Class A/B Stock Structures

November 25th, 2009

News came out yesterday that Facebook has created a dual-class stock structure where Class B Common Stock has 10 votes per share compared to the ordinary 1 vote for Class A shares.  I certainly don’t know what Facebook plans to do with this type of stock, but Google has a similar deal (Cypress Semiconductor does as well), which has caused a lot of entrepreneurs to ask me about this type of setup.  Here’s what I think.

The Good – Voting Control
This type of structure allows founders to retain a lot of control over a company even as it grows enormously.  To use a very simple example, as founder of a company I could issue 1,000,000 shares to myself.  If the company grows rapidly and takes on a lot of employees I might want to issue 3,000,000 shares to them.

When I do that, I incur economic dilution and voting dilution.  This blog won’t speak to the economic side at all and will just assume the money all works out.  On the voting side, though, you can see that I went from controlling 100% of the stock to a mere 25%.  I have lost most of my control over the company.

I could issue more shares to myself to bring my percentage ownership back up, but there are a bunch of tax and logistical issues that make that hard to do.

Instead, I could convert my shares into supervoting stock.  If my shares all vote 10:1 and the other 3M shares are 1:1, then I keep control of the company because my 1M shares have 10M votes compared to everyone else’s 3M.

Google has said it adopted this system before going public because it wanted to think long-term and the founders did not want to risk being outvoted on shareholder matters.  B corporations can use similar structures to ensure that their companies’ core social missions can not be easily stripped away.

The Bad -Investors Hate it
My experience with these structures is that investors have a hard time getting comfortable.  Professional investors want to know that they can influence major decisions by the company, so it takes a while to get folks comfortable with the idea that founders have super-special voting rights.

My advice to entrepreneurs is not to rock the boat.  There are lots of perfectly good, non-investor-threatening reasons to create supervoting stock, but if the setup makes it harder to raise money then it’s a big gamble for a startup.

These things work for Facebook and Google because those are well-established, already successful companies.  They have negotiating leverage on their side.  Most startups are not so fortunate.

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Winding Down a Co-Founder Equity Relationship

July 31st, 2009

I have had several questions about this topic recently from different angles, so here are the basic concepts when a co-founder or early employee leaves a company.  Note that there are overlapping employment, noncompetition and other issues here that I am not going to touch in this post.

The Setup

CloudWidget, Inc. has three co-founders.  They own equal 1/3 shares of the company and everything goes along swimmingly until Founder B moves away/gets a new job/has irreconcilable differences with Founders A&C.  Whatever the reason, B decides to exit CloudWidget and move on.

A&C come to me and ask questions that include:

-> Does B own his stock?
-> Can we get some or all of it back?
-> What should we do?

Threshold Questions

We start with the following key points:

1)  Does B own *stock* outright or stock options?  This is a critical point that many first-time entrepreneurs gloss over and that colors everything else that follows.

2)  Is there a vesting period attached to the stock/stock options?  If so, what is it?

Important Concept #1 – Earning into Equity

Every participant in a startup should earn into his/her shares over time so that if/when the person leaves s/he won’t get a free ride on the backs of the people still plugging away.  If B’s equity was stock options, then almost certainly the options are subject to vesting.  Leaving the company stops the vesting and B must exercise the option and pay the purchase price to get actual shares within 90 days (usually) or the option expires and all right to buy shares vanishes.

It is more common for co-founders to buy stock at the outset than to get stock options, though.  I encourage all my startup clients to put this founder stock on a vesting schedule as well.  This gives the company the right to buy the stock back at the price paid by the founder.  The right expires over time: typically 25% of the shares are owned outright and not subject to repurchase after 1 year, and the repurchase right lapses as to the remainder in monthly increments for another 3 years after that.

For some reason lots of people accept the idea of stock option vesting as a matter of course, but don’t put stock on a repurchase schedule.  Again, I highly advise that everyone do this.

