When you work for a tech startup that has raised a lot of money but has an uncertain future, you — as an employee with stock options — should ask yourself:
If the company gets bought or goes public, will I make any money?
When Facebook went public, it produced a reported 1,000 millionaires. But more often, startups exit for minimal amounts or not at all, and employees discover the stock they have been holding is worthless.
Early startup employees are usually given “common stock” or options on common stock. Common stock can make you rich if your company goes public or gets bought at a high multiple to its official valuation. But most employees don’t realise that common stock holders only get paid from the pot of money left over after the preferred stockholders have taken their cut — and in some case common stock holders can find their stake has been crammed down so far by the preferred stock that it’s nearly worthless, even if the company is sold for more money than investors put into it. Any company that has raised a large amount of investment equity or debt, especially in successive rounds, risks cramming down the value of employees’ common stock.
We spoke with a venture capitalist about what types of stock option-related questions startup employees should ask their CEOs. The conversation shifted to the New York startup scene, where Fab and Foursquare are good case studies.
Foursquare, for example, has raised $US121 million with $US20 million of that in debt. It will likely have to exit at a huge multiple of that sum for every single employee with stock options to feel the benefit. Likewise, Fab has raised $US336 million in a series of rounds. Considering the startup has laid off more than half its staff in the past year, the most recent terms probably weren’t favourable for stock option-holding employees.
“I think there are some great people probably in both Foursquare and Fab who may be in for a tough surprise when there’s a ‘good’ outcome, $US100 — 400 million. But all the money [presumably] goes to debt and preferred equity holders as opposed to them,” our VC says.
Fab declined to comment for this story. Foursquare — which has an extremely different situation than Fab — wouldn’t share details of its terms, but did say that employees are encouraged to ask these sorts of questions at weekly all-hands meetings.
Here’s what the VC, who asked to remain anonymous, thinks those employees should ask.
1. “How much equity have you raised, how much debt have you raised, and on what terms? What’s the total preference stack?”
This will help you know when your stock, which will typically be common stock, will start to become meaningful. You’re essentially trying to find out how much structure — or preferred stock — a company has hanging over its head, and how many other people will be paid in an exit before you.
There are terms founders can put in place while raising money to protect the interest of important employees. For example, sometimes there’s an “equity carve out,” which basically ensures that stock for select startup executives and employees gets put on the top of the equity stack, to be paid off after debt but before preferred stock. It’s possible startups like Fab or Foursquare thought to ask for this from investors, but it’s something executives there may want to inquire about.
2. “How does the payout structure work?”
In other words, if a company like Fab or Foursquare got acquired for a lump sum, at what price would the common stock get touched? Are your options a priority in the case of an exit?
Don’t’ be afraid to ask something specific such as, “If our company gets acquired for $US200 million with the current investment in it, how much of that goes to common?”
The investor explains: “Then you can see, ‘OK this is great. I think this company should be worth more than $US200 million, and at $US400 million it’s a great payout for me.’ Or, ‘This is crazy. This company has to be worth more than $US800 million for me to make something meaningful.'”
3. If you’re in a position to negotiate, ask for a special deal on your options.
Since debt and preferred get paid off first, executives being recruited into a company may want to see if they can work out a special deal where their stock moves to the top of the payout pile during an exit, below debt and above any structure — or preferred stock — the company has agreed to.
“Senior executives who have been around the block a couple times may say something like, ‘I’m happy to join, but I want to make sure I’m not at the bottom,” the VC explains. ” I want some of my equity to come out first, or maybe second after the debt. I just want to make sure this is going to be worth my time.'”
4. Ask all of the above questions anytime there’s a significant round of financing.
If there’s a large equity round or a lot of debt raised, the investor feels it’s fair to ask your employer these types of questions. Especially if you know the round was raised while the company was struggling.
Employers don’t technically have to answer these questions, but if they are unwilling to give you straight answers you have a right to feel wary.
So, what are Foursquare’s and Fab’s’ terms, exactly? We don’t know about Fab because the company declined comment. But its CEO Jason Goldberg recently wrote a blog post about why his employees continue to be motivated. “Want to know what it takes to turn around a company and rebuild it?” He wrote. “Fab is one of the only places in the world you can get that kind of experience.” He didn’t mention anything about stock options.
Here’s what Foursquare told us:
“We’re pretty open with our employees on where the company stands,” Foursquare spokesperson Brendan Lewis told Business Insider via email. “This means things like revenue growth (which is up 600% 2012-2013 and 500% Q1 2013-Q1-2014), the terms of our recent fund raises (convertible debt round in April and Series Ds in December and January) and that each means for the individual employee. Additionally, employees are encouraged and regularly ask management questions about these things at company all-hands meetings, our weekly ‘office hours’ where each executive is available for meetings on any topic, and special 1:1 meetings.”