Startups and Growth

16 minutes, 43 links

Startups and Growth

Common questions covered here
How do startups raise money and grow?
What is the significance of rapid growth to startups?
What distinguishes startups from other small businesses?
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If you’re considering working for a startup, what we cover next on how these early-stage companies raise money and grow is helpful in understanding what your equity may be worth.

If you’re only concerned with large and established companies, you can skip ahead to how equity is granted.

Startups

Common questions covered here
What distinguishes startups from other small businesses?
What is the importance of growth in a startup?
What kind of companies are startups?

Definition A startup is an emerging company, typically a private company, that aspires to grow quickly in size, revenue, and influence. Once a company is established in the market and successful for a while, it usually stops being called a startup.

confusion Unlike the terminology around corporations, which has legal significance, the term startup is informal, and not everyone uses it consistently.

Startups are not the same as small businesses. Small businesses, like a coffee shop or plumbing business, typically intend to grow slowly and organically, while relying much less on investment capital and equity compensation. Distinguished startup investor Paul Graham has emphasized that it’s best to think of a startup as any early stage company intending to grow quickly.

technical C corporations dominate the startup ecosystem. LLCs tend to be better suited for slower-growth companies that intend to distribute profits instead of re-investing them for growth. Because of this, and for complex reasons related to how their capital is raised, venture capitalists significantly prefer to invest in C corporations.

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Fundraising, Growth, and Dilution

Common questions covered here
Why are fundraising and venture capital important to startups?
How do fundraising, growth, and dilution relate to the stages of a startup?
What does increased dilution indicate about the value of my shares?

Many large and successful companies began as startups. In general, startups rely on investors to help fund rapid growth.

Definition Fundraising is the process of seeking capital to build or scale a business. Selling shares in a business to investors is one form of fundraising, as are loans and initial coin offerings. Financing refers both to fundraising from outside sources and to bringing in revenue from selling a product or service.

Definition Venture capital is a form of financing for early-stage companies that individual investors or investment firms provide in exchange for partial ownership, or equity, in a company. These investors are called venture capitalists (or VCs). Venture capitalists invest in companies they perceive to be capable of growing quickly and commanding significant market share. “Venture” refers to the risky nature of investing in early-stage businesses—typically startups—with unproven business models.

A startup goes through several stages of growth as it raises capital based on the hope and expectation that the company will grow and make more money in the future.

Definition Companies add (or “issue”) shares during fundraising, which can be exchanged for cash from investors. As the number of outstanding shares goes up, the percentage ownership of each shareholder goes down. This is called dilution.

confusion Dilution doesn’t necessarily mean that you’re losing anything as a shareholder. As a company issues stock and raises money, the smaller percentage of the company you do have could be worth more. The size of your slice gets relatively smaller, but, if the company is growing, the size of the cake gets bigger. For example, a typical startup might have three rounds of funding, with each round of funding issuing 20% more shares. At the end of the three rounds, there are more outstanding shares—roughly 73% more in this case, since 120%×120%×120% is 173%—and each shareholder owns proportionally less of the company.

Definition The valuation of the company is the present value investors believe the company has. If the company is doing well, growing revenue or showing indications of future revenue (like a growing number of users or traction in a promising market), the company’s valuation will usually be on the rise. That is, the price for an investor to buy one share of the company would be increasing.

danger Of course, things do not always go well, and the valuation of a company does not always go up. It can happen that a company fails entirely and all ownership stakes become worthless, or that the valuation is lower than expected and certain kinds of shares become worthless while other kinds have some value. When investors and leadership in a company expect the company to do better than it actually does, it can have a lot of disappointing consequences for shareholders.

Dilution Illustrations

Common questions covered here
How is dilution best illustrated?
How does dilution work for existing shareholders when the startup raises another round of funding?
What happens to the value of my shares when more shares are issued?

These visualizations illustrate how ownership of a venture-backed company evolves as funding is raised. One scenario imagines changes to ownership in a well-performing startup, and the other is loosely based on a careful analysis of Zipcar,* a ride-sharing company that experienced substantial dilution before eventually going public and being acquired. These diagrams simplify complexities such as the ones discussed in that analysis, but they give a sense of how ownership can be diluted.

