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    Home Unlabelled Startups Why didn't I get any money from my startup? - A guide to Liquidation Preferences and Cap Tables

    Startups Why didn't I get any money from my startup? - A guide to Liquidation Preferences and Cap Tables

    December 22, 2018

    Startups Why didn't I get any money from my startup? - A guide to Liquidation Preferences and Cap Tables

    Why didn't I get any money from my startup? - A guide to Liquidation Preferences and Cap Tables

    Posted: 21 Dec 2018 02:36 PM PST

    Note: I recently wrote a series of comments in response to a post by danny841 about the value of his wife's stock options now that her company has been acquired. It was suggested that the community might benefit from having it turned into its own thread. Not being one to turn down a sanctioned opportunity to collect Karma, I'm happy to oblige.

    Note 2: The tables may not format correctly on mobile. Sorry!

    Most founders share a dream. That dream being that one day, after a lot of hard work, someone will knock on their door and offer them a Scrooge McDuckian pile of money for their startup. However in order to get to this point, a founder will likely need to raise money from investors to grow. The terms attached to those investments will influence how any final buyout proceeds are distributed. If a founder isn't careful, they may find that their boat money turns out to be bus fare.

    To understand why, we first need to understand how a startup grows and issues equity.

    When a startup is founded, its founders divide up the equity in it by issuing shares. The resources brought to the table can vary, but usually they're just enough to get to some sort of proof of concept phase. We can visualize the outstanding shares of the company with what's known as a Capitalization Table (Cap Table). At this point, it might look something like this.

     Shares % Owned Founders 1,000,000 100

    A lot of successful startups don't grow using their own resources. In fact, with startups that have huge opportunity and potential, doing so would be far too slow. In order to reach their potential, they sell shares to investors. The amount of money they need to raise is usually based on expectations of what will be required to meet a certain milestone, with the number of shares issued being determined by a valuation metric that's beyond the scope of this discussion. This process is usually done multiple times in order to reach successive milestones. Each fundraising round is referred to as a Series, and generally assigned a letter. After the first round (Series A), the Cap Table might look like this.

     Shares % Owned Founders 1,000,000 50 Series A 1,000,000 50

    As startups grow, they acquire non-founding employees. However working for startups carries risk. It's a business that's more likely to fail, and sometimes it can't afford to pay what a more established company could. In order to compensate these employees for that risk, they're generally issued Stock Options that allow them to buy shares of the company at some point in the future, for the price today.

    This is great for the employees, but it creates an issue for investors. If I give you $10M for 1,000,00 shares thinking I'll own 50% of your company until the next Series, and you issue 1,000,000 options to employees who all decide to exercise those options, I won't actually own 50% of your company. I'll only own 33%. This is what is referred to as Dilution. The issuing of additional shares reduces the overall % of a company held by any specific shareholder.

    In order to avoid this, Pools are established with each Series, so all investors know the smallest possible (fully diluted) position they may be expected to have in a company before the next Series. Employee Pools tend to be between 10 and 20%. We'll assume our startup is generous. After Series A, the (fully-diluted) Cap Table might look something like this:

     Shares % Owned Founders 1,000,000 40% Series A 1,000,000 40% Employee Pool 500,000 20%

    It should be noted that we are now assuming that all employees choose to exercise their options, and that our startup fully issues its employee pool. If a company continues to increase in value (or is bought), the first assumption is safe. The second assumption is rarely valid, but simplifies our example. We'll address contrary situations later.

    Generally the employee pool size is adjusted to maintain its size relative to total outstanding shares. Let's assume we've had two more funding rounds in our startup. The Cap Table might look something like this:

     Shares % Owned Founders 1,000,000 14.5% Series A 1,000,000 14.5% Series B 2,000,000 29.1% Series C 1,500,000 21.8% Employee Pool 1,375,000 20.0%

    Now comes the big day. The company sold for $100M all cash. A few things come into play here. First off, not all options are exercisable immediately. That's the Vesting process, which is designed to keep employees at a company. Many option agreements indicate that upon qualifying event (such as a sale), any unvested options immediately vest. However sometimes they don't.

    Why wouldn't they? Because the person buying the company needs to know the employees are going to stay. They just paid a lot of money for the company, and that means the staff to run it as well. Sometimes they offer new incentives to keep those employees, but often it's easier to just keep them on their old incentives. Sometimes a company will attempt to get its employees to waive any accelerated vesting provisions in order to reduce the size of the employee pool. This isn't often in the best interest of those employees, and acts to increase potential distribution to founders and investors. Something to keep in mind.

