The section about "Underwater Options" is describing what would happen assuming a Participating Liquidation Preference. It's a little misleading, because the vast majority of liquidation preferences nowadays are non-participating. It's an important distinction.
A 1x non-participating preference means that before anyone is paid out, the investors get their money back. The remainder, if any, is distributed pro-rata to other stockholders. For example, if the investors had put in $25M and owned 50% and the exit was for $30M, the investors would get $25M and the last $5M would be split between founders and employees.
A 1x participating preference is much worse. It means that the investors are paid back first, and then still participate in the payout according to their ownership percentage. In the same example as above ($25M in, $30M exit, 50% ownership), the investors take their $25M back, then the last $5M is split between the founders and employees and investors. Thus, the investors get a full $27.5M and the common stock holders see their payout decrease by another 50% vs a non-participating preference.
Your first example made it sound like investors get their money back and that's it for them. In reality, they do participate in the payoff, but only when it exceeds their preference.
Thanks for the clarification, something I'll have to add.
Out of curiosity, how does it work across multiple rounds? I implemented 1x participatory preferences as a simple lifo queue... For non-participatory preferences, are there any complications in calculating the "everybody goes equal from here up" point (50 in the above example) when everyone got in at a different round? Can you have some participatory preferences mixed with non-participatory ones? Is there a good reference for that (at least for a typical case)? Or is this a "call your lawyer" thing?
A preference is just a term on the investment. They could be mixed. It can get pretty complicated.
Take this scenario: (A) Series A non-participating 5M, (B) Series B non-participating 10M, (C) Series C participating 10M, owns 25%. Founders own 50%, no options pool. Company sells for 30M.
- C gets 10M first
- B gets 10M next
- A gets 5M next
- 5M left over, only C is participating; A & B are just floors.
- Pro-rata, remaining ownerships ratio of 50:25 = 2:1.
- 5M/3*2 = 3.33M goes to founders.
- 5M/3*1 = 1.67M goes to Series C investors.
Total tallies:
- Founder: 3.33M.
- Series A: 5M. ROI: 0%
- Series B: 10M. ROI: 0%
- Series C: 11.67M. ROI: 16%
This is mostly for intellectual curiosity, though. If you're a startup founder today… just don't take on any investors who ask for participating preferred. If you're an investor, don't ask for it, it makes you a vulture.
Awesome page, learning a lot. As someone who never really understood this song and dance, here's my feedback. I think you should include a more direct explanation of pre- and post- money valuations. Sure, it's really simple: Premoney+money=postmoney, but that doesn't mean it's common knowledge. Second, the explanation of the option pool shuffle is important to understand the example; it shouldn't be a subtext of an asterisk in the second column. I would also recommend being more direct with the definition of effective valuation as well at the time of its introduction.
It may also be interesting to add levers for duration of time between financial events. Then we can look at the exit analysis from an investor's point of view and understand a little bit more about investing at different stages... then you could add levers for success rates at each stage (Dave McClure tweeted a visualization of this recently)!
If you look at his account around that date, he has a few more tweets on a similar topic. I don't think it's really necessary to understand your main topic, but it could be fun :)
The option pool math is kinda hard to visualize, and that link's "we think you're worth $x, but let's create $y of new options and call their sum your pre-money" quote is probably the most succinct way of explaining it. Did the blue bar with the dotted component for the new options make sense, or was that too subtle? Any other suggestions for how to show it?
That quote of "worth $x, let's create $y" was what made it click for me. Great way to explain it. The dotted lines only really helped me to label the data on the bar chart, but on the right-hand column, I didn't quite get it. What if you underlined 8M with two colors: one for the 6.5M effective valuation and one for the 1.5M New Options (lengths based on makeup ratio)? Also one thing that might help is modifying the horizontal lines; at the same weight, I wouldn't infer a Sum calculation, but if the bottom line were bolder, I might think to add up the numbers
I wish more fresh grads and folks new to startups understood these concepts, particularly around how preferences work and that you can't just multiply # of shares by strike price given all of these considerations.
I love this, it really helped me put into perspective the decisions a founder can make and how it can effect the later stages. I haven't worked in the startup world and I don't have a very good understanding of business so this helped put this corporate finance stuff into perspective.
I would love it if you could add other choices like bootstrapping/family and friends money, accelerators, cofounder issues, and board seats. These kinds of business issues are really hard for people outside of the startup world to understand the consequences of, I personally would really find it helpful. Would make a really good interactive fiction or idle game as well :)
Their percentage stake is how much they put in relative to the pre-money valuation.
Directly above this statement is a bar graph that says "investment 20% equity", while this statement led me to expect it to say "25%". (20% makes more sense to me, but that would mean s/pre/post/)
You have a 2M slice (money) and an 8M slice (pre valuation). The 2 is therefore 20%. I guess "relative" is a bit of an imprecise term. Tried to keep the formulas out of it to make it more approachable, but I'll see if I can be more precise. Thanks!
The underwater options is scary. What I wonder though is what happens if the exercise price is larger than the stake is worth. Since nobody would exercise their options, would not that money be split over the rest of the stake holders?
So when the ROI is negative for some parties, it should grow on the other parties. Isn't that so?
I hear that a lot but you need two numbers: money raised and valuation. Precise valuation is generally kept secret. Even in an IPO my understanding is the numbers never make it out into SEC docs or anything. If you know of a company that has shared this info, would love to see it and tell their story!
To figure out the dilutions, we need the valuation at each round. My understanding is only the IPO valuation is made public, not the per-round breakdowns.
Right, after the IPO everyone is automatically converted to common but for the history of past rounds you need to look at the charter.
The charter is publicly available from the secretary of state wherever the corporation is incorporated. It will state how many shares of each series of preferred stock is authorized. Also, if there is price-based anti-dilution protection (typical in non-seed investments), the charter will state the "original issue price" of each series (i.e. the price per share when first sold). You can check the amount actually sold in the company's SEC Form D filings (also public) and work out the historical valuation that way.
This doesn't account for things like notes converting at a discount, milestones, adjustments for down rounds, etc. But it is possible to get a rough idea of the valuation trajectory.
A 1x non-participating preference means that before anyone is paid out, the investors get their money back. The remainder, if any, is distributed pro-rata to other stockholders. For example, if the investors had put in $25M and owned 50% and the exit was for $30M, the investors would get $25M and the last $5M would be split between founders and employees.
A 1x participating preference is much worse. It means that the investors are paid back first, and then still participate in the payout according to their ownership percentage. In the same example as above ($25M in, $30M exit, 50% ownership), the investors take their $25M back, then the last $5M is split between the founders and employees and investors. Thus, the investors get a full $27.5M and the common stock holders see their payout decrease by another 50% vs a non-participating preference.