One Size Does Not Fit All: The Basics of Technology Company Capitalization
When it comes to startups, one type of equity does not fit all. Below, I’ve outlined several common equities that startup companies issue based on an individual’s role within the company.
Often referred to as “Founders’ Stock”, founders typically purchase shares of the company’s Common Stock at the time of inception via a combination of cash (to help capitalize the company and to cover startup costs such as legal, accounting, and other initial operating expenses) and by contributing intellectual property to the company (such as the business plan, software code, trade secrets and other inventions relating to the business).
What makes Founders’ Stock unique, is that although the founder owns the shares, can vote the shares and can receive all economic benefit from the shares, the shares are typically subject to reverse vesting – meaning the company has a contractual right to repurchase all or a portion of the shares in the event the founder ceases to provide service to the company. The schedule by which the company’s right to repurchase the shares lapses will vary from company to company, however, a typical vesting schedule is 25% of the shares are released from the company’s right of repurchase after one year, and the remaining shares are released in equal installments over the course of the next 36 months.
The agreements setting forth these vesting schedules can also provide for the acceleration of vesting upon the occurrence of certain events. “Single trigger” acceleration means that one event must occur before the vesting schedule is accelerated. These events can be termination without cause or the sale of the company. “Double trigger” acceleration means that two events must occur before vesting is accelerated. A common example of double trigger acceleration is: if the company is sold (1st trigger) and your employment is terminated without cause within the first 12 months following the sale (2nd trigger) then the shares are released from the repurchase option. Acquirors like this language since it ensures that the employees at the acquired company still have economic incentive to come to work following the sale, but protects employees in the event their new employer decides to fire them.
This repurchase right serves several important functions:
- It is a good mechanism to deal with the free rider problem that can arise when you have multiple founders. A founder who leaves the company after just a few months probably should not have the same equity interest as a founder who continues to provide service to the company for many years – you will often hear investors refer to the working founder’s equity as “sweat equity”.
- It gives a team some period of time to attempt to work together and determine who the core team will be, without irrevocably giving away a significant equity stake in the company if a co-founder is not going to work out in the long-term.
- It protects the company’s investors who will invest in the company’s management team just as much as its technology by locking in key members of management and aligning financial incentives with those of the investors.
Allocation of these shares among the founders is outside the scope of this article, but I would recommend a great blog post on this subject by Aaron Houghton, co-founder of Preation and iContact.
Employees typically receive stock options as their ownership stake. A stock option is the contractual right to purchase a certain number of shares (almost always Common Stock) at a predetermined price (referred to as the exercise or strike price) at some point in the future (generally, within 10 years of the date of grant). Options are almost always subject to vesting – though, unlike with Founders’ Stock, the optionee cannot exercise the option until it has vested – and can be, but are not always, subject to acceleration. The vesting schedule described above is also typical for an option.
There is a lot that can be said about stock options, so please see this feature written by CNNMoney.com if you care to learn more.
Investors will fund the operation of the company by investing cash to purchase their equity interests. More often than not, they will purchase Preferred Stock, which is a class of stock that is granted certain rights, preferences and privileges that are superior to those of the Common Stock. You may have heard how investors can impose onerous terms on entrepreneurs or even assume control of the company post-investment. The special rights granted to the Preferred Stock is how this is accomplished.
Below is a list of some, but far from all, of these rights, preferences and privileges that are typically granted to the holders of shares of Preferred Stock:
- Liquidation Preference – Your investors will be entitled to receive their money back before you do in the event you sell the company.
- Preemptive Rights – You must offer your investors the opportunity to purchase additional shares of stock in the event you intend to sell additional shares so that they can maintain their proportionate ownership interest in the company.
- Anti-Dilution Protection – If you sell shares of stock in the future at a lower price per share than your investors paid to purchase their shares (with certain exceptions) the conversion ration that determines how many shares of Common Stock will be issuable upon conversion of the Preferred Stock will be adjusted in an advantageous manner for the investors.
- Registration Rights – Your investors will have the ability to force you to register their shares for sale in a public offering, or even for the company to undertake a public offering at some point in the future.
- Co-Sale Rights – If you or any other founder attempts to sell your shares, the investors will have the ability to substitute a number of their shares for yours in such transaction. The logic is that your payday and theirs should come at the same time.
- Redemption Rights – Your investors may have the right to force the company to repurchase their shares at some point in the future.