Every entrepreneur needs a cursory understanding of how startup financing works, how shares are issued, and how cap tables are managed. For this reason, I thought I’d share some personal knowledge and best practices for getting started. Here is my financial cheat sheet for tech entrepreneurs looking to build a product or service they want to fund, grow and (eventually) sell.
Company formation
I won’t bore you with the details, but C-corporations carry certain characteristics that favor and protect shareholders including (1) limited liability, (2) perpetuity, (3) transferability, and (4) management — via a board of directors. Sophisticated investors (e.g., VCs) will, therefore, require that you form a C-corp before they invest their money into your company. Some folks will recommend starting off with an LLC as a cheaper alternative; however, if you’re planning to raise outside funding, you’ll likely end up spending the same amount of money by the time you convert over to a C-corp. For this reason, I recommend you simply cut to the chase. Personally, I’ve formed C-corporations few times now, and in fact, this is precisely what we recently did with my newest venture, Taffy.
Authorized and issued shares
As part of the C-corp formation process, you’ll need to “authorize” and “issue” common stock. What’s the difference between the two? Authorized shares are the number of shares a corporation is legally allowed to issue, while outstanding shares have already been issued. At formation, you don’t want to issue all of your authorized shares, because you’ll likely need some for later. For example, you may want to add an equity incentive plan that allows you to grant stock options to employees, consultants, advisors and the like. If you plan to eventually secure an equity financing, you’ll need to have enough authorized shares set aside to accommodate a potential 1:1 conversion down the road. (More on that under Preferred Stock below.)
So, how many shares is the right number to start off with? That’s entirely up to you and your cofounders. Just keep in mind that if you authorize too few a number, you won’t have very many shares you can issue to non-founders. And each share you do issue will represent a larger percentage of the total shares outstanding. If you authorize too many shares, you will end up needlessly increasing your annual franchise taxes to your incorporating state. Personally, I like issuing nice round numbers like 1 million or 10 million. For the purposes of this example, let’s just assume we’re issuing 10 million shares.
Now that we know how many shares will be issued to the founders (“founders’ shares”), it’s easy to determine how many shares should be authorized. My general rule is to simply double the total number issued. In this example, you would authorize 20 million shares. (Note: You are not cheating yourselves by issuing less than what’s been authorized, since the value of your entity is split among the total fully-diluted outstanding shares, after payment any debt or liens. For example, at this initial stage, the entire value of the company would be allocated to the 10 million issued shares alone.)
Equity incentive plan
What are stock options?
Stock options are a terrific way to incentivize employees and compensate outside service providers. Stock options provide the holder with a right, not an obligation, to purchase the common stock of a company at a specified exercise price on or before a specified date. Hence, the holder will presumably exercise an option (i.e., purchase the underlying stock) at a point when the market value of the shares is greater than the price they must pay for them. As an example, if in the very early days of your company, you issued stock options to certain employees with an exercise price of $0.10 per share, they may be well-inclined to exercise their options if the company were acquired today for an all-cash price of $5.00 per share. Keep in mind there are many scenarios and factors to be considered, but in this example, it would likely make sense to simultaneously sell the shares upon exercise.
Types of stock options
The two most common types of stock options are: (1) incentive stock options (ISO), which are typically granted to employees as “sweat equity”; and, (2) Non-qualified Stock Options (NSO), which are most often granted to outside service providers such as consultants and advisors, as compensation. ISOs provide a tax advantage in that no income is reported when the option is exercised, and if the shares are held for one year from the date of exercise and two years from the date of grant, any profit made on the sale of the shares is taxed as long-term capital gain rather than as income. NSOs result in additional taxable income to the recipient at the time they are exercised. (Note: There are several factors not covered here that should be considered, with respect to how gains may or may not be taxed. Please consult a tax expert, for more advice.)
Stock option pool
If you want to issue stock options, you’ll need to create an equity incentive plan, adopted by the board and approved by the stockholders. Most VCs will require that the company set aside an incentive plan of 15–20% of total outstanding shares, net of their agreed stake in the company. In other words, it’s the founders who are typically “diluted” by the option plan. In the above example, you may want to create an option pool for, say, 2.5 million shares, bringing your total fully-diluted outstanding shares to 12.5 million. The new option pool represents 20%, but keep in mind the unissued shares portion of your equity incentive plan will need to remain in the expected 15–20% range by the time you “price” your first round.
I recommend you set up your option pool fairly early on, as you’ll likely need this in order to help incentivize your earliest team members and external resources. For Taffy, we created an equity incentive plan within days of forming the company.
Vesting
ISOs will typically “vest” over four-years, with a one-year cliff, which means that 25% of the shares vest after one year; then, 1/36 of the remaining shares will vest each month for the next 36 months. NSOs will typically vest over three years from day one, at 1/36th per month. (Note: You can actually have option shares vest however you like, but I strongly suggest you at least include some form of vesting. There is little sense in issuing fully-vested shares, in my humble opinion.)
