Ask HN: Equity and Funding

[arcanainc]

Jack launches a startup, incorporates it and issues 1M shares, all of which go to him since he's the sole founder. He approaches VC firms for funding and a firm agrees to fund the startup in exchange for 30% or 300K shares. Does this money go to Jack (since he owns the shares)? Shouldn't it go to the company?

How does this work exactly?

[cperciva]

When a VC firm funds a company, they aren't buying existing shares -- they're buying newly created shares. Before being funded, the company has 1M shares outstanding, and Jack owns all of them. After funding, the company has 1,428,571 shares outstanding; Jack still owns 1M shares (which is now 70%), but the VC owns 428,571 newly issued shares (30% of the total) which it bought from the company for $300k.

In reality it's a bit more complicated because VCs employ a swindle called an "options pool", but that's not the issue in question here.

PG runs through a simple example of how this works in his How to Fund a Startup essay: http://www.paulgraham.com/startupfunding.html

[arcanainc → cperciva]

Thank You! Finally, a reply. Any resources online where I can read up on this process?

P.S. Since you mentioned it, what's an 'options pool'?

[cperciva → arcanainc]

Any resources online where I can read up on this process?

Stick around on HN and you'll see lots of links to angel investors, VCs, and other startup people explaining all this.

what's an 'options pool'?

The idea is that you give your employees options (or often restricted stock) so that they have a stake in the company's success. For legal reasons, the creation of any new stock must be authorized by the board of directors, and they don't want to meet every time someone new gets hired; so instead they authorize a pool of stock and tell the CEO to go ahead and hand it out. So far, so good.

The swindle comes here: VCs usually insist on the creation or expansion of an options pool before investing, and count the unissued stock as part of the valuation. Rather than paying $300k to buy 428571 shares and ending up holding 30% of the company, a VC might insist on the creation of a 20% options pool, with the result that Jack owns 1M shares (50%), there are 400k authorized but unissued shares in the pool (20%), and the VC gets 600k shares (30%) for his $300k.

Because those shares don't actually exist yet, the VC actually owns 600k / 1.6M = 37.5% of the company, even though he nominally only bought 30%.

[arcanainc → cperciva]

But when those 400K shares are created and issued to the employees, won't the VC's share get diluted to 30%?

[cperciva → arcanainc]

Yes -- just like they would diluted in the next round of investment. (And really, employees working for sub-market salaries in exchange for stock options are just another type of investor.)

But the founders get diluted too. In the no-pool case, the founders have 70% of the company post-investment, whereas in the 20%-pool case, the founders have 62.5% and get diluted down to 50% as the pool is handed out.

[arcanainc → cperciva]

Ah. So the time of creation of the options pool doesn't matter, since eventually the founders get down to 50%. It's a matter of whether the options pool should be created in the first place.

[gojomo → arcanainc]

http://venturehacks.com/articles/option-pool-shuffle

...and everything else they write!

[fezzl]

The company almost always issues new shares. Investors would want the capital to be injected into the company as working capital, not to enrich the founder.