Behind every successful startup is a team that has invested everything—from their time, to their money, or even their entire career. However, all these different investments lead to different ownership rights, which means that understanding startup equity can become a complex task. The remainder of this article will explain the basics of startup equity and address common questions associated with complex capitalization.
Equity: The Basics
Equity represents the ownership of a company. Each equity security entitles the owner to obtain interest in the company’s profits or control, but the interest can also take other forms such as the right to acquire another type of equity, i.e. stock options. Ownership rights are organized in the company’s capitalization table.
What are the Different Types of Equity?
Equity securities can take many forms, but the most common for a startup include common stock, preferred stock, convertible preferred stock, and stock options and warrants. While each security represents ownership in the same company, the attributes of ownership differ.
Common stock is a basic security that entitles the owner to a portion of the company’s profits or sale proceeds. The holders of common stock share the remaining proceeds of a sale by ownership percentage after other debt and equity holders are paid back for their investments.
Preferred stock entitles the owner to be compensated for their investment upon the sale of the company by receiving a liquidation preference, in addition to dividends, before owners of common stock receive their portion of the proceeds. A liquidation preference is a monetary value equal to or greater than the initial purchase of the stock, and the dividends may accrue at regular intervals or be paid at the discretion of the company.
Stock options and warrants are similar securities that represent the option to purchase another security (e.g. common stock or preferred stock) for a predetermined price which is referred to as an exercise price. Stock options will often expire at a given date and the rights to purchase another security are forfeited.
Who Receives Which Type of Equity?
Because each investor has contributed in different ways, the equity that each receives should be different.
Founders will retain common stock and controlling rights, but they may also be compensated with other securities.
Investors who provide more tangible capital receive preferred stock or convertible preferred to protect their investment.
Employees can be compensated with equity, along with their salary. This equity can be stock options or restricted stock, which is common stock that is transferred only after certain conditions are met. Because both stock options and restricted stock have vesting periods, the added incentive to continue working until the securities have vested makes these securities particularly suited for employee compensation.
Other parties involved in equity fundraising, such as investment banks that perform underwriting, will receive warrants with the option to purchase either common stock or the preferred stock of the relevant equity fundraising round.
Stock Options: The Basics
Understanding stock options requires an understanding of the various attributes that are associated with the security. The basic attributes of stock options are the following:
- Underlying Security – The security (e.g. common stock) that can be purchased at the exercise price.
- Exercise Price – The predetermined price at which the underlying security may be purchased.
- Vesting Date – The date at which the stock options can be exercised going forward.
- Maturity Date – The date at which the stock options expire and the right to purchase the underlying security is forfeited.
The exercise price is of particular importance with respect to tax law. IRC 409A, which is defined in this previous post, requires all stock options to be issued with an exercise price equal to the value of the underlying common stock at the issue date. This means that a 409A valuation is often required to comply with tax law and avoid complications for employees.
Preferred Stock: The Basics
Startups perform equity fundraising in intervals, and since the inherent value of the company changes in the interim, each round of preferred equity can have different rights associated with their ownership. Attributes that can change between rounds include:
- Seniority – The seniority level determines who receives their money first in a liquidity event, i.e. the most senior preferred security holders will receive their liquidation preference and dividends before the junior securities, which may cause the junior securities to receive less than their liquidation preference.
- Conversion Price – When, and if, a convertible preferred security holder chooses to convert into common stock, the conversion price is the value per share of common stock that is converted from the liquidation preference and dividends.
- Participation Rights – Preferred equity holders may be given the right to participate with common stock beyond their liquidation preference and dividends, thereby receiving part of the purchase proceeds as if the preferred security had converted, but without forfeiting liquidation preference or dividends. If the terms include a cap, then the preferred owners will cease to participate with common stock once the cap is reached.
- Liquidation Preference – Frequently used by venture capital to specify which investors get paid first and how much they get paid in the event of a liquidation event, such as the sale of the company.
Don’t Know Where to Start?
Learning to understand complex equity structures is an involved process, and entrepreneurs don’t always have the time to focus on the myriad of aspects involved in fundraising. If your startup is in the process of fundraising, Scalar has the expertise and industry experience to ensure that you know the market value of your business, so you can focus on growth.
Scalar provides Valuation Consulting services and Enterprise Valuation services for clients that are in the process of accessing the venture funding market. Our team of valuation specialists will leverage industry knowledge and experience to provide you with a timely and accurate valuation, enabling you to make informed decisions and to improve your value.
If you are in need of valuation services, you can request a complimentary consultation or call us at 385.831.1010.