The Finance of Startups: For Dummies (Part 1)

Okay, I’m going to admit something here. Publicly. I don’t know a lot of things when it comes to startups. *phew* That’s like a big weight off my shoulders. I’m sure you’re surprised. Well, let me be more specific – I don’t know much about the financepart of startups. Yes, I have one of those MBA degree things buried somewhere in my house, but I didn’t really grasp finance. Truth be told, my learning style was much different from the way my finance professor taught, and as it was the foundational course, I got very little out of it.

Starting with this month, I’m going to post an article or two about a subject I don’t know much about. I’m not sure what the structure’s going to be, but I’m going to start and just let it play out and course-adjust as I see things working out. It’s like a startup itself! Essentially, I’m hoping to disseminate my learning for you in, hopefully, an easily digestible blog post. Be sure to share at the end any concepts or questions you have, too.

Where to begin? I’ll start with a 3-5 questions or concepts that I and/ or a friend has wondered about and try to answer those through research. I expect some of the questions and answers will be simple for some of you, but for others, it’ll be useful information. Let’s get this finance party started!

I was working with a startup recently that was trying to raise capital, but the investors wanted shares in preferred stock. This was one part of the wrinkle in the fund-raising, but here’s our first subject – what’s preferred stock? Well, when it comes to stock, there’s largely two types – common and preferred. Common stock is what we normally trade on various exchanges.

Preferred stock represents some degree of ownership of a company, but as its denomination implies, preferred shareholders get a bit of “special treatment”. In the event of bankruptcy, assets are distributed amongst shareholders – creditors, bondholders, preferred shareholders, and THEN common stock holders. That means that common stockholders are last in the pecking order when it comes to receiving funds from a liquidation.

The other BIG area where preferred stock differs from common stock is in dividends. When companies have cash assets in the bank, the company can choose to pay out via dividends. With preferred stock, dividends are pretty much paid out on a fixed dividend like clockwork. Common stockholders, again, get dividends only after preferred shareholders are paid out. In the event dividends aren’t paid on some set date, then whenever dividends ARE paid out, preferred shareholders get their cuts first.

Note: different stocks can also have different CLASSES. Classes are set by the company to retain (diminish or empower) voting power to specific shareholders.

Resource: http://www.investopedia.com/university/stocks/stocks2.asp

You know the really concentrated orange juice you can buy from a store? If you drink the concentrate straight, it’d be wicked strong. You add some water to it (diluting) and it starts to be of a consistency you can handle without squeezing your eyes shut. However, there also comes a point where the more and more water you add, the less of an orange juice taste you get. You get more of it, sure, but it doesn’t quite pack that punch anymore.

Taking that terrible analogy (I can admit these things) to shares, we can look at dilution as a means of creating “more juice”; though, with less “punch” per cup you divvy out – a reduction of ownership percentage. Follow me. Dilution in the startup world typically occurs when holders of stock exercise their options (buy stock at some agreed upon strike price – more on that later) and especially if the company is raising a round of equity financing.

In a raise, startups may issue new stock to investors with some equity percentage. In this case, as more stock is created, the value of the company may rise (depending on valuation of the company), but the denominator (number of shares – “shares outstanding”) increases usually at a larger rate. Thus, each value of the stock decreases – gets watered down. And equally “thusly”, if you owned 100 shares before for 10% of the company (total shares outstanding = 10 * 100 = 1,000 shares), and the company issues 1,000 more shares (2,000 total shares outstanding), your ownership percentage just dropped as well to 5% (100 shares ÷ 2,000).

That’s not all bad, though. Even though your ownership has dropped, the value of the company will have most likely increased and the company could now be in a stronger financial position to do even better (or just survive… you know, whatever). So if you don’t look at it as a “percentage” deal and from a straight-value perspective, you’re looking better.

Resource: http://www.investopedia.com/terms/d/dilution.asp

If you’re joining a young startup in the growth stage or earlier, especially, you may be given the opportunity to get equity in addition to your salary. Everyone probably thinks this is where you can become millionaires. It could happen, but it’s rare – how often are these billion dollar unicorns popping up? I digress… When you read your offer, you’re likely seeing some number of shares (say 100) with a vesting period of Y (say 4 years) with some “strike price” of Z (say $20). “What the heck is going on?!” you ask. Let’s break it down.

Okay, so let’s pull this together with a couple examples from above. 100 shares, 4-year vesting period, and a strike price of $20. Let’s say the offer says the stock vests according to the following schedule: 25 units in the second year, 25 units in the third year, 25 units in the fourth, and 25 in the fifth. If the employee remains with the company till year 3, the employee has earned 50 shares at a price of $20 each, but has forfeited the 50 shares. If the employee stays the whole five years (and then some), he/ she will have earned all 100 shares at $20 each.

Same example, but let’s look at a 1-year cliff vs. the gradual schedule. Only at the anniversary of the employee’s start date will 20 shares be vested to the employee. From each month onwards, 1.67 shares are vested each month (100/60 months). A fractional share doesn’t really happen often, but I’ll let it slide for now. So if the same employee leaves after 36 months, he/ she’d have accrued 1.67 * 36 months = 60 shares at $20 each, forfeiting 40 shares. See the difference?

Should the company go big and IPO later, the employee can choose to exercise his options by selling at the market price (“spot price”)… if it’s $100, then the employee can sell all 100 shares at $100-20 = $80 per share = $8,000.

Now, there’s a wrinkle to all of this (as always with finance, darn you)… you can’t just carry off $8,000. You must understand the rules of the plan as some vesting options do not let you touch the money till some retirement age before making penalty-free withdrawals.

Sources: http://www.businessinsider.com/everything-you-need-to-know-about-cliff-vesting-2011-5, http://www.investopedia.com/terms/v/vesting.asp, http://en.wikipedia.org/wiki/Strike_price, http://www.investopedia.com/university/employee-stock-options-eso/eso1.asp

Yowza, there’s a lot of good nuggets of information up there, so I’m going to stop at 3 today. This was fun to learn a bit about, and share with you, so I’m looking forward to keeping this train going. Next time, I’d like to touch on:

Next month, I’d like to also dive into some financial statements of a company or two, and share what I find interesting similar to David Cummings’ posts about companies’ S-1 filings – see “Notes from the New Relic S-1 IPO Filing”.

So before going, going to ask the same questions I usually do: what are your thoughts about finance in startups? What questions/ concepts are you wondering about that I can help do some research for you? What questions do you have about what I’ve shared above, or comments?