    Critically, there's something known as Liquidation Preference. Liquidation preferences, when they exist, can be the most important factor in determining how much a given shareholder receives in a buyout. Not all shares are created equally. Sometimes when a company needs to raise money, they need to let new investors know they will receive their money back before existing investors do. If they really need the money and are having a hard time raising it, they may even have to tell new investors that they'll receive multiple times their money back before existing investors receive any money.

    Why would existing investors agree to this? Because if the business fails, they'll definitely lose all of their investment. So it's better to agree to take less, than lose everything.

    Liquidation preferences can do weird things to payouts. Let's use our startup as an example. We'll need some additional information.

    Founders (and employees) hold what is called common stock. Common stock splits whatever funds are left after paying out all other shares.

    Series A paid $2,000,000 for their shares. These are 2x non-participating, meaning that they can choose to receive back 2x their original investment, or convert their shares to common stock. They cannot do both, and so will do whichever would result in their getting the most money.

    Series B paid $10,000,000 for their shares. These are 2x participating, meaning that they'll receive back 2x their original investment *and* they'll convert to common stock and receive a portion of the remaining funds.

    Series C paid $15,000,000 for their shares. These are 3x participating 5x capped, meaning that they'll receive back 3x their original investment and convert to common to receive a portion of remaining funds, however they cannot receive more than 5x their original investment

    Seem confusing? It definitely can be. There are a lot of different ways liquidation preferences can be build, but generally participating, multiples, and caps are the ones you'll see.

    How does this play out with our $100M buyout?

    Series C receives 3x their initial investment, or $45,000,000 and converts to common stock. There's still $55,000,000 left to distribute.

    Series B receives 2x their initial investment, or $20,000,000 and converts to common stock. There's still $35,000,000 left to distribute.

    Now Series A has a choice. It could receive 2x its original investment, which would be $4,000,000. Or it could choose to be treated as common stock. If it chose to do this, all classes in our original cap table would be common (as all other series converted). Therefore it would receive 14.5ish% of the remaining $35,000,000, or $5,090,909. This is clearly the better choice, so Series A chooses to convert to common.

    This leaves us with $35,000,000 to distribute to our common shares based on their respective share of common stock owned, and a final distribution as follows.

     Shares % Common $ from Liq $ from Common $ Total % of Proceeds Founders 1,000,000 14.5% $0 $5,090,909 $5,090,909 5.1% Series A 1,000,000 14.5% $0 $5,090,909 $5,090,909 5.1% Series B 2,000,000 29.1% $20,000,000 $10,181,818 $30,181,818 30.1% Series C 1,500,000 21.8% $45,000,000 $7,636,363 $52,636,363 52.6% Employee Pool 1,375,000 20.0% $0 $7,000,000 $7,000,000 7%

    Notice how the % of proceeds actually received are drastically different from the % of shares held? That's the effect of liquidation preferences, and why they're so important.

    Let's compare this to another scenario where the buyout is only $80M.

    Series C still receives 3x their initial investment, or $45,000,000 and converts to common stock. There's still $35,000,000 left to distribute.

    Series B still receives 2x their initial investment, or $20,000,000 and converts to common stock. There's still $15,000,000 left to distribute.

    Series A again has a choice. It could receive 2x its original investment, which would be $4,000,000. However this time if it chose to be common stock, it would receive 14.5ish% of $15,000,000 = $2,181,818. In this instance, it would choose to receive $4,000,000, and its shares would not convert to Common.

    Now our common distribution of the remaining $11,000,000 (80M - 45M - 20M - 4M) is as follows:

     # Shares % Common $ from Common Founders 1,000,000 17% $1,872,340 Series B 2,000,000 34% $3,744,681 Series C 1,500,000 25.5% $2,808,511 Employees 1,375,000 23.4% $2,574,468

    And our overall distribution looks like so:

     # Shares % Owned $ Liq Pref $ Common $ Total % of Payout Founders 1,000,000 14.5% $1,872,340 $1,872,340 2.3% Series A 1,000,000 14.5% $4,000,000 $4,000,000 5% Series B 2,000,000 29.1% $20,000,000 $3,744,681 $23,744,681 29.7% Series C 1,500,000 21.8% $45,000,000 $2,808,511 $47,808,511 59.8% Employees 1,375,000 20.0% $2,574,468 $2,574,468 3.2%

    Notice the difference in payouts to each class. The purchase price in scenario 2 was 80% of the purchase price in scenario 1, but the payout to the founder and employees was less than half.

