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 September 12th, 2007

The SEC has proposed to mandate electronic filing of Form D (among other changes), used to document securities offerings. These filings have been a major pain in the neck through my career, so I am definitely in favor of anything that makes the process simpler.

I am even more excited by the apparent recognition on the part of the SEC that people actually want to see the data that gets reported. It gives me hope that EDGAR will one day open up to search bots as well. Public companies file all of their required reports on the EDGAR system so there is an enormous wealth of information. EDGAR has only the most rudimentary of search features, though. Moreover, EDGAR turns away search bots from all the major search engines.

Private companies have stepped in and (presumably) pay the SEC for acess to the data. They then charge users to perform sophisticated searches.

This is bad practice. The SEC requires filings in order to inform the public. It should be free and easily accessible. I am hopeful that the Form D database will give the SEC the feedback it needs to realize that EDGAR should be open and searchable.

• Securities

Jay Parkhill September 11th, 2007

My friend Steve Poland roped me into an advisory role with Ringside Startup- he had the neat idea to extend the idea of crowdsourcing content into crowdsourcing a business itself. We and the commenters on the site talked a lot about securities laws and ways we might be able to get some equity to people contributing ideas.

Business Week Online has just written an article about Steve and the crowdsourcing concept. It does a nice job comparing efforts in the music, sports and tech spaces, and does a compare/contrast between Cambrian House (which I have covered before) and me.

It’s the first time I’ve been quoted in a major press outlet, so I am very pleased. They didn’t even misquote me!

• Blogging , Securities , Startups

Jay Parkhill September 10th, 2007

Vosnap is a project/company that emerged from Startup Weekend in Boulder, Colorado last July. A whole bunch of people locked themselves in an office for a weekend with a goal to launch a product by the end of it.

They still haven’t launched, but that doesn’t mean it’s not a great idea. Talented people working together are fun to behold.

One trick, though, is how to properly reward everyone’s efforts. This is really a question with two parts:

1) How to value each person’s contributions relative to the others; and
2) How to issue equity to each person under US securities laws.

The Sand-Dollar-Hour System
I once heard about an alternative economic system developed in west Marin County, Calif. It involved sand dollars as units of currency, and was completely egalitarian in that each person earned a certain number of sand dollars per hour worked, whether as neurosurgeon or streetsweeper. The idea never caught on much, but it stuck with me, and the Vosnap group seems to have done something similar.

As their blog explains, they have 60 contributors, each offering different sets of skills. Rather than try to make judgments of relative importance among them (a sure recipe for collapse of the project) each person got one “share” for each day at the weekend, up to 3.

Simple enough, though it would have been better if they had been sand dollars or cowrie shells. Nobody gets it perfect, I suppose.

Crowdsourcing Cleverness
I have written previously about crowdsourcing and securities law issues. The bottom line is that securities laws aren’t conducive to doling out shares to lots of people.

However, some clever soul must have considered that if each participant is “active in the business”, then the contributors can jointly form a limited liability company in which no securities “sale” is involved. That is to say, if the equity earned is all of the “sweat” variety, then there is no securities offering, and no securities compliance issues to worry about. Note that this only applies to LLCs, not corporations.

A Little Ugliness at Tax Season, but it Gets the Job Done
So Vosnap itself is a corporation, which works well for venture funding purposes. The LLC owns 1/2 of Vosnap, Inc., and the Startup Weekend participants own their relative shares of the LLC.

Clever. The tax issues are going to be a little messy when income tax season rolls around (there will be two entities to prepare tax returns/statements for, and each LLC owner will get a K-1 partnership statement to include in their personal returns), but it gets a piece of the business to all participants and gives them some incentive to keep plugging away at it. Nice thinking.

• Securities , Startups

Jay Parkhill April 26th, 2007

Steve Poland is a bright guy with an interesting business idea at webothlike.com. More interesting is that he is blogging the entire startup process and seeking active input from the general community along on the way. I am one of his advisers.

Early in the process Steve was trying to figure out how to get started, and we talked about ways he might be able to bring in some early cash. Almost everyone- Steve, the public and me- agreed that it would be a lot easier to get the $20,000 he needed if he could sell shares to his readers.

