Series: Startup Gotcha

We like to be as transparent as possible when I’m trying to convince a candidate to join our team. After all, we’re asking for one of their most valuable resources, namely, time and opportunity. When I started this company with my friends, we strived to build a place that, unlike any of the places that we’ve worked at, offered clear transparency and definable upside. Since then, we’ve realized that it’s one of the core tenets of the company. So, in an effort to convince prospective employees to come work with us but also, just be a generally helpful resourceful for people out there, we’ve decided to start a “gotcha” series highlighting all of the things we think you should watch out for when considering a startup opportunity.

The content of this series will mostly be general and applicable to all startups. In specific instances, we’ll be specific about what we do and why we chose a specific policy.

Disclaimer: The people who wrote/edited this (i.e. Allen Li) have extensive financial/startup/legal knowledge but are not lawyers by any means. This is not legal or tax advice. You should consult your lawyer if you have any questions.

PART I: You said the valuation was what?

Let’s face it — valuation is the first thing everyone wants to talk about. What other metric can employees use to evaluate opportunity A with opportunity B? Well, we’re here to tell you that before you take that number at face value you should ask this extensive but non-exhaustive list of questions/topics (they should be able to send your their last term sheet for ease):

Question #1: Where does this valuation come from? When was it from?

Is it the pre/post-money valuation from the last round? Or is it an indicative term sheet you’ve received? Is the valuation equal to the last round’s price per share multiplied by the number of fully diluted shares?

For the people new to startups, post-money valuation generally refers to the valuation assuming all shares were valued at the price per share the last round transacted at. For example, if I had a company with 100 shares and someone bought the one share most recently at $10, this would mean the company is worth $1,000. However, in startup land, because capital is generally injected, the company would issue a new share and that would be sold at $10. So, instead, we have 101 shares making the company’s post-money valuation $1,010. The pre-money is simply the valuation less the amount that was put in ($1,000 in this example).

Question #2: Have you received the entire funding? Are there any stips (requirements) associated with the round?

Sometimes investors will build in milestones prior to the funding coming through. For example, they may say we’ll fund $10M day 1 but only another $10M funded after you’ve hit this much in revenue or have been approved for this license. This isn’t necessarily positive or negative but something to be aware of.

Question #3: Were there any other instruments (warrants) issued along with the round?

In venture, warrants are equity instruments commonly issued to strategic partners to reward them differently versus other equity investors. As a general matter, it makes sense — if I bring business to the company, I should be compensated differently from other equity investors. However, it gets murky if, for instance, the lead investor also is the one who gets the warrants. The price then needs to be adjusted for the warrants they received. For example, if the investor was issued 5% in penny warrants and invested 10% in the company at a $100M valuation, then their investment basis is closer to $66M.

Question #4: What was the liquidation preference in the round? What about the dividend rate? Is it non-cumulative? What is the liquidation preference seniority?

The most well-known example of an unfavorable fundraising term is a >1x liquidation preference — of course an investor is willing to pay MORE for shares that get paid out first up to 2x their invested basis. However that artificially increases the math of valuing the company as price per share x number of shares in the company. Similarly, if they get paid out first (senior liquidation preference), they would, again, be willing to value the shares more as well.

Dividend rates are usually pretty inconsequential but are basically the additional amount above and beyond the liquidation preference that an investor has to earn. Think about this as a minimum return in a liquidation scenario. Cumulative means that it continues to accrue past a single year.

Question #5: Any ROFRs (Rights of first refusal)? Super pro-rata rights?

Right of First Refusals refer to an investor’s right to have the last look at financing at a company. When the company solicits a holistic set of terms from another investor, the Right of First Refusal holder has the right to take those set of terms. In a perfectly liquid market, this doesn’t do anything — every knows the price of an asset and you can go buy at the market price at any time. In an illiquid market like VC, this “chills the bid” or causes investors to shy away from doing work on the company because they know someone else may take advantage of the price setting work they did. Unsurprisingly, this is a favorable term for the investor which they should be willing to pay a higher price for.

Super pro-rata rights mimic the ROFR in terms of allowing an investor to buy more of a company but instead forces a company to take additional dilution at the next round and increase the round size. Mechanically, the company is forced to allow an investor to invest at the terms of the current round up to a certain percentage ownership. This doesn’t “chill the bid” but does result in the company taking more dilution than they wished to take. (Yes, you can argue to solicit a round with lower dilution and achieve the same outcome)

Question #6: What are the non-standard provisions in the round?

All of this points to one simple premise: all valuations are not created equal. If the answer is yes to any of the above, this doesn’t mean that the company is bad, just that they gave something up to get an artificially high valuation. You could argue valid reasons for doing so but it’s something to be careful of. Conversely, a company may also choose to take a lower valuation from an investor for very valid reasons. For example,

• Sequoia is well known to command the ability to ask for lower valuations because of the long term positive signaling factor their brand brings to the company.
• A company might be convinced to give warrants to an investor because they are strategic in some way or form (business etc).