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Stages of a Startup

Common questions covered here
What are the typical growth stages of a startup?
What is the difference between companies and corporations?
What is the difference between Seed and Series A, B, and C funded startups?

Understanding the value of stock and equity in a startup requires a grasp of the stages of growth a startup goes through. These stages are largely reflected in how much funding has been raised—how much ownership, in the form of shares, has been sold for capital.

Very roughly, typical stages are:

  • Bootstrapped (little funding or self-funded): Founders are figuring out what to build, or they’re starting to build with their own time and resources.

  • Series Seed (roughly $250K to $2 million in funding): Figuring out the product and market. The low end of this spectrum is now often called pre-seed.

  • Series A ($2 to $15 million): Scaling the product and making the business model work.

  • Series B (tens of millions): Scaling the business.

  • Series C, D, E, and beyond (tens to hundreds of millions): Continued scaling of the business.

Keep in mind that these numbers are more typical for startups located in California. The amount raised at various stages is typically smaller for companies located outside of Silicon Valley, where what would be called a seed round may be called a Series A in, say, Houston, Denver, or Columbus, where there are fewer companies competing for investment from fewer venture firms, and costs associated with growth (including providing livable salaries) are lower.**

caution Most startups don’t get far. According to an analysis of angel investments, by Susa Ventures general partner Leo Polovets, more than half of investments fail; one in 3 are small successes (1X to 5X returns); one in 8 are big successes (5X to 30X); and one in 20 are huge successes (30X+).*

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caution Each stage reflects the reduction of risk and increased dilution. For this reason, the amount of equity team members get is higher in the earlier stages (starting with founders) and increasingly lower as a company matures. (See the picture above.)

The Option Pool

Common questions covered here
What is an option pool?
What percentage of stock typically makes up the option pool?
How do companies decide the size of the option pool?

Definition At some point early on, generally before the first employees are hired, a number of shares will be reserved for an employee option pool (or employee pool). The option pool is part of a legal structure called an equity incentive plan. A typical size for the option pool is 20% of the stock of the company, but, especially for earlier stage companies, the option pool can be 10%, 15%, or other sizes.

Once the pool is established, the company’s board of directors grants stock from the pool to employees as they join the company.

technical Well-advised companies will reserve in the option pool only what they expect to use over the next 12 months or so; otherwise, given how equity grants are usually promised, they may be over-granting equity. The whole pool may never be fully used, but companies should still try not to reserve more than they plan to use. The size of the pool is determined by complex factors between founders and investors. It’s worth employees (and founders) understanding that a small pool can be a good thing in that it reflects the company preserving ownership in negotiations with investors. The size of the pool may be increased later.

Counting Shares

Common questions covered here
How are outstanding shares counted?
What is the difference between authorized but unissued, issued and outstanding, and fully diluted shares?

There are some key subtleties you’re likely to come across in the way outstanding shares are counted:

Definition Private companies always have what are referred to as authorized but unissued shares, referring to shares that are authorized in legal paperwork but have not actually been issued. Until they are issued, the unissued stock these shares represent doesn’t mean anything to the company or to shareholders: no one owns it.

confusion For example, a corporation might have 100 million authorized shares, but will only have issued 10 million shares. In this example, the corporation would have 90 million authorized but unissued shares. When you are trying to determine what percentage a number of shares represents, you do not make reference to the authorized but unissued shares.

confusion You actually want to know the total issued shares, but even this number can be confusing, as it can be computed more than one way. Typically, people count shares in two ways: issued and outstanding and fully diluted.

Definition Issued and outstanding refers to the number of shares actually issued by a company to shareholders, and does not include shares that others may have an option to purchase.

Definition Fully diluted refers to all of the shares that a company has issued, all of the shares that have been set aside in a stock incentive plan, and all of the shares that could be issued if all convertible securities (such as outstanding warrants) were exercised.