Important Concept #2 – Getting the Stock Back

If B holds a stock option CloudWidget needs to do very little.  On termination the option automatically stops vesting.  Good employment practice dictates that CloudWidget give notice that any vested shares must be exercised within [90] days or will lapse, but that’s the extent of CloudWidget’s affirmative duties.

Let’s assume instead that B bought his stock outright, that it was subject to a repurchase right and that some, but not all of the right had lapsed.  CloudWidget needs to find B’s stock purchase agreement and read it carefully. Some agreements require that CloudWidget buy back the stock within a set period of time (90 days) and some say that the repurchase is automatic on termination.  It is important to know what B’s agreement says so that CloudWidget doesn’t blow its opportunity.

If procedures are followed and the agreement is written correctly, B agreed to the repurchase terms when he signed the agreement, so his consent is not required now.  CloudWidget merely needs to exercise the repurchase right, cancel his stock certificate (hopefully in escrow with CloudWidget or its attorneys) and send him a check along with a new certificate for the vested, un-repurchased shares.  If B had vested in 1/3 of his shares he will end up with 1/9th of CloudWidget; A&C each own 4/9ths going forward.

Important Concept #3 – Not Burning Bridges in the Process

This is frequently the hardest part of the whole situation.  Companies need to know what their rights are, and then exercise them judiciously.  Circumstances vary dramatically case by case, and I always let my clients now that the agreement is the baseline for ending a relationship but is not definitive- everyone is free to reach any other agreement that makes sense, and it is often worth trading a little cash or equity in order to maintain a friendly relationship where possible.

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The Case of the Late Co-Founder

January 13th, 2009

This situation comes up for me all the time and it is really hard to manage in a way that makes everyone happy.

The scenario is that founders A and B start a company and split the initial shares.  Time passes, business happens.  The company may or may not take on investors or issue equity to employees, but the business grows one way or another to the point that even by the most conservative valuation methodology- free cash on the balance sheet- the company can no longer justify the super-duper-low stock price the founders paid.

Person C them comes into the picture.  C is an extremely high-powered executive who can bring tremendous value.  A and B want to treat C as effectively a co-founder and give her a share of equity equal to theirs.  The challenge is that since the company now has real value, C’s share of it can be expensive.

A, B and C come to me and say “please do your legal magic and make this all work out right”.  Sadly, there is no magic here, just a bunch of unhappy compromises.  There are three main intertwined issues: how much the stock costs, when to pay for it and what the tax consequences will be.  Here’s my shot at acknowledging them and pointing out the options in 500 words or less.

What the Stock Costs
This is simple on its face.  Per share value = company valuation / number of shares.  The valuation number is the toughest variable to work out, and the methodology we use depends in part on IRS rules.

When to Pay For the Stock
Wherever possible, we want to buy the stock early.  Owning stock outright starts the capital gains clock ticking and that can make a big difference when the company is sold (the SEC’s Rule 144 holding period starts at the same time).  Owning a stock option does not count toward the capital gains period until the option is exercised.

What are the Tax Issues to Dodge?
The two big ones are capital gains rules, which require the stock to be held for one year before it is sold, and Section 409A, which imposes a penalty on stock or options issued as “deferred compensation” (i.e. basically any equity issued now and paid for later) if the stock or options are issued at a price deemed below fair market value (more on 409A here).

And here are the preferred ways to handle this situation, with their attendant drawbacks.

Buy the Stock
This is the cleanest option.  Buying the stock outright avoids 409A issues completely and starts the capital gains clock.  In my experience, though, most people do the math and decide that a year or two of sweat equity is one level of risk, but cash is something else entirely.  Most people opt not to take this option, especially when the price is in the 5, 6 or 7 figure range.

Stock Options
This used to be everyone’s favorite way to handle this situation, and it may still be the best.  If the company has real value, co-founder C could have a huge bill to get her stock.  Options let her defer payment of the price until she knows the company is going to be worth something (esp. the night before the company is sold).

