Startup Toolbox

Jay Parkhill July 17th, 2008

This post may get a bit wonky.  I’ll do my best to keep it straightforward.

I have talked to a lot of people in my career who get confused by the value of shares of stock in a startup company.  A venture-oriented company has two or more different kinds of shares with different values attached.  Here’s how to keep them separate.

Pre-Money, Post-Money and Per-Share Value
When a company does a financing, it sets a value for the entire company- the “pre money” valuation before the new money comes in.  Let’s say the value is $10M.  If the company has 5M shares outstanding, this means that each share is worth $10M/5M = $2.00.  This is the price investors will pay to buy stock in the company.

If the investors are putting in $5M, they are buying $5M/$2 = 2,500,000 shares.  The company now has 7.5M shares outstanding, and the total “post-money” valuation is $15M.  We can see by the numbers that on a per-share basis (2.5M/7.5M) and a dollar-value basis ($5M/$15M) that the investors now own 1/3 of the company.

Common Stock vs. Preferred Stock Pricing
The part that gets tricky is that investors buy preferred stock, but the company also has common stock that it will issue to employees.  Preferred stock has superior rights, especially including a right to get paid first when the company is sold.  By convention and IRS rules, we are allowed to say that the preferred stock is worth more today than the common stock.  Thus, when we sell preferred stock to investors at $2.00/share, we can give options to employees to buy common stock at a much lower price- $0.30 or so.

This works well for the most part.  Investors want certain rights that employees don’t care about and pay extra for them.  Employees would rather get low-priced options than the preferred rights.  Everybody is happy.

But I Thought Each Share Was Worth $2.00?
The place people get tied up is comparing the enterprise valuation with the common/preferred stock differential. We valued the entire company at $10M, which meant that each share was worth $2.  At the same time, we say that common stock is not worth $2 and is only worth $0.30.  Which is true?  Both.  Here is how and when to use each number.

Enterprise Valuation is for the Big Picture and Financings Only
When we value the company for a financing, we put a value on the whole company as though it is about to be sold.  We take into account all of the economic preferences and assume that all stock is converted to common.  Every share is the same at that point.  In other words, if the pre-money valuation is $10M and the company has only common stock outstanding, each share is worth $2.  The valuation is really forward-looking to an eventual exit.

Common Stock Price is For Employees Today
Until that happens, though, we maintain different types of stock with different rights- common and preferred.  The preferred is sold based on the as-converted valuation, but the common has fewer rights and we can issue options at a lower price.  The company’s total valuation continues to be $10M and each share would be worth $2 on a sale of the company, but before that happens each share of common stock is actually worth $0.30.

The Simple Rule
The easiest way to think about this is that preferred stock is for investors and common stock is for employees.  Be aware that pricing is set differently for each.

• Financings , Securities , Startups , capitalization , preferred stock , stock options

Jay Parkhill May 27th, 2008

I wrote a post on Gigaom over the weekend that covers the basics of a VC investment term sheet. A couple of the comments wondered whether preferred stock screws the founding team by definition. Another comment there answered the direct point pretty well (preferred stock is just part of the process). Fred Wilson’s post from this morning covers the philosophical angle as well and is worth reading as a complement to the mechanics I spelled out.

To paraphrase him- and dig under the surface of his comments a tiny bit- a VC’s job is to take risks, and so is a founder’s. The founder takes a chance with his idea and livelihood. The VCs risk someone else’s money- and in the process her own livelihood as well, because if none of her investments pan out she is going to be looking for a new line of work.

The VC may also be very active in a business, but not on a day-to-day basis. Ultimately, a VC’s job is to give an entrepreneur some tools to build a company, but the VC has only so much control over how (and how well) the tools get used.

Preferred stock helps line up the relative risks given all of these factors. As a friend of mine put it even more simply, preferred stock offers a mechanism to ensure that if things go poorly, morale runs low and everyone starts to wonder when to throw in the towel, the people actually running the company on a day-to-day basis will feel more pain than the investors.

Sometimes this is enough glue to keep the whole thing together and sometimes it isn’t. I have seen cases where a company has failed and investors have given up some of their liquidation preference so that founders can get *some* cash back. I have also seen preferred stock terms used to enrich investors at founders’ expense. There is no magic about any of it. Cheating and fairness are a function of the people involved; preferred stock is merely the framework on which the VC investment process is built.

• Financings , VCs , preferred stock