A key difference between fully diluted shares and shares issued and outstanding is that the total of fully diluted shares will include all the shares in the employee option pool that are reserved but not yet issued to employees.

important If you’re trying to figure out the likely percentage a number of shares will be worth in the future, it’s best to know the number of shares that are fully diluted.

technical Even the fully diluted number may not take into account outstanding convertible securities (like convertible notes) that are waiting to be converted into stock at a future milestone. For a more complete understanding, in addition to asking about the fully-diluted capitalization you can ask about any convertible securities outstanding that are not included in that number.

confusion The terminology mentioned here isn’t universally applied. It’s worth discussing these terms with your company to be sure you’re on the same page.

Definition A capitalization table (cap table) is a table (often a spreadsheet or other official record) that records the ownership stakes, including number and class of shares, of all shareholders in the company. It is updated as stock is granted to new shareholders.*

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Classes of Stock

Common questions covered here
What is the difference between common stock, preferred stock, and founder's stock?
What factors make liquidation preference complex?
What is the significance of liquidation overhang to my stock options?

Definition Investors often ask for rights to be paid back first in exchange for their investment. The way these different rights are handled is by creating different classes of stock. (These are also sometimes called classes of shares, though that term has another meaning in the context of mutual funds.)

Definition Two important classes of stock are common stock and preferred stock. In general, preferred stock has “rights, preferences, and privileges” that common stock does not have. Typically, investors get preferred stock, and founders and employees get common stock (or stock options).

The exact number of classes of stock and the differences between them can vary company to company, and, in a startup, these can vary at each round of funding.

confusion Another term you’re likely to hear is founders’ stock, which is (usually) common stock allocated at a company’s formation, but otherwise doesn’t have any different rights from other common stock.*

Although preferred stock rights are too complex to cover fully, we can give a few key details:

Definition Preferred stock usually has a liquidation preference (or preference), meaning the preferred stock owners will be paid before the common stock owners when a liquidity event occurs, such as if the company is sold or goes public.

Definition A company is in liquidation overhang when the value of the company doesn’t reach the dollar amount investors put into it. Because of liquidation preference, those holding preferred stock (investors) will have to be paid before those holding common stock (employees). If investors have put millions of dollars into a company and it’s sold, employees’ equity won’t be worth anything if the company is in liquidation overhang and the sale doesn’t exceed that amount.*

confusion The complexities of the liquidation preference are infamous. It’s worth understanding that investors and entrepreneurs negotiate a lot of the details around preferences, including:

  • The multiple, a number designating how many times the investor must be paid back before common shareholders receive proceeds. (Often the multiple is 1X, but it can be 2X or higher.)

  • Whether preferred stock is participating, meaning investors get their money back and also participate in proceeds from common stock.

  • Whether there is a cap, which limits the payout if it is participating.

  • technical This primer by Charles Yu gives a concise overview. Founders and companies are affected significantly and in subtle ways by these considerations. For example, as lawyer José Ancer points out, common and preferred stockholders are typically quite different and their incentives sometimes diverge.

  • The Holloway Guide to Raising Venture Capital explains liquidation preference overhang in detail.

important For the purposes of an employee who holds common stock, the most important thing to understand about preferences is that they’re not likely to matter if a company does well in the long term. In that case, every stockholder has valuable stock they can eventually sell. But if a company fails or exits for less than investors had hoped, the preferred stockholders are generally first in line to be paid back. Depending on how favorable the terms are for the investor, if the company exits at a low or modest valuation, it’s likely that common shareholders will receive little—or nothing at all.

How Equity Is Granted

In this section we’ll lay out how equity is granted in practice, including the differences, benefits, and drawbacks of common types of equity compensation, including restricted stock awards, stock options, and restricted stock units (RSUs). We’ll go over a few less common types as well. While the intent of each kind of equity grant is similar, they differ in many ways, particularly around how they are taxed.

Except in rare cases where it may be negotiable, the type of equity you get is up to the company you work for. In general, larger companies grant RSUs, and startups grant stock options, and occasionally executives and very early employees get restricted stock awards.

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