    Earlier we discussed the assumption that the Employee pool was fully issued (i.e. all options had been issued, and every option had been exercised.) This is important, because it affects distribution as well. To see why, first we need a little more information on what an option is.

    Simply put, an option is an agreement to acquire a number of shares for a set price (known as the Strike Price). Often times they'll only be valid between a set of dates. (Between the date of Vesting, and the date of expiry.) The strike price can be anything, but for tax purposes for employees it's generally the current share price on the day the option is issued. When you exercise an option, you pay the Strike Price, and you receive the shares.

    Returning to our example, we've assumed that the employee options are in-the-money, which is to say that the price they receive per share is greater than the strike price per share on the option. In our example, each employee would receive $1.87 per share owned ($2,574,468 / 1,375,000). If the strike price on the employee options was $3.00, an employee would choose not to exercise those options, as they would be agreeing to pay $3.00 to receive $1.87. If this were the case in our above example, the employees options would be worthless. Because no employee would exercise them, the resulting payout would look as follows:

     # Shares % Owned $ Liq Pref $ Common $ Total % of Payout Founders 1,000,000 18.2% $2,444,444 $2,444,444 3.1% Series A 1,000,000 18.2% $4,000,000 $4,000,000 5% Series B 2,000,000 36.4% $20,000,000 $4,888,889 $24,888,889 31,1% Series C 1,500,000 27.3% $45,000,000 $3,666,667 $48,666,667 60.8% Employees 0 0% $0 $0 0%

    Notice how everyone elses distribution increase when the employee options weren't exercised? This is why companies will sometimes try and prevent accelerated vesting of employee shares. The smaller that pool, the greater the funds available for distribution to other classes.

    Let's look at one final scenario to illustrate the effects of liquidation preference. At first glance, a $53M buyout seems exciting. Only $27M has been invested at this point. Let's see how it plays out.

    Series C still receives 3x their initial investment, or $45,000,000 and converts to common stock. There's still $8,000,000 left to distribute.

    Series B receives $8,000,000 and converts to common stock.

    And that's it. All proceeds from the transaction have been distributed, meaning there are no funds available to be distributed to common stock. The final returns are as follows:

     # Shares % Owned $ Liq Pref $ Common $ Total % of Payout Founders 1,000,000 14.5% $0 $0 0% Series A 1,000,000 14.5% $0 $0 0% Series B 2,000,000 29.1% $8,000,000 $0 $8,000,000 15.1% Series C 1,500,000 21.8% $45,000,000 $0 $0 84.9% Employees 1,375,000 20.0% $0 $0 0%

    Founders, employees and Series A investors all receive nothing. All that work, and high risk early stage capital goes uncompensated.

    So what's the point of working at all if all of the benefits are going to be scooped away? Well, it's important to note a few things about liquidation preferences like this.

    1. They tend to show up when a company is struggling to raise investment. If you're having a hard time raising capital, it's likely because there's some significant risk associated with your business. Maybe you've failed to meet your benchmarks. Maybe it's highly speculative. Whatever it is, the new investors want to know they'll get their money out first, and they'll make enough to compensate them from taking those risks. On the other hand, if you have a number of sources of investment interested, there likely won't be any liquidation preference. In fact, they may want to try and cash existing investors or founders out early in order to increase their own equity holdings. As rarehugs pointed out in a comment on the prior thread, a founder should think very carefully about cashing out early. If someone thinks your equity is worth buying now, it means they think it will be worth substantially more later.
    2. They generally only apply to private companies. Once you're public, selling your shares is generally much more straight forward. However it should be noted that often liquidation preferences apply to the process of going public. When you go public, generally all series are converted to common stock, or exited. The order in which proceeds or common stock are issued during an IPO are often influenced by existing liquidation preferences.

    Now that you understand the risks, what can you do as a founder to ensure you don't end up receiving less than you expect from your eventual exit?

    First, you're generally better off taking a lower valuation early on than you are a higher multiple. Later stage investors aren't likely to accept a multiple lower than one offered to previous stage investors. If you're trying to raise $500K for your seed round, and you have an offer to take 20% of your company with a 1x multiple (2.5M valuation) or 10% of your company with a 2x multiple (5M valuation), and you expect to require multiple future round of financing, you'd likely be better off with the lower valuation.

