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If Common Stock Is Worthless, What Does That Mean for Entrepreneurship?
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Plain common stock has become largely worthless in funded companies. Preferred shareholders have increased their rights and protections, while liquidity events have become rare. Meanwhile, common stock has remained largely unchanged, having value diminished by the changing world. There is an argument that creating value in common stock may help to improve returns from private equity and venture capital. Common stock is the foundation of entrepreneurship. It is the basis of management compensation, employee options and voting control. Creating the opportunity for management to make real returns from their common holdings creates an alignment of interest with investors. How can you attract the best talent and the best opportunities when the compensation model is broken? Any experienced entrepreneur, investor or wise employee understands that an extraordinary success is required to wrest any value from common stock when there are outside investors involved. Let’s look at a simplified example to identify some of the problems with common stock. A five-year-old company with $10 million in revenues decided to sell for $50 million in cash. The company has raised $10 million for 25% in preferred stock. The investors have a 1.5 liquidation preference that provides them with $15 million on exit, and they also participate at 1/3 of the remaining proceed as a result of preferred dividends, providing investors with roughly $27 million of the $50 million in proceeds. If you pull 10% off the top for closing related expenses, common stockholders are left with just under $21 million. In this example, a CEO with 10% in common will stand to earn $2.1 million on a 5x revenue sale for $50 million. An investor with 10% in preferred will stand to earn $10 million. It is likely that the CEO has taken below market compensation for years to get the company off the ground, which may average out to $500,000 of lost wages over five years, assuming that the CEO earned nothing for some period of time. It is also likely that the common shareholders, who are often management and employees, will be asked to bear the burden of an escrow, earnout, or other type of holdback. If 20%, or $10 million, is held at the time of close, the CEO would walk away with $1 million, $500,000 of which makes up for lost wages. This simplified example does not factor in the impact of having to purchase options, which diminishes the value of common further. Improving the value and protections of common stock is challenging. Investors have come to expect certain rights that have built up over time. Law firms use templates to generate incorporation agreements and bring common stock into existence. Expectations have been set within established companies, and changing existing agreements is time consuming, expensive, and difficult with no guarantees for success. Changing the definition of common in new companies runs the risk of scaring away investors, unless the companies are exceptional. On April 16th, the Founder Institute, a new training program for startup founders, incorporated as a Delaware C corporation and introduced new Class F common shares. Some of the terms in Class F stock are far reaching, only able to be justified by the best new companies. Class F stock offers founders a suite of protective provisions, 2:1 Board votes per Founder versus normal Board Members, and 10:1 share votes as compared to normal common. Participating Class F shares vest monthly without a cliff to act as compensation for founding teams, and “single trigger acceleration” allows one Founder to leave without hurting co-founders. Class F holders get acceleration on change in control and approval rights on new investments, liquidity events, Board size, and dividends. Over the next months, only the best companies will raise money, anyway. In the negotiation about whether a Class F right should survive through an investment, some preferred terms may be reduced or eliminated. Hopefully, there will be a meaningful discussion about the rights and value of common stock in the new world. The companies in the Institute will use the Class F incorporation documents, which are also freely available below: http://www.founderinstitute.com/information/agreements Adeo Ressi is founder and proprietor of TheFunded.com Most Commented Posts |
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April 24th, 2009 at 2:58 pm
“There is an argument that creating value in common stock may help to improve returns from private equity and venture capital.”
I think you must mean there is an argument for making the rights of common stock holders stronger relative to other stock holders. Else there is no reasonable argument.
April 25th, 2009 at 1:53 am
[...] Class F common stock is discussed in Techcrunch, VentureBeat, PE Hub and the [...]
April 25th, 2009 at 3:33 pm
In the above calculation, why would the CEO be holding only 10% of commons? It started out as say as example CEO is holding 10% as against gain for investor holding the same..but later the case went on to assume that’s the case.. The payout for the founders should be way higher.. in general, investors take the initial risk in putting the money (as against founders add their skills) so bigger the market hit it is the more likely founders benefit dis-proportionately.. the smaller the success investors take away larger pool.. In the scenario above founders just got $10 million revenue for $10 million investment so they should be happy (besides, without proper investors and future ability to scale — they would not have got 5x multiple also..)
April 27th, 2009 at 10:57 am
@theunfundedmember:
“bigger the market hit it is the more likely founders benefit dis-proportionately” can’t be true because the investors take their cut first.
Rather, as Adeo effectively points out, at smaller exits, the investors benefit disproportionally. At larger exits, the founders catch up to even asymptotically. But the key of the last 10 years is that the larger exits have all but disappeared.
I love the idea of Class F stock to shift the power a bit. I also love the idea of walking away from VC entirely. Decreased demand will be the most powerful force to shift the terms.
April 27th, 2009 at 1:22 pm
A surprisingly cogent insight from Adeo. What to do about is another question. The reality is that building a business is hard, and if you raise venture capital to do it you increase the risk that common stock will not pay out. So one should only raise VC funds if the rewards justify that extra increase. In the case of medtech and biotech (the world I know) venture capital is generally worth the risk. As the above posts observe, this is an issue in small exits. Fair enough. But it can be a problem in big exits as well, if the company goes through a down round that washes out the common. The right investors should, ideally, restore incentives to common. Without that, really, what do we have?
April 27th, 2009 at 2:21 pm
Uh, I think it means that bootstrapping and taking minimal third party investment is the best way to increase value for common or even class F stock. Founders can do very well on what would merely be considered a single by a VC if they take minimal third party investment.