Vesting can be “accelerated” upon certain events, such as that of a “change in control” — i.e., when majority ownership of the company has changed hands, as in an acquisition. Accelerated vesting is most common for senior executive positions, or those which may be considered redundant if the company is acquired by another entity. There also common for outside advisors, board members and the like. An example of accelerated vesting for an advisor might be that 100% of unvested shares immediately vest prior to a change in control. An example for a key employee might be that 50% or 100% of unvested shares will accelerate on the last date of employment, in the event of a “double trigger” — meaning (1) there’s been a change in control, and (2) the employee has been terminated within six months of the change in control. The latter example of acceleration is meant to protect those who’ve devoted time and energy to the company, and often at a significant salary discount relative to the market.
Convertible debt
Like Taffy, if your company is in its early days, you may want to raise seed capital from friends, family and/or Angel investors, in the form of “convertible debt”. Convertible debt is essentially an interest-bearing loan that can be converted into shares upon the company’s first equity financing of some minimum raise — e.g., $1,000,000. For founders, the advantage of convertible debt is that you don’t have to put a valuation on your company prematurely. For convertible debt holders, the advantage is they will receive more purchasing power than other investors when the stock is “priced” at what’s typically known as the Series A round.
As an example, a “promissory note” may carry the following key features: (1) 5% interest, (2) 20% discount, and optionally, (3) pre-money cap. If you provide a pre-money cap feature— which helps to improve the odds of securing the investment itself, the note holder will receive the better of the 20% discount or the pre-money cap.
Let’s say your stock gets priced at $1.60 per share at the Series A. This would mean the seed investors pay only $1.28 for the same shares. But because they put their money into the company some time ago, they will simply receive 125% as many shares for each dollar ($1.60/$1.28). In the example, the pre-money cap kicks in if the capped price per share is lower than $1.28. (More on this below.)
Series A
If your company is doing well, and you’re able to win the hearts of institutional investors (e.g., VCs), strategic investors and the like, you may want raise a significant chunk of money to help further your company’s growth. (Note: If you don’t need the money, don’t do a financing. You’re better off not diluting yourself.) Most companies will seek larger funding for a variety of reasons — working capital, expansion into new products or territories, M&A, etc.
How it really works
If you’ve ever watched ABC’s Shark Tank, you’ve surely heard the “sharks” say that a 5–10% stake is not worth their time. Well, this is fairly true because most professional investors want enough stake to provide real upside potential, in the event of a successful exit. If they can’t get meaningful ROI for their investment, they simply won’t participate. The truth is most VCs expect a 20% stake. (Note: In economic times where funding is less available, this expected stake will fluctuate higher — e.g., 30% or more). But generally, it’s a magical number of sorts. VCs will, of course, take more if they can get it. This is where you come in. You need to make sure your company has enough real or perceived value to win over the hearts of investors, and you need to speak the lingo.
Setting the expectation
You can set the expectation on your valuation, but this requires some quick thinking and/or advanced preparation. First, you should know how much money you need to raise. Then, add a buffer to be sure you don’t end up going back to the well in a more vulnerable position. Let’s say you land on $5 million total. You already know the investors will expect a 20% stake in your company, so that means the $5 million represents 20% of your company. In other words, your “post-money” valuation is $25 million ($5m / .2). Your “pre-money” valuation is the post-money valuation minus the money itself. In this example, the pre-money would be $20 million ($25m - $5m). This is the number most VCs are interested in. “How much are you looking to raise and what’s your pre-money valuation?” You need to nail this, and a solid response might be “We’re looking to raise $5 million at a $20 million pre.” They will do the quick math in their heads and conclude that there’s an acceptable 20% stake available.
Be realistic
Unless you’re Facebook, Uber or Airbnb, do not expect that you can raise $5m for 10% or even $2.5m for 10%. For early-stage tech companies, just be prepared to sell a 20% stake in your company and try to get as much as you can for that, making sure you don’t (1) price yourself out of a deal, and (2) put your company into a position where you may need to “down-round” later on because your valuation was unrealistically high at your Series A round. (Note: Your company should increase in valuation with each round of funding. A down-round — where your valuation is lower than your previous round — can be not only embarrassing, but quite costly.)
Lead investor
Typically, the investor who puts in more than half of the Series A round negotiates and sets the terms of the deal — pricing, preferences, etc. They are referred to as the “lead investor”. Lead investors will summarize the terms of the deal in a “term sheet” document, and all other investors participating in the syndicated round will generally accept those same terms.
