Alchemist Accelerator was delighted to welcome Jeff Erickson for a primer on equity. Jeff is a startup founder, angel investor and Carta veteran, now at Forecastr. These are my personal notes from the session, and any errors are mine and not Jeff’s!
What does Rachel bring to the marketplace?
What is equity?
Equity is ownership in your company. There are two forms you need to worry about as founders:
- Economic ownership, which is what we’ll talk about today.
- Governance ownership, which is something to think about. In theory, you could have 90% economic ownership and not have governance control. Startups typically are set up as a C corp with a board of directors and is the board that makes decisions for the company. For certain decisions you might need 75% shareholder vote but typically most of big decisions in C corp are made by the board. The board has a fiduciary responsibility to shareholders but it can vote to oust even a majority owner.
Know the differences between common vs preferred stock
Investors have preferred stock, which means that they get paid out first. Founders/employees/advisors get common stock with “residual” rights, which means they get what’s left over. As a founder, if you agree to some pretty onerous preferred rights or liquidation preferences, subsequent investors will say “we want at least those terms or better,” so be careful what you accept from early investors. As an investor I might even hurt myself if the preference stack is lopsided.
Understand stock options
You’re bootstrapping in the early stages and it’s hard to afford an engineer who’s been at Google earning $300k. Maybe you can afford $100k but that’s not enough. In that case, you can say, “We’re not able to pay you a market salary but we want you to have some interest in the upside of the company so we’ll give you some stock options.” You’re granting these individuals the option to buy shares later at a fixed price - the “strike price.” Ten years from now the company goes through acquisition or IPO. The shares they got the right to buy at $0.05 are now worth $10, which is meaningful.
Stock options are very incentivizing for employees or advisors. Make sure you understand how much and at what level different employees might want stock options.
There are two types of stock options:
- Incentive Stock Options (ISOs) typically for employees
- Non-qualified Stock Options (NSOs) for advisors or contractors
You have to set a strike price at time of granting. The IRS will not let you randomly select strike price - there needs to be some validation of what the shares are worth. A 409A Valuation is what you get to put you in compliance with section 409A of the tax code. Note that this is not the same as the valuation investors will look at. You as a founder and all your employees want 409A valuation to be as low as possible. Your third party (eg Carta) wants it to be high enough that IRS sees it as justified.
Vesting schedules
Vesting applies to stock options and to founder shares. Say three co-founders split the company in thirds. One founder gets an offer in New York and walks away with a third of the company. That’s not fair to the other founders.
You always want to put vesting schedules in place for the founders as well as the ISOs. Investors don’t want to see “oh, this key employee doesn’t have any vesting left, so what is their incentive to stick around?” Typically options accrue for one year, so employees receive 25% of the grant on their work anniversary (one year cliff) and then are issued monthly for another three years (four year vesting schedule)
Typically all the founders would have the same vesting schedule. Where you might have differences is if one founder had been there a year longer than another founder, in which case you can backdate or accelerate vesting.
Best practice: get a good startup attorney. They know how this works, they know what’s fair, they know how to structure it.
SAFE (Simple Agreement for Future Equity)
A SAFE says “I’ll give you this money and we’ll convert this to equity at a future time.” Two important features of a SAFE are a discount as incentive for investors and a valuation cap. A 20% discount is pretty standard in early stage companies. At the time the SAFE converts (the conversion trigger), the investor is going to be able to purchase shares at a 20% discount, i.e. if shares are worth $1, the investor gets to buy at $0.80.
Most investors aren’t super excited about just a discount. There’s no guarantee on a SAFE that you’re going to raise in the future - maybe you get to $100M and never have to raise - if I only get the 20% discount on a $100M valuation over a long period of time, that’s not a good investment. We need to set a valuation cap. If we don’t raise for a little while, or if the next raise is at a huge valuation, you’re still going to benefit from coming in early.
Convertible notes
Convertible notes are similar, but a couple of different things are more advantageous for investors. Debt will probably still have a discount, a conversion trigger and a valuation cap. Debt will also have a maturity rate, eg 12 months. If things aren’t going well, your investor can say “I’m going to call my note. I want my $1M with interest.” You don’t have that with a SAFE.
Investors are not very interested in an 8% return on your startup. If things aren’t going well, you probably don’t have $1M to pay them back. Then it ends up in a negotiation. You either need to go out and raise more funding and pay back the debt, or the investor can, theoretically, liquidate the company. You as a founder are going to have to negotiate things. The investor is probably not going to be made whole. You’re going to walk away.
If the company has some serious intellectual property, you’re going to put that at risk. The investor could call that note at your maturity date, shut you down, take your IP and have somebody else run the company.
Equity Management
Say you issue common shares to founders and put a vesting schedule in place. Then you go out to friends and family and do 3 SAFE notes for $50k each. They’re not exactly equity yet but they’re going to convert in future. You need to keep track of all that. Next a rock star employee gets ISOs, advisors get NSOs, now there’s a vesting schedule with stock options you need to keep track of. You raise your first round, you’re issuing preferred shares, SAFE notes convert. You hire more employees with stock options, more vesting schedules to keep track of. Some of the stock options convert to common shares. More investors come in and get more preferred shares. At some point it gets kind of crazy How do you keep track of your company’s equity?
- Keeping a good cap table is going to make it easy to answer questions
- You’ll be able to tell how much as a founder you own
- You can tell how much dilution you’ll take in a raise
- You wouldn’t believe how many times startup attorneys have to remind founders they only have 100% of the company to give away
- Manage and track employee options and vesting schedules
- Avoid lawsuits! The last thing you want to do is leave investors off the cap table
What do investors look for in your cap table?
The cap table is one of the first things investors will ask for in due diligence. If you can send it over in 30 minutes, and if it’s accurate, their confidence level goes up. Here are some of the things you want to be aware your investors will be looking at:
- How much equity do you have left as a founding team? Investors are thinking “We need to raise multiple rounds, this founder won’t have anything left.” That’s a red flag
- Who are the key employees? Have some moved on? Is a founder no longer active? Why did this person leave?
- What’s the turnover in your company? You issued options to 30 employees and 20 left and never exercised their shares. Do they know something we don’t know? Are there cultural issues?
- Is there enough in your option pool to attract future employees? What’s your hiring plan?
- Who else is on the cap table? If they see investors that might be disreputable, that’s going to be a red flag and might kill a deal. If Marc Andreessen’s on your cap table, that’s probably a good thing
- Are there any surprising preferences or obligations?
- Most investors want to have a clean cap table. If you have very small investors ($5000-$50,000), it probably makes sense to use a special purpose vehicle and roll those up. It’s one line item. That syndicate can vote as one group - you don’t need to have every single shareholder sign off on something. That said there are some costs associated
- Why use a service at all? Why not keep a detailed spreadsheet? It takes a bunch of time and you have to update it constantly. You don’t like to call your attorney very often. Now your attorney is working off a different version of the cap table than you are. Spreadsheets can be error prone. If one formula gets corrupted and you make decisions on it, that can be a real problem
- Make sure you get a good startup attorney!
Best practices
- Keep your docs in order, whether it’s Carta or a data room. Those documents will be used for due diligence and any time there’s a question
- Make sure you keep your cap table up to date and accurate. As soon as you issue a SAFE or someone exercises a stock option or you make a stock option grant, update your table or notify your attorney. It will save you a ton of time and expense later
Thanks again to Jeff for an awesome session. Alchemist Accelerator is lucky to have you!
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