    Second, don't raise more than you need. By their very nature, multiples work on the underlying investment. The more you raise, the higher the bar you need to achieve before you'll see proceeds for yourself.

    Third, when you're raising your first round of funding, model out your cap table all the way to when you expect to exit. Look at your long-term road map, and estimate how much money you'll need to raise at each stage to get there. Think about what your company will be worth when it hits each milestone. Build a cap table just like we did above, and see how much equity you'll have left, as well as what your distribution might be. Understanding the endgame helps you understand each step you take to get there in context.

    Hopefully that provides some helpful information to some of you. Remember, it's not just about the amount of money you raise along the path, or what your company is worth. The terms attached to the money will ultimately determine how much of that you and your investors receive.

    TL;DR: Liquidation Preferences, when they exist, can be the single most important item when raising funds, and can result in founders receiving a substantially smaller share of proceeds when they sell. Understand and pay attention to them.

    Edit: I don't want to crowd out the discussion threads with Thank Yous to people for the kind words, but I'm reading them and absolutely appreciate them! I'm glad people are finding this information useful!

    submitted by /u/Bizzle_worldwide
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    Advice for a young developer

    Posted: 21 Dec 2018 02:52 AM PST

    I wanted to a start a start up for my app but I'm afraid my age may cause my idea to be dismissed by investors or even stolen from me. I've did enough research to were the latter will be highly unlikely, but can anyone of you kind experience souls tell me what I might need to expect going through with this. I want to get an investment to expand, I'm bootstrapping to maintain it right now.

    Details about my start up - Working MVP with beta users and positive feedback (only 30 users right now, just started beta testing this month) - Detailed Business plan that includes my market research, marketing plan to expand, detailed investment expenses, source of revenue and estimations, scaling plans and more. (I used a ton of sources I found to be credible to create my plan to decrease the chance of missing something vital) - social media type app, with similar competitors but they lack the main features which is the focus of my app (included in business plan)

    I'm only 19, and I'm self taught. Im a freelance developer and I have references of my work and my clients. But I'm sure this raises a red flag for investors. I wanted to start looking for angel investors when I get 100 beta users (is that to low?) All advice is welcomed, thank you!

    Edit:a word

    submitted by /u/QTheAstronomer
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    If your startup has $10k in the bank, how would you effectively scale your customers using different channels?

    Posted: 21 Dec 2018 09:20 AM PST

    Hey All,

    I started a podcast adtech startup with and the two other founders who are experienced in both advertising tech and media podcast/radio, which has landed us some big content partnership deals. To get the first few deals, we knocked on doors, cold emails, and used our relationships to get some really names on board. Being a double sided platform, we have the typical chicken and egg problem with publishers and advertisers.

    When we first started we made a deal with an ad agency that vastly underperformed. They brought us one publisher and 3 ad deals over the course of a year. We did this to allow us to focus on the tech but ended up having to do all the work ourselves to get people in the door. Running out of patience, we decided to move on and bring stuff in-house.

    So, we've bounced around a few ideas like paying a sales agency, hiring a few sales people base + commission, commision only etc.

    I'm not looking for a golden bullet, but I could use on advice, ideas, proven techniques as I admit that marketing is where my knowledge is lacking. Most of my time these days are spent on emailing, demos, pitching, and reading B2B marketing and sales blogs which can feel like i'm going down the rabbit hole.

    ​

    submitted by /u/gabethegeek
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    I am building website for sharing paper books. Should I use Google Books API to retrieve book details

    Posted: 21 Dec 2018 06:23 PM PST

    I have been working on a service for sharing paper books for some time. Users currently have to add all book details manually. A number of people have requested easier ways of adding books such as scanning. I decided to start with adding the possibility to retrieve book details via ISBN number from the Google Books API. This will probably reduce friction and result in more books being added to the system and better acquisition and activation.

    The service is currently free, but I hope to add some form of monetisation in the future. The problem is that I recall reading the terms of use of the Google Books API somewhere that seemed to imply that one cannot use the API to create a commercial service. Can anyone with experience using the Google Books API shed some light on this issue regarding terms of use.