Riding alongside
Your convertible debt holders will also convert at the “priced round”, as noted above. If your debt holders have a pre-money cap that provides for a better price than the 20% discount, the cap will be triggered. Let’s say, for example, your seed investors had a $4 million pre-money cap. If the pre-money valuation comes in a $20 million, your seed investors would receive 5x ($20m / $4m) the number of shares a new Series A investor receives for each dollar invested (ignoring interest for simplicity). This is obviously much more favorable than the 20% discount, but your company still makes out on the deal. How? Let’s say, for example, you had instead raised your seed round for a 20% stake in the then-young company. And let’s say you raised $500k. Those investors would now have a 16% stake, after dilution from the A round. Would $500k really have been worth selling a 16% stake in your company? Under the convertible debt scenario, your seed investors would pay roughly $0.32 per share (far better than the $1.28 per share provided by the discount), assuming your shares were priced at $1.60. This would equate to roughly 1.6 million shares, which would represent just under 9% of the company. Since 9% is less than the 16% alternative, it’s obvious the company has done well by issuing convertible debt rather than selling shares at the seed round.
Preferred stock
Investors typically receive what’s known as “preferred stock”. Preferred stock provides investors with certain advantages over common stockholders, including:
Convertibility — The ability to convert preferred shares into common (typically 1:1), in the event holding and/or selling common shares becomes more valuable.
Liquidation — The amount that must be paid to preferred stockholders before distributions may be made to common stockholders.
Dividends — The ability to declare and collect annual dividend payouts.
Dilution
As you may have figured out by now, issuing equity beyond the founders’ shares means you’re actually issuing new shares. You don’t cut a slice of the original pie for employees and investors; you increase the size of the pie. In this example, you started out with 10 million shares, added 2.5 million for option pool, and then roughly another 5 million shares for the Series A (including the convertible debt holders). This brings your total fully-diluted outstanding shares to around 17.5 million.
So, let’s take a quick look at “dilution”. In the beginning, your original 5 million shares represented 50% of the company, as split between you and your cofounder. However, those same shares now represent roughy 28% of the company (5m / 17.5m). The effect of this reduction in ownership is called dilution, because your position has essentially been watered down. But obviously for good reason. In this case, you’ve raised $5.5m and grown your company into the success it is today. And chances are you’ll have a successful exit further down the road.
Cap Tables
A capitalization table is essentially a spreadsheet summary of all the equity transactions that have occurred since your company’s inception. The cap table also includes a variety of legal documents — stock issuances, sales, transfers, cancellations, conversions of debt to equity, and exercises of options. Managing the cap table includes drafting and signing of legal documents, recording transactions, communicating with shareholders and complying with regulations among other things. Most startups will seek outside assistance in managing their cap tables, typically from a law firm; however, a Controller or CFO should also be capable of managing this for your company. With a bit research, any founder can start a rudimentary cap table in their company’s earliest days. The bigger trick lies in drafting and executing the appropriate board and shareholder documents, and obtaining and managing the other various legal documents associated with each transaction.
Debt financing
I’m not a huge fan of debt financing, so I’m not going to say a whole lot about it. But, if you’re able to raise money through debt rather than equity, then by all means do so. Debt is cheaper than equity for a variety of reasons. However, you will likely need to be generating revenue, and you’ll need to allow the debt holders to put a lien on your assets. You may also need to adhere to debt covenants, and possibly sign a personal guarantee. For these reasons, debt is likely not even feasible for most startups. But it’s something to keep in mind, in the event your company is of the right profile down the road.
Exits and returns
There are many factors that go into if and/or when your company should seek an exit — whether by acquisition, IPO or otherwise. But you can bet investors will expect their money back and then some, generally within a 5–10 year timeframe.
So, how much are investors expecting? It depends quite a bit on your type of product/service, the evolving marketplace, technology, and plenty of other factors. But generally, VCs expect a 5–10x or better return on their investment. Assuming your business is not a statistical outlier (i.e., you’re not the next Snapchat, nor the next Yik Yak), most VCs might be looking for their $5 million investment to eventually return $25–50 million. (Of course, they know it could flop, as well.) In our example, their investment represents 20% of your company, so that would suggest your VCs believe your company could eventually be worth $125–250 million ($25–50m / 20%), in total. Of course, there are countless scenarios. The point here is to keep in mind what might be your VC’s perspective, as that can serve as a decent data point on their expectations and what could pan out down the road. Worst case, this perspective certainly cannot hurt you.
Conclusion
I hope this post has distilled a few basic yet important concepts, and provided a few helpful tips you can use as you build and grow your company. This cheat sheet isn’t for everyone, but it’s something I’ve put together throughout my 15 years of experience working for startups and advising tech founders and CEOs. I have followed these basic guidelines a number of times now… and for various startups, including my own. Taffy is my latest and greatest, and no exception.
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