Startup Capitalization

One of the greatest advantages of sitting right next to a CFO is that I get to interact with him frequently. Over the last year or so, I have learned quite a bit about Startup Financing, Cap Structure, Stock options, etc during these interactions. There are 3 very important things that an entrepreneur has to watch -

1. Total number of Authorized shares - this is the maximum number of shares that can be issued to investors as registered with the state of incorporation. Of course, companies have the option of increasing, splitting or reverse splitting the number of authorized shares relatively easily and often do so when they raise new rounds of funding.
2. Total number of Outstanding shares - this is the number of shares that are held by stockholders. The more common use, in high tech vernacular, is Fully-diluted outstanding shares which is the outstanding shares plus the shares reserved for issuance under stock option plans (grants + cancellations + remaining to be granted) plus the amount of shares to be converted under warrants and convertible debt. Essentially, the number of shares if every right to a share of stock as converted
3. Liquidity option on Preferred stock - shares held by employees and founders are typically Common stock. VCs get preferred stock which normally as a “liquidation” preference which means in the event of a liquidity event, they have to be repaid before Common stock is. The liquidity option determines the amount to be repaid for each preferred stock if a liquidity event occurs (acquisition, bankruptcy, etc). Common stock holders get paid only after all the preferred stocks have been repaid in full.

Let's take an example and walk through these numbers.

Lets say a friend and you decide to float a company, Acme Industries. You typically incorporate in Delaware (it has the friendliest corporate law) with a total of 100 Million Common (Authorized) Shares at a par value of $0.001.

Between the two of you, you decide to hold on to at least 60% of the Common shares to ensure that you have a controlling interest. This would amount to 30 Million shares each for a total cost of $30,000. Typically, this would create the basis for you to go add sweat equity for future work on the company You'll allocate a further 20% (20 Million shares) for future stock and option grants(key employees and future issuance). The remaining 20% can be used to attract outside investors with preferred shares convertible into common should you be fortunate enough to do an IPO (more on this later).

Once you have the prototype, you start pitching to VCs to raise enough capital. Lets say KPCB decides to advance a term sheet to buy 10 Million of Series A preferred stock at a “pre-money value of $30,000,000 or $0.50 per share. You would float 10 Million Preferred shares at par value of $1 for KPCB to bring the “post money valuation” to $40,000,000. At this point, the VC firm has a 9.1% stake in your company (10M shares/110 M).

Term sheets are normally loaded in favor of the investors, esp. when presented to a first time entrepreneur. Make sure you pay close attention to the liquidity option - this is a hidden cost of the capital that you will have to pay later on. Liquidity options vary between $1 and $2 depending on market conditions. I'm told $1 liquidity options are available these days, but during the difficult 2004-05 period, $1.25 was the most common option with some going as high as $1.75.

If all goes well, you would become cash flow positive with just a Series A funding and work towards your exit plan. Acquisitions are more common than IPOs, so if your company gets acquired for $20 million, you'd repay the investors $10 million (if you've a liquidity option of $1) and share remaining $10 M amongst the shareholders.

More often than not, companies require a Series B, C, D or more funding before they are able to exit. In such cases, companies are forced to increase the number of authorized shares (because total Common outstanding + total Preferred outstanding must never be greater than total authorized). This causes a dilution in the stake of common shareholders. Top executives often negotiate “dilution protection” so that they will receive the same % of options for one round following hire so their relative position stays the same. Thus a new CEO would be incentivized to raise money right away and not wait and try to protect their stake as a % of the total dilutable options, which means that they are given enough options to maintain their stake at a certain percentage. They also ask for the Cap table or cap structure so that they know how much their stake in the company is relative to other shareholders. This is rarely done for regular employees, but something to keep in mind as you grow in your career and look for opportunities.

Finally, the best advice for entrepreneurs is that they get themselves a very good attorney with lots of experience before they start raising funds to negotiate a good term sheet. Top attorneys can get things done effectively and quickly, however, they must also balance their VC connections since they are a great source of referrals and would hate to bite the hand that feeds them :)