409A throws up one roadblock here.  To avoid the 20% penalties, the company will need a valuation of its stock.  This is often manageable, though no one likes paying ~$10,000 for the valuation.

The bigger drawback is that she will probably lose her shot at capital gains treatment.  She would need to exercise a year before the company is sold to get into capital gains land, and if the exercise price is high that may not be feasible.

Historically, more of my clients have elected this option than any other.  No one likes paying taxes, but at least this option limits the risks (assuming the 409A issue is handled well).

Promissory Note
Back in the dot-com days this was popular.  Executive buys the stock and gives the company a promissory note for the purchase price, intending that the company would either forgive repayment or Executive would repay it from sale of the stock in a merger or IPO.  When the companies hit the wall, however, bankruptcy trustees seized on these notes as collectible debt and a number of very unhappy conversations followed (“you mean I got almost no salary, my stock is worthless *and* I need to pay you $200,000?!?”).

A promissory note would work for C’s purposes, but it carries a lot of risk.  It is a promise to pay the company and if things don’t go as expected C can find herself not merely uncompensated for her time spent with the company, but actually owing money to it.  Once in a while a situation arises where this arrangement can make sense, but it is rare.

Is That It?
That’s what A, B and C always ask me when we talk through the possibilities.  Unfortunately the answer is yes.  We use the most favorable valuation we can justify to bring the price down (assuming we have any flexibility there), but in the end the whole purchase price must be paid.  C can pay up front or she can pay later, but there is no way to do what clients really want- which is to sneak C in at the original founder price.

The lesson?  There are two, I think.  (1) get in as early as possible; and (2) get your stock documented right when you arrive before the deal gets any worse.

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Why Deferred Salaries Don’t Work for Startup Founders

September 4th, 2008

One of the toughest conversations I have with many startup founders is about salaries.  Founders may come from larger companies that pay them an annual salary and the idea of getting *no* cash for a significant period of time is really hard to wrap one’s mind around.  The argument goes something like this:

“I make $X currently, I know I am worth that much and I really need to get the cash.  I can defer collecting it for a little while, but I need to catch up at some point.”

My humble suggestion is always the same- don’t think about it that way.  You are building equity in a new business.  The equity is your return.  You are unlikely to see your “deferred” salary repaid in that way, so make sure you have enough stock in the business to give the upside you need and work toward making that worth something.

There are really two alternatives to this, neither of which is feasible: accruing a hypothetical salary to be repaid when some large bundle of cash hits the company’s accounts through financing or sales efforts, and taking stock in lieu of cash.

The Extra Cash Theory

The repayment on filling the coffers approach is based on the false premise that at some point there will be “extra cash” available.  This never happens.  Investors put money into a business in order to build structures that will take the business down the road.  Seeing their cash go straight through a company’s bank account is anathema- except when a founder has actually put in cash without getting stock for it.

The revenue argument is probably even worse.  Revenue is hard to come by and most businesses don’t see enough of it to justify paying back salaries on top of current ones and other business expenses.  The idea of generating enough revenue to cover accrued/deferred salaries is a fantasy in almost all cases.

Stock for Salaries

The stock-for-salary proposal is actually much worse than the extra cash idea.  What many founders don’t realize is that the IRS treats stock in that case exactly the same as cash and taxes it at the same rate.  If a founder accrues $100k in salary and collects it in stock she still has $100k in income to report.

The problem is that she has $100k worth of illiquid stock, a tax bill of $35k or so and no cash to pay the taxes.  This is not a happy situation for anyone.

No Deferral, No Salary, Just Stock

The way out of the dilemma is to give up on the idea of taking much cash out of the business in the early going.  Buy your founder stock (for cash!) at a very low price when you start the business.  That is what you get instead of a salary, so be mindful of unnecessary dilution (no “advisory” options to friends and relatives) and work on making that stock as valuable as you possibly can.  You may not see much cash for a couple of years or more, but if you are lucky the stock will more than compensate for the sacrifices made in the early days.

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