Special Disclaimer: I am absolutely not a lawyer or tax professional. Please don’t treat this as legal or tax advice.
I wrote this post mid-way through fundraising for Modulate – around the time that terms started getting discussed in real detail. The idea in my mind was simple – I was fundraising as a full-time job and still barely able to keep up with all the hidden traps and complexities built into the way equity is managed in startups. So there was no way I could ask Modulate’s future employees to make informed decisions around things like equity compensation without providing some resource that could at least illuminate the basics.
This is my attempt at such a guide. I hope it proves valuable!
Let’s start with the basics. A share of stock is a share of a corporation. If there are 100 shares of stock and you own 1, you own 1% of the business. This means you have 1% of the votes on company issues, and upon an acquisition, your stock could be sold for 1% of the overall sale value.
For most people, this is a sufficient understanding of stocks. However, if you are joining an early stage startup, this basic understanding can actually lead to some severe misunderstandings. Generally speaking, doing the math on “how much is my stock worth” is a good way to overestimate your compensation. I don’t recommend treating equity grants as equal to any amount of money – rather, treat them as lottery tickets. But if it’s important to you to understand that lottery ticket in more detail, then this guide is meant for you.
Privileges of Stockholders
Note that some of these rights and privileges can change slightly according to your company’s stockholder agreement – make sure you’ve read your specific agreement to learn the details. But, generally, holders of common stock have access to rights such as:
- Voting Rights
- Holders of common stock are granted a number of votes typically proportional or equal to their shares of common stock. They are permitted to cast votes on a variety of company initiatives, such as the composition of the board of directions, or the decision to perform a stock split. These votes most commonly take place during a yearly stockholder meeting, but may be called for at other times as well.
- Disclaimer: Voting is generally majority rule – which means the major stock owners will dominate the conversation. If you’re joining a private company, it’s likely the founders own a majority of the common stock, in which case your voting rights might not be very meaningful in practice. At public companies, where stock is generally split much more broadly, the votes of minority shareholders may take on greater significance.
- Shared Profits
- Should a private company elect to pay dividends, those dividends will be on a per-share basis – meaning you will receive more of the profits of the company depending on how much of the stock you own. In addition, should the company be acquired or go public, you will generally have the opportunity to sell your individual shares at a price corresponding to the overall sale price, meaning you get to participate in the profits gained from the sale (though doing so is in exchange for your stock, so you lose your rights afterwards.)
- Disclaimer: There’s no requirement that private companies pay dividends – and, in fact, most small startups will be inclined to pour their profits into growth rather than distribute them. Don’t expect any windfalls from this during the company’s early life.
- Preemptive Purchase Rights
- Should the company create additional shares of common stock, shareholders typically have the right to purchase these shares themselves at the expected price before the company can sell to outsiders.
- The Right To Sue
- As a shareholder, you are legally an owner of the company – meaning you have the right to sue if the representatives of the company don’t respect any of your above rights.
Valuations are made up numbers used to describe the anticipated value of a class of stock.
I want to repeat that.
Valuations are made up.
Depending on the stage of the company, these numbers might be based on lots of data, or maybe just a nice story. But it’s important to understand that these numbers have nothing to do with your ability to sell shares for any particular amount of money.
So where do valuations come from? There are two ways a valuation can come about. The first is the valuation that emerges from a fundraise.
Say a hypothetical company raised $1M, in exchange for 20% of the issued common stock of the company. In that case, we can ask “at that rate, how much would it have cost for investors to buy all the common stock”, and get our answer as $5M. This is called the “post-money” valuation – it corresponds to the value after the investors put their money in.
You could then say “well, the investors put in $1M – so prior to their investment, the company should have been worth exactly $1M less.” That number – $4M in this case – is the “pre-money” valuation.
The other way a valuation can come about is from an official overview of the company’s assets. This is called a 409a valuation because the government does not specialize in naming things usefully. 409a valuations attempt to assess the real, present worth of the company, while valuations which emerge from fundraising tend to be based around idealized future value. So fundraising valuations are typically higher than 409a valuations.
Valuations serve two important functions. The first is as part of the startup’s story, and as a signal about investor expectations. Again, it’s important not to confuse this with the actual worth of company shares, but it’s also not meaningless – companies with higher valuations are expected to succeed, and (all else equal) might be better bets. That said, all else is never equal – things like the founders’s skills at storytelling (which has nothing to do with running a business), the specific investors they have involved, etc – are much more likely to cause a slightly higher valuation than some hidden truth about one startup being less risky than another. (Hint: all startups are risky. If you’re looking for a startup that has no risk of collapsing, you’re not looking for a startup.)
The second function of valuation is to value shares given to employees. If a company wishes to hire a new employee with a 2% equity incentive, that means they are handing the employee 2% of the shares in the company as part of their compensation. For tax purposes, it’s necessary to estimate the value of this asset, and valuations are used to do this. This is the only direct sense in which a valuation corresponds to real money, as far as employees are concerned.