Unfortunately, US securities laws were the holdout. They say that anyone who wants to solicit money from the general public needs to do so via the expensive, highly regulated public offering process. Private securities offerings must be just that- private. Publicly offering to sell securities, such as through a blog, automatically strips away the ability to use private offering rules.

i was intrigued, then, when Steve told me about Cambrian House. That company is using the wisdom of crowds to solicit its own set of business ideas. The twist is that for every idea submitted, participants get a “share” of Cambrian House stock. I signed up to test it out and now have a share of stock listed in my account.

Being a securities lawyer, I wondered how the company does this. They recently put up an FAQ that explains in part.

The FAQ says that a separate entity, Cambrian House Coop, has a right to 1% of the Cambrian House equity, revenue and/or dividends (the text is a little unclear). This leads to a couple of thoughts:

First, the economics. 1% of a company is not a whole lot and my share is a tiny fraction of that. If the company becomes worth $100,000,000 the entire program will have a value of $1,000,000, which must then be divided among as many thousands or millions of people as register and earn shares. So this is a neat gimmick but I’m not sure the reward matches the effort. If I kill myself to crank out more ideas than anyone else I may end up making a few tens of thousands of dollars between now and whenever the company is sold. Neat, but I won’t cut back my day job to work at it.

Second, the mechanics. Crowdsourced program participants will not actually own a piece of Cambrian House, but of the Cambrian House Coop. Participants will be entitled to elect the Board of Directors of the Coop, whose role is to determine how shares are distributed. So participants own no part of Cambrian House itself, but of the related entity that exists solely to help distribute 1% of whatever money Cambrian House decides it has made. This seems like an incredible amount of effort to distribute a relatively small amount of money.

This isn’t meant to be a criticism of Cambrian House. They seem to have a lot of faith in the wisdom of crowds and are simply trying to extend the financial reward to the people that make it all possible.

It’s not a critique of securities laws either. Their purpose is to help make sure that investors receive enough information about a business to understand what they are getting into before they sign on.

Unfortunately, these two concepts sail right past one another. Crowdsourcing is based on the idea that aggregating the ideas of communities increases value for everyone in the aggregate. Securities laws worry that any single individual might not have the resources to make a sufficiently educated decision.

It might be fun if Digg-style ratings could be used to help determine a business’s investment worthiness and the public could rely on that. We are definitely not there yet, though and probably never will be, so for Steve, Cambrian House and everyone else there may always be an imbalance between the benefit a company can get from the community and the equity value the company can give back to individuals within that community.

• Financings , Securities , Startups

Jay Parkhill April 23rd, 2007

Harvard Business School’s Working Knowledge e-zine is one of my favorite weekly reads. They dig a little deeper than many press outlets into many fascinating issues. Two that seem sure to provoke debate have to do with How Women Can Get More Venture Capital and whether market forces or government regulation will do more to stop global warming.

The latter piece is interesting mostly for the comments.  I will admit that I am surrounded by more like-minded people that otherwise on the subject of global warming, so I find it fascinating to read through the comments on a site that writes for a business-oriented rather than green-specific audience.  It is fascinating to see the range of intelligent viewpoints represented- from “increasing oil costs will drive consumers toward alternative energy sources” to “companies should pollute if it rewards shareholders more, and vice versa”.

The VC money for women entrepreneur article seems certain to fuel extensive debate, and I wish it was open for comments as well.  One of the author’s findings was that VCs worry more that female entrepreneurs will leave the business prematurely or put other (family) needs first, and at the same time the author’s research on women in the VC industry found that women *did* leave the field at a much higher rate than men between 1995-2000.

The conclusion seems to be that women need to work harder than men to convince investors they are committed to the business.  On the other hand, the article cites the case in which two women, one six months pregnant and the other having come back from a family-related year off work successfully raised money for Zipcar.

• Cleantech , Securities

Jay Parkhill March 6th, 2007

The California Department of Corporations seems likely to adopt a new set of rules affecting compensatory benefit plans by the end of March. The rules cover a variety of plan types, but stock option plans are the most commonly used type of plan.

