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Liquidation preferences and employee options drastically affect equity.

When starting a company it is important to understand how equity will change hands at every round. The valuation of the company is one of a few key terms to negotiate, but to do so effectively you need to also, at least, understand liquidation preferences and employee option pools.

We will go through each term independently and explain a few major ways the terms are used. As you read this document you can also refer to the attached spreadsheet to guide you:  download here.

Pre-Money Valuation:

The valuation of the company is typically discussed by how much the company is worth before raising money. In simple terms, if the company is worth $6M pre-money and then raises $1M it would be worth $7M post-money. This would entail selling 14.2% of the company.

Liquidation Preference: 

Investors likely will ask for a liquidation preference whereby if there is a change of control those investors will get paid a multiple of their investment first and then the rest of the shareholders will be paid. There are two main types of liquidation preference:

Participating liquidation preference: means an investor a multiple of their investment AND participates in their ownership percentage of the remaining money. For instance, let’s say an investor invested $1M in a $6M pre-money valuation ($7M post) with a 2x participating liquidation. They would then own 14.4% ($1M\$7M) of the company and would get upside on any change of control. If the company then sold for $15M the investor would get back 2x of their investment first for $2M (2 * $1M) and then the rest of the remaining $13M ($15M – $2M) would be distributed among ALL shareholders. The investor would then get an additional $1.9M (14.4% * $13M) for a total of $3.9M ($2M + $1.9M).

Non-Participating liquidation preference: means an investor gets the higher of their multiple OR participation. Let’s do an example using the same numbers as above where the investor has a 2x liquidation preference and a 14.4% ownership of a $7M post-money valuation. If the company again sold for $15M, the investor would have a choice of either receiving $2M (2 * $1M) for their liquidation preference OR $2.2M (14.4% * $15M) for their participation. Thus the investor would then receive $2.2M.

Liquidation preferences are stacked and paid out last in first out meaning a Series B liquidation preference likely would be paid out before a Series A liquidation preference. In all cases, this provides a preference for investors to the disadvantage of investors of prior rounds, employees, and founders.

Employee Pools:

As you grow the startup you will also issue options or shares to employees. This is structurally handled by setting aside a pool of options to provide for employees at each round of financing. The pool is typically set aside pre or post-money:

Post-Money Pool: Means that option pool is not included in the share price that investors buy and is added afterward to the total number of shares outstanding diluting all shareholders proportionally. Let me explain.

In the above example, an investor invested $1M at a $6M pre-money valuation. At this point, let’s assume that 1M shares were already outstanding and belonged to the founders. The price per share would then be $6 ($6M\1M) and 0.16M ($1M\$6) shares would be issued to the new investor. The total shares outstanding would be 1.16M, the investor would own 14.2% and the founders would own 85.8%.

Then a post-money employee pool of 10% would be issued of 0.13M options bringing the total shares outstanding to 1.3M (1.16M+0.13M). This would thus drop the investors’ ownership share to 12.9% and the founders’ share to 77.1% with the employee pool remaining at 10%.

Pre-Money Pool: Means that all newly issued employee options are calculated into the fully diluted price per share which investors then buy. Let me explain.

In the above example, an investor invested $1M at a $6M pre-money valuation. Before raising the round 1M founder shares were outstanding. Then, a 10% employee pool was issued, but this time pre-money for a total of 1.11M (1M + 0.11M) shares outstanding. The price per share would then be $5.3 ($6M\1.11M). Finally, investors would be $1M worth of shares at a price of $5.3 per share issuing an additional 0.19M ($1M\$5.3) to investors. The total shares outstanding would be 1.32M Investors would own 14.3%, founders 75.7%, and the option pool would be at 10%.

The above example highlighted how the founder ownership was 77.1% with a post-money employee pool compared to 75.7% pre-money employee pool. Thus, post-money employee pools are more favorable to existing shareholders as everyone is proportionally diluted by the employee pool.

The attached spreadsheet allows you to play with the variables yourself and assumes the company sells post-Series A. To start, the spreadsheet demonstrates: (Download Here)

  • 2 founders start a company and each own 50%.
  • They raise a $1M seed round at a $6M pre-money valuation with a 10% post-money employee option pool.
  • They then raise a $7M Series A at a $15M pre-money valuation with a 10% post-money employee option pool and a 2x non-participating liquidation preference. At this point, founders own 50.8% collectively, employees 6.6%, and investors 39.2%.
  • Finally, they sell the company for $45M. Founders receive $22M, employees $4.5M, Seed round investors $3.8M (3.8x IRR), and Series A investors 14M (2x IRR).

Founders definitely need to understand these terms while raising money, but employees do too. They can work for you in properly capitalizing a company to sell or take public. The terms can also work against you in sideways cases where the company doesn’t achieve the desired growth trajectory or when a strategic partner proposes an early acquisition offer. Appropriately structuring the cap table for one’s objectives and constraints become a huge strategic asset.

This post is only a summary of terms, to dive deep into term sheets read Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist

Also, check out my other blog post on Should I Join a Startup which discusses average equity compensation for mid-level employees post-change of control.

Or, check out the resource section for the: Best Entrepreneur – Books, Blogs, & Resources

 

2017-09-16T14:31:46+00:00

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