On a more technical basis, assuming a company is providing you a valuation based on a “print” (i.e. a transaction that has been or will be completed), what is occurring is that the shares being sold are what is being valued. This includes all the terms and conditions and even the voting rights associated with the shares. You can certainly imagine that the more control an investor has over a company the more comfortable they feel with the outcome and hence the price they paid. This equation also factors in realistic outcomes — a later stage company generally has more tangible value and therefore liquidation preferences are weighted more. Conversely, there’s rarely a reason to think that a 12 person software startup has real tangible value in a liquidation scenario and hence most VCs underwrite it to a zero in case of a loss.

As a final note, while we have probably added a lot more complexity to your calculus when evaluating an opportunity, the good news is that if the following are true, your old framework of thinking about it is PROBABLY fine.

• It is a post-money valuation based on a completed round
• There are no peculiarities and everything is vanilla NVCA
• It is not a unicorn or something where downside protection should be strongly considered
• The investors are generally well known. More conservative valuation if Sequoia/old school institutional investors and probably aggressive valuation the more unknown family offices and lower tier VCs involved

For what it’s worth, we currently:

• Have vanilla NVCA terms and no weird provisions
• Instead of paying warrants, have gotten investors to give us business commitments in exchange for investing. This is probably the most unique thing we’ve been able to accomplish.
• Provide quotes based on the last post-money valuation on a fully diluted and converted basis and have now started to provide prospective employees a model built by one of our employees (credit to Nisha) to understand the value of their equity package (including tax comparisons)

It’s probably not that unique but important to highlight nonetheless.

Part 2: Wait so what do I own?

So now that you hopefully have a general sense of how to value the company (notice I didn’t say your shares), let’s talk about what you’re actually getting. In most cases, companies will offer you options (ISOs or NSOs) or some equity instrument that vests over a time horizon. So, depending on the stage of the company, you probably want to determine what percentage of the company you own (earlier stage companies) or what the dollar value of your shares if a liquidation event were to occur (later stage companies).

Here’s our again non-exhaustive list of questions:

Question #1: What share count (or equivalent thereof) am I getting?

This is going to be your numerator in most percentage based calculations

Question #2: On a fully-diluted as-converted basis (including any conversions of warrants, convertibles, SAFEs, option pools, etc), what is the share count of the company?

This is a conservative (though not overly) assessment of denominator in a percentage based calculation. In the case of the option pool, it assumes that the company decides to issue all options prior to a liquidation event. If it doesn’t your percentage ownership would be increased by 1/(1-X%) where X% is the remaining equity pool.

Question #3: What is the legal entity of the shares I am getting? Is this the same entity that all of your investors invested in? Please provide a structure diagram with all affiliated entities

This question is to make sure value isn’t being accrued elsewhere or being siphoned out without your knowledge. As an extreme example, a company could have a holding company that owns the IP you create and do not own the equity shares of. Alternatively, they could form a joint venture with a separate entity that transfers value out of the company.

Question #4: What share class am I getting or do my options, once exercised, convert into? What other share classes are there? What share class do the founders own?

Generally you should receive common shares (or the equivalent) but it’s important to understand what share classes are in the capitalization stack and therefore, different interests in the company. If the founders own the same share class as you, they’ll be more likely to maximize the outcome that best benefits your share class (see next part for more context)

Question #5: How much do I get paid out in the situation where the company liquidates for the valuation you just described?

People can come up with complex structures where your payout is extremely dependent on the exact circumstances but this is probably the easiest question to ask to determine something close to the true “dollar” value of your option at the moment. Note, it’s important to note that the value of your option is slightly greater than that due to the volatility and future optionality but it’s good for understanding how the company’s liquidation waterfall works (see option theory for more details).

The point of these questions is to highlight many of the ways you can get screwed by not understanding what you actually will be owning. It’s easy to be “lazy” and blindly assume that the other employees/investors in the company have done the work and diligence. (See TopTal’s case as a great example) However, given your time is precious, it’s important to ascertain as much as possible and make sure the work and effort you put in for the next couple of years isn’t rendered to zero. So for your own sake, please do your due diligence.

Part 3: Are we all on the same team? (founder share sales, double trigger, vesting)

It should be obvious that when you join a company you are implicitly making a very large bet on the founders. Whether it be an early stage company or even a late stage one, venture companies are based on the premise that the founders have the ability to perform magic and suspend disbelief. Accordingly, they’re given a significant amount of control over the company, far more than what is allowed and typical. Instead of giving investors the ability to affirmatively decide on certain actions, the venture capital construct relies on what is called protective provisions or “blocking rights”. Combined with softer dynamics like the natural cheerleading that occurs or straight up founder’s shares having 20x voting rights type constructs, venture company founders more often than not very much have “control”. So, unsurprisingly, if you decide to join a company you must get to a point where you trust the founders.

While I believe strongly in trust, I think incentive alignment is an essential building block in building that trust. It’s great to work towards the same general goal but when you don’t have certainty that your utility function is proportional (or at least directionally the same), it’s hard to concentrate on doing the best you can. I think this was probably less problematic back when venture capital was less well funded but seems rampant today given the competitive dynamics of the industry.