Vesting Terms Reflect Real Life
The new rules generally conform California law to IRS rules. California has a few requirements that aren’t covered by the IRS, so the changes will help to avoid a few different “gotchas”. Some of them are basically stenographic, such as the (soon to be former) requirement that options vest at least 20% per year. I have not yet worked with a company that used a 5 year or longer vesting period, so the issue was moot for all practical purposes, but the language still needed to be in the plan. It always makes me happy when I cut language out of a document, so this is a nice step.

2/3 Shareholder Voting to be (Mostly) Eliminated
The other notable “gotcha” is the funny rule that companies can not have options outstanding to purchase shares in excess of 30% of the company’s capitalization without 2/3 shareholder approval. The new rules would eliminate the 2/3 voting requirement (majority vote for option plans is still required for favorable tax treatment) if the plan otherwise complies with IRS rules.

It is the rare company that *needs* that many options outstanding, but I have once or twice encountered a situation in which it made sense, esp. the “late co-founder” situation where a person comes in after the stock price has risen and assumes such a critical role that s/he should be treated as a de facto co-founder for equity purposes.

In those cases, it may be too expensive for him/her to buy founder’s stock and an option is the simplest way to get a substantial equity share to the person. Once or twice I have worked with companies where it has made sense to authorize options in this situation, pushing it up to the 30% of outstanding capital limit. Shareholder voting would not be required to issue stock outright to the person, so it is nice to see that the voting requirement has been eliminated if the equity comes as an option as well.

California Steps into Line
All in all, the new rules aren’t particularly momentous, but that is really the point. California is such outlier on so many issues, with its own special rules, that it is nice to see it simply come into line with “standards”.

• Securities , Startups , Taxation

Jay Parkhill January 5th, 2007

I recently found a couple of articles talking about the AIM and its place in the scheme of things for cash-hungry businesses. My earlier point about the AIM was that it is not a very good “out” for companies hoping to escape the US environment. Most companies merge eventually, and if a suitor is subject to Sarbanes-Oxley and the rest of the SEC’s requirements, the prospective selling company had better comply as well or risk a drop in its purchase valuation.

AIM as a Step on the Road to Liquidity
Cleantech Investing summarizes the benefits and pitfalls of the AIM pretty well. It is easier and cheaper to go public, but harder for big shareholders to get liquidity given the thin trading in most stocks on the market. The AIM therefore serves more as an alternative to mezzanine financing for certain kinds of companies- it is not a good source of liquidity and at present doesn’t appear to be a great place to remain long term.

This may all change over time, of course. The number of US-based companies on the AIM (36 by my count) is very small. Still, the data definitely supports my thinking that companies need to maintain a plan for Sarbanes compliance.

AIM as Market of Choice for Clean Energy Companies
The other interesting point Cleantech notes is that a survey lists the AIM as the go-to market of choice for clean energy companies, and predicts it will remain that way for the next three years. The survey summary is frustratingly short on detail as to why this should be so. It cites the “arduous US regulatory environment” as the principal driver behind the trend, but doesn’t explain why this makes the AIM more compelling for clean energy businesses than for those in any other sector.

The danger I see in this thinking is companies financing themselves into a corner by going public too quickly with too little planning for how to keep M&A valuations high in the long term.

• Cleantech , M&A , Markets , Sarbanes-Oxley , Securities

Jay Parkhill January 1st, 2007

The AIM, formerly known as the Alternative Investment Market of the London Stock Exchange, has gotten attention recently in the US due to increasingly complex and burdensome reporting requirements for companies listed on US-based stock exchanges, most notably the Sarbanes-Oxley Act of 2002.  In particular, Sarbanes-Oxley’s Section 404 requires companies to certify that their internal controls and procedures are sufficient to provide complete and adequate disclosure of material issues to investors.

Sarbanes only applies (formally at least- more on that point below) to public companies listed on US exchanges, esp NASDAQ and the NYSE. A trend has thus arisen in the last couple of years where companies seeking to raise capital from public markets do so on exchanges outside the US. A few companies have listed on the Toronto Stock Exchange, but the exchange receiving the most attention is the London Stock Exchange’s AIM.