April 27th, 2009 at 8:22 pm
One solution is for founders and employees to take some reasonable number of shares off the table, selling to investors in up private rounds, and mitigating the risk of worthless to marginally valuable common upon a “small” exit. This compensates them for the “lost wage years” and rewards mgmt and employees for the successful launch and build of their company. Certainly the arguement from VC/Investor is reduced motiovation on behalf of founding team/mgmt to continue hustling once they have cashed out some of their stock/options. A solution is anagreed upon cap for insider selling at each round. If they choose to not distribute during private rounds then they are rolling the dice that the exit will be big enough to cover all the preferred shareholders to yield an adequate payoff.
April 27th, 2009 at 8:24 pm
While “liquidity events have become rare” in the short term, the M&A market will come back in the medium term (or so we assume) and the argument therefore needs clarification. It is really the complete lack of IPO liquidity events that have hurt the value of common shares. In an IPO, preferred shareholders are forced to convert to common, putting everyone on the same footing going forward with respect to appreciation of their stock value. M&A exits also force that conversion, but the stock of the acquired company then goes away and shareholders don’t get to take advantage of any increases in value thereafter.
April 27th, 2009 at 10:41 pm
this is not a great example.
$50MM exit for $10MM raised in VC is a mediocre exit, especially since the the investors valued the company at about $40MM assuming they bought 25% of the company. so i wouldnt feel that bad for management. with that type of funding the exit should have been at least $100MM, which would have netted common $100MM-$15 = $85MM * 75% = $63MM not including fees. That would be good for the entrepreneurs and VCs would get 3.6x.
as an entrepreneur, i’d say DON’T raise 10MM in VC if your exit is only going to be $50MM. bootstrap, get customer financing, do whatever else - its just not worth it. $50MM exit companies should take $5M max, and more like $2-3MM to keep investors and common aligned.
the bigger issue is that the exits aren’t there to justify most VC investments.
April 27th, 2009 at 10:44 pm
First, there are a few problems with the example. If the hypothetical company has raised only one round of funding and given up 25% of the equity, and the CEO holds 10%, then were is the other 65%? It probably rests with employees at large (typically 20%) and Founders (45%!)
So not only have you ignored the typical 20% in the hands of employees broadly, but even including that you come up short almost half the company (the 45%)
Also, it is rare for preferred stock in these types of companies to actually accrue dividends (which are far more common in established, PE-backed type companies). Usually the dividends are “when and if declared by the Board” and “non-cumulative”, and having dealt with scores of companies I can only think of one where the preferred dividend actually came into play.
Finally, the 1.5x preference would be a _participating_ preferred preference. If it’s just plain convertible preferred, then usually the investor has the right to the _greater_ of 1.5x or the as-converted-to-common return. So in your example the preferred has participation, but that, like preferred dividends, is a very rare thing in a young company with only one round of Series A financing (that type of structure is more often seen in later rounds as a protection mechanism for late investors).
So, your example is flawed in several ways and takes what would probably be a quite happy outcome for an entrepreneur and somehow makes it sound like a horror show. If I can raise $10 million over any number of rounds and wind up at a $40 million fully-diluted post-money [25% dilution] valuation and build a $10mm/yr business I’ll be a very happy camper. So you should go re-run your math and check your assumptions.
All of that said, however, the basic point that it is a tough time to be an entrepreneur is a good one. The more realistic scenario is that someone raises say $15 million over 3 rounds (seed/A, B, C) and winds up with >50-60% dilution and a 20% option pool, and builds a $10 million business that can only sell for $20 or $30 million.
The real issue is that exit valuations aren’t there to support historical levels of investment in venture-backed IT companies. Whether stock is common, preferred, Class F, or any other, the real problem is that the pies just aren’t getting big enough to economically feed everyone, given the cost of the ingredients.
This will result in less entrepreneurship in some areas, leaving behind those who (like most great entrepreneurs) are irrationally optimistic about their prospects, and exceedingly passionate about their businesses. but really it all amounts to an adjustment in the price of labor and capital to reflect the economic value of the investments, and the displaced entrepreneurial talent will seek out other sectors of the economy that can adequately pay them for their talents, if those sectors exist.
Isn’t that what capitalism is all about?
April 28th, 2009 at 4:21 pm
@westside: It is a mediocre exit, but even mediocre exits are rare at this point in time. A more frequently occurring example would be a forced shutdown or a forced restart. The problem is that you never know how big the company will be when you start one, and some companies require capital to get off the ground.
@just.a.guy: Dividends are common in preferred equity deals, sometimes cumulative and other times declared, so they need to be factored into any example. In this example, the standard presence of dividends was used to round up equity participation.
@just.a.guy: The editorial references that the stock is participating preferred. TheFunded tracks term sheets issued, rejected, and accepted, and the vast majority of term sheets are participating preferred with a >1.0X liquidation preference.
@just.a.guy: The example predicates that there are both employee shareholders and angel investors in the common, like with most venture-backed companies.
May 4th, 2009 at 10:02 am
[...] and VentureBeat recently reported on this innovation and Adeo Ressi provided his thoughts in PEHub. A form of Certificate of Incorporation that includes provisions for Class F common stock, [...]
May 10th, 2010 at 6:43 am
Hi Adeo,
I want to understand the example you stated in this article a little differently. How will the situation in the example change if the founder has Class F Stock.
Regards,
Preetham