One last point on the valuation front is that it’s possible for the company to authorize stock without issuing the stock. Valuations from fundraising correspond to the amount of issued stock. Say a company has 10M authorized shares, and issues 3M to each founder. The founders then issue 1M of the authorized stock to investors in exchange for $1M. In this case, the post-money valuation of the company is $7M, corresponding to the amount of issued stock, even though 3M more shares have been authorized. Should those authorized shares be issued later, it would dilute everyone else’s value. In other words, if another 1M shares are issued without the valuation changing, then the $7M valuation now corresponds to 8M issued shares, so each share is now valued at $0.875 instead of $1.
Variations on Stock
I hope all of the above made sense, because here’s where it gets complicated: there are different types of stock. There are also assets which correspond to stock but are not stock themselves. And all of them have different valuations and can have different kinds of rights.
Restricted stock is simply common stock which vests – meaning that you don’t actually own all of it on the purchase date. Instead, a vesting schedule determines the rate at which the stock becomes yours. So I might pay to purchase 100K shares of a company, but on a four-year vesting schedule which accrues monthly. In this case, every month, I’d gain ownership of 100K/(12*4) ~= 2000 shares of the company. Even though I paid for all 100K shares up front, they wouldn’t become mine until each month went by. This is important for two reasons. The first is that the rights of the stock – for instance, voting rights – are not mine until that stock vests. The second is that the vesting of the stock is what’s recognized by the IRS as the gain of an asset. So normally speaking, I’d need to pay taxes each time more stock vested, which is both painful and expensive, since the stock that vests in 3 years might actually be valued much more highly than the stock was when I first purchased it.
In order to avoid this issue, it’s highly recommended to complete an 83b form within 30 days of the initial restricted stock purchase (also known as a grant.) This form tells the IRS that you’d like to be taxed for all of the stock, despite it not having vested yet, immediately. Thus, you pay more tax up front, but don’t have to worry about paying any additional taxes until you decide to actually sell the stock and realize the gains in its value.
It’s worth noting that most vesting schedules also include a 1 year cliff – meaning you receive no equity for the first year, and then receive that whole year’s worth one year in. You then would continue month-to-month from there. (Sometimes it’s weekly or bi-weekly instead of monthly.)
Restricted Stock Options
Stock options are the most typical offering granted to new employees. The “Restricted” here means the same as with the Restricted Stock mentioned above – basically, your options vest.
Briefly, what are options? Options are the right to buy an asset later at a price set today. Why is this sensible for a company to give to employees, instead of just giving away stock?
Say a company wants to give their employee 1000 shares, today valued at $10,000 (the company has been doing extremely well.) If they did this as restricted stock, then with an 83b form the employee would have to pay roughly $4,000 in tax immediately – despite not having received any money yet! (Remember, equity is not the same as cash!) This can be quite difficult for some employees and is expensive either way.
Instead, the company might choose to offer 1000 options, with a strike price (that is, the price at which you can purchase stock later) of $10/share. Because this strike price matches the current value of the shares, these options are nearly worthless today – so the tax the employee must pay is negligible. But, if in two years the shares are worth $50 each, the employee can exercise their options (that is, purchase the shares) at $10 apiece – realizing nearly identical gains to if they’d held stock.
They will need to pay tax at this point, but only on that $40 difference, which is considered compensation. (If they are exercising options which have not vested, they’ll want to file an 83b election to pay taxes on their equity now as well.) This allows employees to defer the tax payment until they’re prepared to pay it – and, since employees often don’t exercise their options until the company is bought, they might earn the money from their stock on the same day, making it much easier to meet the tax payments. It’s worth noting too that if they owned stock, they’d be paying taxes on the difference between their purchase price and their eventual sale price – so this is not unique to options, even though it manifests slightly differently.
One further note about options is that the long- or short-term capital gains taxes apply based on the time between the exercise of the option and the sale of the stock. So if you wait to exercise your options until the company is purchased, you won’t ever have to pay taxes until you have your money, but your tax rate will be higher. If you can afford it and have high confidence in the company, it’s best to exercise your options a year or more before the company is acquired (or goes public) so as to have access to the long-term capital gains tax rate.
Investors will occasionally purchase Common Stock, especially at very early stages, but at later stages most investors will required Preferred Stock. This is a different class of stock, with a separate valuation from Common Stock – and in fact, there are many Preferred Stock types. (Typically each fundraising round will see a different type of Preferred Stock created corresponding to that round.)
Preferred Stock also has different rights than Common Stock. It often takes special provisions such as:
- The right to veto any potential acquisition
- The right to appoint a board seat directly
- The right to have their investment (or a multiple of their investment) repaid before any money flows to common stockholders during an acquisition
These rights will be specific to the terms accepted by the founders during fundraising – you’ll need to discuss with your specific company in order to understand the full scope of how Preferred Stock differs from Common Stock.