In some respects, this is a natural fit. The AIM was created in 1995 as a “lighter-touch” alternative to the main London Stock Exchange. Costs of an initial listing are much lower than the LSE, NASDAQ or NYSE and ongoing regulatory requirements are much less stringent as well.

There are currently about 1,600 companies listed on the AIM, of which 36 described themselves as US-based as of this writing. The regulatory requirements consist principally of the oversight of a “nomad“, a nominated advisor hired by the company both to vet the company’s filings and to advise the company on investor-relations issues. The Wall Street Journal (subscription required) has a good article on pros and cons of the nomad system. Since January 2005, the number of US companies listed on the AIM has tripled from 12 to 36, indicating a possible trend in the making (though the numbers do not exactly indicate a mass exodus from US exchanges).

However, companies hoping that the AIM will let them avoid the US regulatory framework are misguided (Sarbanes-Oxley imposes the most stringent set of requirements in the US currently, so this post focuses on compliance with it).  It is the rare company, public or private, that continues in business indefinitely without being acquired.  Any company that lists on the AIM thinking it will be able to forever avoid Sarbanes issues succeeds only in (a) limiting its pool of prospective acquirors to other business not subject to US securities laws, (b) reducing its sale price by the amount required to bring the company into compliance, or some combination of the two.
Thus, companies listing on the AIM still need to comply with Sarbanes-Oxley. AIM provides a way for companies to go public at significantly lower cost than in US markets, but as the title of this post suggests, the AIM is not a way out of Sarbanes-Oxley compliance.

However, this is not to say that AIM has no value.  There may well be companies capable of going public and supporting a reasonable valuation on a small-cap exchange, but for whom compliance with Sarbanes-Oxley and other US regulations would be excessively burdensome.  This seems like a pretty big gamble, but it is possible that such companies could go public on AIM, get enough cash to kick the business into high gear, then bring in US compliance at a later date.

Given that the AIM has underperformed major US indices recently (see chart), it seems as though the risk here is extremely high. As this chart shows, the S&P 500 during 2006 outperformed the AIM as a whole by close to 15% (note: I have not tried to separately measure performance of US-based AIM companies).
On balance, then, the AIM sounds like a great opportunity, but it entails significant tradeoffs as well.  Companies listing on AIM need to be aware that long-term planning will probably require them to deal with Sarbanes-Oxley and other US securities laws at some point, and choosing not to comply in the short term may foreclose- or alter the economics of- merger opportunities in the future.

• M&A , Markets , Sarbanes-Oxley , Securities , Startups

Jay Parkhill November 10th, 2006

It doesn’t really break any new ground, but here is an interesting calculator that shows how Charles River Ventures’ QuickStart program might work.
The calculator is set up to demonstrate returns, so you can plug in different numbers for the amount of the QuickStart loan, the amounts of each subsequent fundraising round, and the exit valuation. The calculator then spits out the return to the founders and each set of investors.

This is interesting, but pretty long-term and hypothetical. I would be more interested to see a calculator that shows the effect of the QuickStart loan on a company’s cap table. E.g. how much of the company can founders preserve for themselves by using a QuickStart loan instead of a larger funding round?
I have done a million of these for my clients and thought I could try to add to the general base of knowledge here. I have no idea how to make an HTML calculator, but here is an Excel file that does the job.

The scenarios can get very complicated, but the basics could be expressed pretty simply. The main variables are:
*amount of initial loan
*amount of Series A round
*valuation at time of Series A (or percent of company sold for Series A funds)

The calculator could then spit out alternative cap tables showing founder/investor ownership percentages. One column would show ownership structure under the QuickStart model and the other would show the ownership assuming a larger VC financing. The value of the smaller, earlier financing should become readily apparent.

I made a couple of assumptions in the calculation, esp that the “VC funding” route would be for 1/2 the amount of the QuickStart Series A, and at 1/3 the valuation. Reasonable minds may disagree on the numbers, but the concept is that the target company would not need as much money in an earlier VC funding, and that the valuation at which the money comes in would be significantly lower.

• Financings , Securities , Startups