Convertibles and preferreds
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Part of the problem is the sheer amount and complexity of information required to understand equity and ownership in the call option preferred shares place. For most people to understand how much of a company they actually own, all they really call option preferred shares is the fully diluted share count, the broader breakout of ownership among different classes of shareholders, and a couple other details.
There are lots of things that can increase the fully diluted share count over time — more options issued, acquisitions, subsequent financing terms, and so on — which in turn could decrease the ownership percentage. Of course, people may also benefit from increases in options over time through refresher or performance grants, but changes in the numerator will always mean corresponding changes in the denominator.
The exercise price of employee options — the price per share needed to actually own the shares — is often less than the original issue price paid by the most recent investor, who holds preferred stock. Dilution is a loaded word and tricky concept. On the other hand, raising more money helps the company execute on its potential, which could mean that everyone owns slightly less, but of a higher-valued asset.
After all, owning 0. But… the value of that ownership has increased significantly: While not all dilution is equal, there are cases where dilution is dilution — and it involves the anti-dilution protections that many call option preferred shares may have. The basic idea here is that if the company were to raise money in a future round at a price less than the call option preferred shares round in which that investor is participating, the investor may be protected against the lower future price by being issued more shares.
The amount of additional shares varies depending on a formula. It also means the fully diluted share count goes up by an additional 10 million shares; all non-protected shareholders including employees are now truly diluted. We saw the effects of such a full ratchet in the Square IPOwhere the Series E investors were issued additional shares because the IPO price was half the price at which those investors had originally purchased their shares.
Some investors may also have liquidation preferences that attach to their shares. Simply put, a liquidation preference says that an investor gets its invested dollars back first — before other stockholders including most employees with options — in the case of a liquidity event such as the sale of the company.
Given the high sale price for the company in this example, the liquidation preference never came into play. It would, however, come into play under the following scenarios:. When a company goes through several rounds of financing, each round includes a liquidation preference.
There are various flavors of liquidation preference that can come into play depending on the structure of the terms. But some investors do more than 1x — for instance, a 2x multiple would mean that the investor now gets 2x of their invested dollars off the top.
The impact of this on other stockholders can be significant. The common and option holders are no worse off than they were when our investor had only a 1x liquidation preference:. This is the language that determines who gets to approve an IPO. In most cases, the preferred stockholders, voting as a single class of stock, get to approve an IPO: Add up all the preferred stockholders together and the majority wins.
Sometimes, however, different investors can exercise control disproportionate to their actual economic ownership. This typically comes into play call option preferred shares a later-stage investor is concerned call option preferred shares the company might go public too soon for them to earn the type of financial return they need having entered late. In such cases, that investor may require that the company get its approval specifically for an IPO, or if the price of the IPO is less than some desired return multiple like x on its investment.
How would they do this? By asking for more shares or lowering the conversion price at which its existing preferred shares convert into common. This increases the denominator call option preferred shares the fully diluted share count. To be clear, none of this is to suggest nefarious behavior on the part of later-stage investors. Besides the financing and governance factors that could impact option value, there are also specific types of options that could affect the economic outcomes.
In general, the call option preferred shares favorable type of options are incentive stock options ISOs. Basically, ISOs mean that startup employees can defer those taxes until they sell the underlying stock and, if they hold it for 1 year from the exercise date and 2 years from the grant datecall option preferred shares qualify for capital gains tax treatment.
Non-qualified options NQOs are less favorable in that someone must pay taxes at the time of exercise, regardless of whether call option preferred shares choose to hold the stock longer term. Since the amount of those taxes is calculated on the exercise date, employees would still owe taxes based on the historic, higher price of the stock — even if the stock price were to later fall in call option preferred shares. One of the most frequently asked questions about options is what happens to them if a startup is call option preferred shares.
Below are some possible scenarios, assuming four years to fully vest but the company decides to sell itself to another company at year two:. This means that, if someone is given the option to stay with the acquirer and choose to stay on, their options continue to vest on the same schedule though now as part of the equity of the acquirer.
Unvested options get cancelled by the acquirer and employees get a new set of options with new terms assuming they decide to stay with the acquirer. Unvested options get accelerated — they automatically become vested as if the employee already satisfied her remaining two years of service. There are two flavors of acceleration to be aware of here, single-trigger acceleration and double-trigger acceleration:. Note, these are just general definitions. There are specific variations on the above triggers: And double triggers give the acquirer a chance to hold on to strong talent.
But how the money ultimately gets divided across these various buckets can sometimes diverge call option preferred shares what the initial option plan documents dictate as acquisition discussions evolve. Rulethe exemption for issuing employee stock options. But times have changed, and the requirements that were put into effect April have failed to keep pace.
Companies are now staying private longer and are therefore raising more capitaloften from new entrants to venture investing with more complicated terms. Rule should be updated to better reflect the information people need to understand options. Startup outcomes are, by definition, unpredictable. Every startup is unique, every situation has unknown variables, and new data will always change the economic outcomes.
Working at a startup means getting in early for call option preferred shares that has yet to be proven, which means call option preferred shares could have great risks call option preferred shares and potentially, great rewards. The original issue price is just what it says: This price tells us what various financial investors believe the value of the company was at various points in time. The conversion price is the price per share at which the preferred stock will convert into common stock.
Dilution Dilution is a loaded word and tricky concept. Liquidation Preferences Some investors may also have liquidation preferences that attach to their shares. It would, however, come into play under the following scenarios: The common and option holders are no worse off than they were when our investor had only a 1x liquidation preference: ISOs vs non-quals and exercise periods Besides the financing and governance factors that could impact option value, there are also specific types of options that could affect the economic outcomes.
Below are some possible scenarios, assuming four years to fully vest but the company decides to sell itself to another company at year two: Unvested options get assumed by the acquirer. There are two flavors of acceleration to be aware of here, single-trigger acceleration and double-trigger acceleration: So people would get the benefit of full vesting whether or not they choose to stay with the new employer.
In double triggerthe occurrence of the acquisition alone is not sufficient to accelerate vesting. Related Stories Raising Call option preferred shares