It typically helps to do a sample calculation here, so let’s take a slightly nontrivial hypothetical. Company C has two founders, who each own 40% of the Restricted Common Stock, and have both fully vested, so now just own Common Stock. In addition, there is a coalition of investors with Common Stock from a friends and family round who own 18%. You, the only employee, own the remaining 2% of Common Stock.
However, C has also raised two fundraising rounds. Their Series Seed took in $2M on a $8M pre-money valuation, and their Series A took in $5M on a $20M pre-money valuation. We’ll assume that both Preferred Stock categories require their money to be paid back before additional funds are distributed, though the Series A Preferred Stock takes precedence.
C is sold for $3M
The Series A investors receive all $3M, proportionally split amongst themselves according to their investment in that round. Nobody else sees a dime.
C is sold for $6M
The Series A investors receive $5M, the Series Seed investors receive $1M distributed proportional to their investment in that round. Nobody else sees a dime.
C is sold for $20M
Now ownership percentages begin to matter. After the Series Seed, the investors owned 20% of the company, and the Common Stock holders owned 80%. After the Series A, the new investors took 20% overall, diluting the remainder. So after the Series A, the Series A investors own a 20% stake, the Series Seed investors own a 16% stake, and the Common Stock holders collectively own 64%. But this would mean the Series A investors only receive $4M – and they put in $5M! So they’ll still get their $5M before the rest gets allocated. Then, of the remaining $15M, the Series Seed investors will receive $3M – enough to satisfy their liquidation preference. So the remaining $12M gets split amongst Common Stock holders – you, with 2% ownership, receive $240K, which is 1.2% of the actual sale price.
C is sold for $80M
Since the company was sold for enough to guarantee that all investors get at least their investment back, under this preference scheme (which is fairly founder/employee friendly), the money will be allocated according to percent ownership. So the Series A investors receive $16M, the Series Seed investors receive $10.8M, and the remaining $53.2M is split amongst Common Stock holders. Thus, you, as an employee owning 2% common stock, end up with $1.064M – closer to 1.33% of the actual sale price. (This is the fair dilution of your 2% stock after two sales of 20% of the company.) Note that, as the sale price goes up, not only does the cash value of your return increase, but so does your percent take – this is because, generally speaking, Preferred Stock liquidation rights have absolute thresholds, and once you overcome them everything is distributed evenly.
Sometimes Preferred Stock could come with much stricter privileges – for instance, 3X liquidation rights would require the Series A investors to be repaid $15M, leaving almost nothing for employees during the $20M acquisition. Similarly, “Participation Rights” allow investors to double dip – even after the Series A investors took their $5M back, they’d also get a portion of the remainder equal to their proportional equity stake in the company. These clauses seriously diminish the expected return of employees and founders alike, and we’ve seen many VCs even start to avoid them for fear of disincentivizing the founders and their teams too heavily. Make sure you understand the exact structure of these clauses when you start thinking about what possible acquisitions might mean for you!
We briefly mentioned dividends before – for Common Stock, they occur as declared by the board of directors and allocate a portion of profits to stockholders proportional to their ownership stake.
However, Preferred Stock negotiations can cause additional dividend obligations for the startup, which of course takes away from the pool of wealth which can be collected by you. Not all Preferred Stock includes these clauses – some merely participate normally in dividends as if they were common stock. However, there are two fairly common dividend requirements which might be added.
The first is non-cumulative dividends. This is basically just an annual requirement that the company pay a set dividend (usually set as a proportion of the original share price). However, the company has the right to forgo that payment, so long as no other dividends are being paid, should they judge it in their best interest.
The tighter constraint is cumulative dividends. These have a similar structure to their non-cumulative counterpart, but with the caveat that, should the board of directors forgo a payment, that payment is added to what’s required in the future. Then, should an acquisition occur, or should the company wish to buy back the Preferred Stock, these owed dividends must be paid on top of the actual value of the stock. (So, in the $80M acquisition example given before, if the Series A Preferred Stock had an 8% dividend that had been missed for two years, they’d be owed $800K, which would be taken off the top of the $80M before any of it was allocated to other stockholders, separate from the $16M those investors would receive for the value of their shares.)
Valuing stock exactly is hard, even if you knew the future. Without a solid understanding of the preference terms and other classes of stock which exist, it’s extremely difficult to assess exactly how much a given share is worth. However, a good rule of thumb is the following:
- Acquisitions at less than the amount of money put into the company mean you likely won’t see any money.
- Acquisitions at less than the valuation of the company at the most recent raise will have you see a fair amount less than you thought your equity was worth.
- Acquisitions at a significant markup will probably have you receive (proportionally) the same amount as preferred investors – but you’ll have to remember to take your overall dilution into account.