.30 per share (his cost), which is $.70 cents per share.
So, if Marco had options on 200,000 shares, or 2% of the company, he actually makes only $140,000 (200,000 shares * $.70 per share profit).
Acceleration makes a difference for vesting
Furthermore, if the company was sold 2 years after Marco started, he would only have vested half of his shares, so he would only be eligible to buy 100,000 shares at $.30 per share, and he would make a profit of $70,000.
Well that isn’t fair, you might say, if he was supposed to get 2% of the company, he should be able to get profit on the full 200,00 shares, right?
Maybe, maybe not. This is what we call acceleration of vesting, and it is one of the most hotly contested issues in any acquisition negotiation. Founders and employees want all of their shares to vest fully at the acquisition. Acquirers want founders and employees to stick around after the acquisition, so they want no vesting acceleration.
The result is that there is usually some accommodation made and usually it’s different for founders than for employees. In one of my companies, for example, we accelerated all employee options by 1 year (so if they had vested 2 years, they would automatically be accelerated to 3 years vesting).
If this happened to Marco, he would go from 100,000 shares (2 years vesting) to 150,000 shares vesting.
So, you need to take into account both strike price and vesting before you can say how much each person makes in an acquisition.
Unfortunately, as we showed in the waterfall, there may be other considerations that affect how much money is distributed to shareholders. This usually has to do with preferred stock and investors.
Sil.ly Issues Preferred Stock to Conceited Capital
Going back to our example, let’s suppose Silly raises $2.5 million at a $5 million pre-money valuation from a prominent venture capital firm, Conceited Capital, or CC for short.
Given that there are 10 million shares fully diluted before the acquisition, this means a price of $.50 per share roughly. Let’s say in this example that they buy 5 million shares at $.50 per share = $2.5 million into the company.
You’ll see in Figure 5 that the fully diluted share count is now 15 million, and the investors (CC) own 33% of the company, while the founders each (Larry, Moe, Curly) now own 20% each (even though they still own 3 million shares each).
Our VP of Sales, Marco Polo, still has options on 200,000 shares, but now it is only 1.33% of the total (of 15 million shares fully diluted). This is a normal process — we say that everyone who had shares before the financing got diluted. The founders got diluted from 30% to 20%, and the employees got diluted by the same amount -33%. Not coincidentally, the new investors (CC) end up with the same percentage of the company as the dilution in the current round (33%).
Preferences vs. Percentage
However, the most important thing to note is that the investors got preferred stock, while the founders have common stock. The employees have options on common stock.
What does this mean? It means that the investors get their money out first, as you look back at the Waterfall in Figure 1: Waterfall model for shareholders.
Let’s suppose the company was sold for $3 million. Since the investors own only 33% of the company, you might think they would get 1/3 of the proceeds, or $1 million.
The whole idea of preferences is that they get their money out first, let’s look at low, medium, and high scenarios.
Low (Price Less Than Investor Valuation). If the company was sold for $3 million, the investors would get their $2.5 million out first, and then only $500k was left for founders and employees.
This is why, once you raise VC financing, it becomes difficult (or at least non-lucrative) to sell the company for a valuation less than the post money valuation in the last round.
Medium (Price at the Last Round Valuation). At the post money valuation in this example, $7.5 million, the investors’ percentage (33%) represents exactly the same dollars as their preferences ($2.5 million in each case), so everything works out. At higher valuation, the investors would rather get their 33% of the company, rather than taking their preferences out.
High. (Price More Than Investor Valuation). Let’s suppose the company sold for $100 million. The investors have the option to get their $2.5 million out, or to take 33% of the company. Naturally, the investors would waive their preferences and convert their preferred stock to common stock, and since they own 33% of the total stock, they would get $33 million in this case.
That’s how simple preferences work. But sometimes preferences can be very complicated. Some investors want to take their money out first and then get their percentage — this is called participating preferred — and it’s often called “double-dipping”.
In some cases, the preferences are set at 2x the amount of money put in — so in our example, this would meant that Conceited Capital would get $2.5 million times two = $5 million out first as preference, before the founders and employees would get anything.
You can see why preferences are so hotly debated during a financing because they directly impact how much each party gets.
Preferences In a Flurry
Let’s depart from Sil.ly, Inc. and look at a real-life example where preferences came into play. Let’s take a look at the example of Flurry, a mobile analytics and advertising company. Yahoo bought Flurry in 2014 for approximately $300 million (actually the number was $290 million, but let’s use round numbers).
In what might seem like a strange move to people who aren’t familiar with secondary markets (markets where employees and founders can sell their shares before the company goes public), I know some people who had an opportunity to buy Flurry shares around six months before the acquisition.
Although they didn’t know anything about an impending acquisition, at the time, Flurry was a leader in the mobile analytics and advertising space and so they thought that this was a good risk to take — it was certainly possible that Flurry could go public someday or be sold for a lot of money.
When I asked what the price was for the Flurry stock they could buy it at, the group that was handling the deal said that the price was based on flurry’s last valuation in a financing, which was supposedly at approximately a $300 million valuation.
Given that Flurry was a leader in a super-hot space, and not that long ago, AdMob, a leader in mobile advertising, had been sold to Google for approximately $700 million a few years back. Since Flurry was a leader in both mobile analytics and mobile advertising, both very hot spaces, it was certainly possible that Flurry would make it to a similar valuation.
A few months later, when it was announced that Yahoo was buying Flurry for $300 million, I spoke to my friends. While they didn’t make any money, I thought they’d be relieved that at least they didn’t lose any money. Since Flurry sold for approximately the same valuation that they bought into it, they should have gotten their money back, right?
It turned out that the investors only got approximately half of their money back, even though the valuation seemed like it was the same. From Yahoo’s perspective, they only cared about the total consideration of $300 million. From the point of view of Flurry shareholders, the way that money was distributed to common shareholders was the most important issue and clearly there were preferences that came into play. The investors got common stock, so their place in the waterfall determined how much money was left over for common shareholders.
The Secret: Understanding the Nature of Stock Options and Preferences Is Essential to Knowing How Much Anyone will Make In an Acquisition
There are of course, other complexities that come into play, including the structure of the company, the structure of the acquisition, as we mentioned earlier, and earn-outs, etc.
The upshot of all this is that a simple percentage ownership in the company, which is how most people gauge how much they will make in an acquisition, may or may not reflect the portion of the final consideration that a person or entity gets. This is particularly true for employees, but this applies not just to employees (who have stock options), but even to founders (who have common stock) and investors (who may have different series of preferred stock, each with different preferences).
The best way to deal with this is to understand the cap table, at least the preferences in the cap table, before making any assumptions, and to draw out the waterfall.
In math class, 2+2 = 4 almost all the time, but in Startup land, 1% doesn’t necessarily mean 1 out of 100!