    Another problem I am worried about is that if users start using the API, all content will be hosted on Google's platform instead of being created in my database. This could result in serious problems in the future if Google decides to block access to their API or introduce a business model that will make it impossible for me to use their API. The rules of the game can change any time meaning that by adding the API I will no longer be 100% in charge of the destination of the service. On the other hand, I understand that reducing friction wherever possible is a must to get the flywheel to start moving.

    Let me know what you guys think. I am counting on those who have worked on book-related apps.

    submitted by /u/churchillls
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    Startup incorporation legal duties and pre-revenue taxes

    Posted: 21 Dec 2018 02:07 PM PST

    I'm confused rn. some blogs say incorporate early for whatever reasons they list. some say the opposite, to not incorporate early because you'll have to pay pre-revenue taxes and there might be legal ramifications like keeping meeting minutes and whatnot.

    I looked up pre-revenue taxes and the only thing I can find related to that is the franchise tax which not all states impose. no other federal or state taxes that I saw applied as a pre-revenue tax. maybe I overlooked something and that is why I need a clarification, What are the pre-revenue taxes that exist and how are they applied once you incorporate? what other legal duties do I need it fulfill so I won't be breaking the law?

    Assume that it is a Delaware LLC or C Corporation that I'm referring to.

    submitted by /u/bulbbeing
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    How do you afford sports and other official licensing when starting a startup?

    Posted: 21 Dec 2018 01:27 PM PST

    Hey everyone. I wanted to know your experience in acquiring sports or other types of licensing when starting a company. I want to make accessories with sports logos on it but licensing is so expensive. Did you start with one team? Would you pitch to a company who already has the licenses? Get investors to pay for it all? Seems risky for an investor to invest a ton of money on licensing when the business hasnt exactly proven to be successful yet. I was also thinking of starting in a smaller market and possibly pick one college team and start there.

    Part 2 which might be better on a legal advice sub.

    Would it be against copyright law to file example have a purple shirt and say Baltimore in black? No logo, just plain text and color. Sorry for all the questions, I just need some answers for my business plan and strategy. Thank you in advance.

    submitted by /u/RandoCommmando
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    In the future, I want to build solar panels in the rural areas of the world. Along with that, I want to make lunar solar and kinetic rain energy popularized. If possible, using perovskite solar cells could work out. How can I accomplish all of this?

    Posted: 21 Dec 2018 12:07 PM PST

    As you can see, I have some pretty ambitious plans. I will explain each one in depth so you can tell me your suggestions as to how I can accomplish these goals.

    First off, I want to build solar farms in the rural areas of the world. More preferably, the parts of the world that receive the most sun. Places that would be ideal (I am not saying these places receive the most sun; They're just ideal places) include western China, the Sahara Desert, deserts in Australia, Arizona, Texas, New Mexico, Mexico, and India. Now, I know I would need a lot of funding which I think would be possibly to receive. I know that solar farms exist and all, but building systems where there aren't any currently could attract funders. I would also like to make these farms better than the rest and make it so each can have high capacities of MW. The most in the world right now is 1,547 MW. I would aim for 2,500 at least on each farm. Keep in mind the solar industry is really just getting started and won't become huge until a few more years in the future. I predict we will see a big boom in solar sometime throughout 2025-2030. It will be like the technology boom but maybe not as big. I just know something is coming. That's my prediction though.

    Secondly, I mention lunar solar. Now, lunar solar is a very interesting concept. "Lunar Solar Power (LSP) arrays would receive higher energy density from sunlight than we get through Earth's atmosphere, avoid weather, and could beam energy to any part of Earth facing the moon." - Discover Magazine. So, basically putting solar panels in orbit and transmitting the energy back to earth by using either laser power or microwave power, solar panels in space could solve the problem of solar energy not working at night (and during rainy/cloudy days) and could produce extra power for here on earth. While it could be more costly and needs to be perfected, it could eventually work well and become practical. Also, putting solar panels on the Moon could work as well and supply much energy for earth.

    I mention rain energy as well in my title. I'm talking about kinetic rain energy. While according to Stanford it could only supply 25% of the USA's need at max, I still think making rain farms in highly rain prone parts of the world could work out. Once again, funding and perfecting a model for how rain could be harnessed would have to be perfected.

    On top of all this, I would like to use Perovskite solar cells if possible. The cells (from what I hear) would be more efficient and would be easier to manufacture. This is just from what I've heard. It could eventually be the future of solar cells.

    So, how could all this be accomplished? What are your thoughts on these ideas?

    submitted by /u/ThePoliticalTalk
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