The first thing I want to highlight is founder share sales. This is when founders sell their shares to investors prior to a liquidity event. To be clear, I don’t have a philosophical opposition towards it — there are founders who have student loans to pay off, founders who’ve invested all of their personal savings, etc. However, there are a couple of dynamics that when combined create misalignment of incentives.

1. Founders often sell their shares without offering their employees the ability to tag along.
2. Founders have the ability to control the price and the terms of the subsequent round of financing.
3. Venture boards, while not controlled by founders, often blindly support founders. In other circumstances, the founders were able to negotiate sufficient control at the board level (see Uber, WeWork, etc).
4. The market has become extremely competitive which means capital providers are more willing than ever to bend to founder demands and at earlier stages of the company than ever.

Why do these three added together create a problem? This means the founders can choose the round that offers them the most favorable terms to get themselves liquidity. In a normal world, the board is there to veto and be the check in the check and balances, but instead, may simply encourage this behavior. Paired with market demand, the net result is you have founders who sold their hyped up company shares 2 years into the company and have de-risked themselves on the backs of the employees they convinced to bet their careers on the company.

There is a sensical way to do this — namely, provide full transparency to your team and allow them to join in on this type of deal. While I personally think keeping a founder hungry is crucial, this at least allows the people who’ve bet on you and the company to know what’s going on.

The second thing to highlight is what happens on a “change of control” or generally, a liquidity event. Before we get into the details, let’s first establish same basic concepts. When you get equity in the company, it has a vesting schedule (usually a four year monthly/quarterly vesting with a one year cliff). While this clarifies your compensation structure in most scenarios, it does not explain what happens if the company is sold or undergoes what is called a “change of control” event (control being control of the company here).

Some companies like to tout that under those circumstances they’ll fully accelerate employee vesting meaning you fully vest all of the unvested stock at the point this occurs. In general, I believe that this is the right idea, especially for early stage employees. They’re making their bet on the company based on the full equity package granted to them. However, in reality, it’s far more nuanced. For example, if the acquiring entity wants the company to continue to operate, they can’t have the employees leaving right after an acquisition. So, it’s pretty normal under those circumstances for equity to not accelerate and instead, just continue based on where the vesting schedule was. Moreover, if necessary, the board could always argue to amend the equity plan or build that into the terms of the sale.

In any case, where it gets more complicated is when the founder doesn’t have vesting (because they negotiated it upfront) or if they have a trigger event which causes their shares to fully vest upon something like a change of control. Under that construct, the founder now has an incentive to sell the company earlier, perhaps before the company has fully realized its value or to an unfavorable acquirer, because they wouldn’t be stuck at that company vesting.

While there is no obvious answer, it is more standard to have what’s called a “double-trigger vesting acceleration” which means two events have to both happen for their stock to fully vest (i.e. change of control and termination not for cause). Regardless, it’s important to make sure that the founder (again, who controls the situation) is on the same side as the employees.

Finally, the third thing (but definitely not the least) is to make sure that the equity plan (while amendable) is fair. There are terms that people debate about including:

Option expiry being 90 days after leaving the company (Segment popularized removing the expiration entirely)

• For what it’s worth, I think this is less of a concern if you have a significantly low enough 409A valuation
• However, it is undeniable that in other situations it discriminates against people of little means. One method is to do what Segment did — that is extend it beyond the 90 day window though the conversion from an ISO to an NSO makes it far less attractive. Another approach taken (which is probably the most favorable) is to grant employees (or at least some of them) the ability to take non-recourse low interest rate loans against the strike price. This allows the employee to capture the benefits at a pretty minimal cost + reap tax benefits.

Repurchase upon any separation from company (not just termination for cause)

• I was made aware recently (actually by Allen before he joined) that our equity plan had a repurchase right at “fair market value” for vested shares following an employee’s separation from the company for any reason, and that it was 50% standard in equity plans. This means that the company could buy back shares at what may be considered rather arbitrary prices once someone leaves, even if it’s been fully vested.
• We have since removed it from our equity plan, because while we would never use it nefariously as a management team, it still feels uncomfortable as an employee and you never know who ends up running the company.

Definition of “for cause”

• Not to get too into the details but upon a “for cause” termination, there are a lot of serious remedies the company can take. Therefore, make sure that for cause termination is something fully in your own control and a sufficiently high standard.
• “for cause” as a legal term of art has a relatively well-established common law definition, but the definition can be tweaked / clarified by defining it explicitly in a document (which is usually accompanied by capitalizing the term such that it is obvious it’s referring to the in-contract definition, usually becoming “for Cause” or “For Cause”). 99% of the time the definition is just a clarification of what is already established in case law, but it could not be so, so it’s always good to check precisely what the definition is

I can go on and on about this but hopefully this post illustrates how much control founders have and therefore how much trust you should (or shouldn’t) have in them. As someone who worked in the financial industry prior to Peach Street, part of my desire to build Peach Street was to build a place where you had transparency and could trust management to do right by you. While this post may be or seem self-serving, I hope people will take this as an honest effort by us to do what’s fair and right and if not, at least take the learnings along with them on their next journey.