When I was growing up, a lot of people told me that I’d have to spend 10 years in a job I didn’t like to get somewhere. Then I started interviewing entrepreneurs and all of them told me not to wait to start doing what I wanted to do. They were right.
Startup Compensation: Salary vs Common Stock vs Preferred Stock vs Options
Entrepreneurship has grown in popularity amongst recent college graduates. My startup recently joined a office space incubator in Chicago and I spent the last week discussing various topics with fellow entrepreneurs and investors. One of the topics that drew the most confusion amongst my peers and their employees revolved around compensation.
In a series of four posts, I want to go through compensation strategy. This post focuses on the securities and methods commonly used to compensate startup employees. The intention for entrepreneurs to understand their capital options and employees to determine how much they’ll be paid.
Whether you are deciding compensation or considering accepting it, use this equation: Compensation = Salary + Stock + Terms (negative value). After understanding all three factors, research the comparable salary in a public company to determine if the offer is fair.
Cash has the least risk because you know it’s worth and it is liquid. Since startups are risky, the only guaranteed money you have is the money already paid out. Since startups don’t have a lot of cash and are still growing revenues by reinvesting gains, companies may offer royalties to developers or commission amounts to salesmen with a cap. While these should be counted as salary, I would discount them by at least 50% because in each of the cases your success is dependent on several other people in sales or development performing their job in a timely manner.
Here is the formula I would use to calculate the minimum salary required: Rent + Food + Living Expenses + Taxes = Minimum Salary Required = Cash + 0.5 (Commission or Royalties). Note, the 50% is generous discount rate (can be larger) and dependent on your situation. If you aren’t getting a reasonably predicable salary, pick a different job or lower your standard of living.
Common Stock, Preferred Stock, and Stock Options
Equity is one of the attractive features of startup culture; however, it is also what makes compensation risky. Few ventures exit; and without a liquidity event (e.g., IPO or acquisition), equity is worthless.
Normally, common stock is awarded to workers and preferred stock is given to investors. In the case of a liquidity event, preferred shareholders will get paid first. Hence, common stockholders in startup which have raised significant amounts of capital must be wary of the preferred shares capitalization and the estimated exit value to understand the amount they will receive: Exit Value - Debt - Total Preference = Residual Common Stock Value. The more money the company raises, the higher they will need to exit.
Capitalization = Shares Outstanding x Price Per Share. This equation is relevant when understanding your common stock portion as well: Your Current Ownership % = # of Shares Granted to You / Total Capitalization. You will be offered a number of shares or a percentage of equity at the appropriate valuation. If a startup is hesitant to provide you with any of this information, don’t work there.
Preferred stock will have different different series (A to Z) depending on the round of capital raised. Typically, before or during Series A, employees will receive restricted stock because their equity percentages tend to be bigger. Ask to see the founder’s agreement and ask for the early execution clause to receive shares at a lower cost basis. Finally, file a section 83b Election within 30 days with the IRS. Additionally, long-term capital gains tax on stock in the USA is 15%.
Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs)
Another type of equity is options. Most companies will have an options pool used to grant equity incentives. These can be thought of as call options which are exercised at a particular strike price and particular date. These are the securities that minted several hundred millionaires in Google and Facebook IPOs.
At the same time, options can bankrupt a person. For example, a company is worth $10M when options are granted to an employee with 0.75% options equity at an $1 strike price. Options Exercise Price = %/100 * Strike Price * Company Value or $75,000 in our example. That amount has to be paid by the employee when translating to common stock. Because the company is worth $50M or 5x the strike price at the exercise date, the option holder is bullish on the company’s prospects, he/she has the money and is wants start the long-term capital gain clock, the decision to pay is made.
There are two types of options: ISO and NSO. ISOs can only be granted to employees at fair market value and are taxed at exit. Moreover, they can be treated as long-term capital gains (look into AMT IRS rules). NSOs are more flexible and is a term for any option that doesn’t qualify as an ISO. These securities can be issued to anyone, even at a lower strike price and earlier exercise date. It’s a pain for startups to issue ISOs, but employees must analyze tax advantages.
Vesting and Dilution Terms
Equity is subject to vesting or the time you receive shares and dilution or the percentage your equity is worth. Vesting is created to ensure that employees earn their equity and are incentivized to stay with the venture. Normally, there is an 1 year cliff with no vesting. From there, straight line vesting may occur monthly.
Every time a company raises money or options are exercised, equity holders are diluted. Additionally, the board can issue more shares diluting everyone. (Options Authorized + Future Investor Shares) / (Total Capitalization + Future Options Authorized + Future Investor Shares) = Dilution Factor. Know that the percent you have will decrease to make sure you get the largest share early.
At exit, (Current % Ownership + Future Vested % Ownership)/100 * Dilution Factor * Company Exit Price - Total Exercise Price = Capital Gains. Typically, options holders bet that the company will grow 5x its value in 3 years and 10x in 5 years. Negotiate for the shortest vesting and the most equity to minimize your risk.
Startups are called risky for several reasons. A lot of your compensation is left to chance and the key calculation you have to make is the risk factor. Hence, financially, Salary + Stock + Terms should be greater than a comparable roles compensation. If you don’t have an appetite for risk or aren’t motivated by the culture of equity, don’t accept the offer.
Lastly, I made many assumptions and am inexperienced so consult a tax account or attorney before making a decision.
Sources and Excellent Reads:
Facebook copied Tumblr’s highlighting idea, but is considering providing a “free trial”. It’s time Tumblr copied someone else’s idea. Oh wait, Tumblr is getting ads (Fast Company Article).
How To Purchase Facebook IPO Shares If You Decide To
Everyone’s talking about Facebook’s upcoming IPO. Regardless of if you want to invest, this post should help you understand the IPO process, find out if you’re qualified to purchase Facebook shares, and provide some opinion on the valuation.
To become more familiar with the offering, immediately check out the most recent SEC S-1 filing and the road show video. Focus on the filing, if nothing else check out the: prospectus summary (p. 1), selected consolidated financial data (p. 38), business (p. 84), and description of capital stock (p. 148).
As expected, the video is heavily scripted, biased, and focuses on the potential with their number of users. However, you don’t have to watch all 30 minutes; here’s a link to summarization. Also, if you want to balance out the melodramatic Zuckerburg, glimpse at the Facebook tag on Tumblr.
Facebook’s IPO Process
There are many reason why a company may want to go public, most notably, to raise capital and provide a liquidity mechanism for investors. There are no earnings, cash flow, profitability requirements for a company to IPO (outside of exchange requirements). This means a good IPO candidate can be a new, untested company.
Here’s the Facebook IPO timeline:
- February 2012: The company files a S-1 with the SEC. The SEC and investors approved of the IPO.
- April 2012: Facebook chose to be listed on the NASDAQ - getting a pretty sweet deal and will be given the FB ticker.
- Current Stage: Investment bankers solicit interest from institutional clients during what is called a road show. Right now the price range is $28 to $35 per share. The approximately 337 million shares will bring in $9.4 billion cash at the low end of the range.
- As early as May 18, 2012: Shares will be priced.
- Sometime after May 18, 2012: FB will IPO, receiving cash for their shares. Plus, a few of FB’s executives, employees, and relatives will celebrate the NASDAQ opening bell. After which, the shares are open to the public.
The type of IPO auction is important to note. FB will be using the traditional allocation method, while 5 years ago, Google used a dutch auction. This partly decides which retail investors (you and I) will have access to the shares and how shares are allocated.
Participating in Facebook’s IPO
20% to 25% of the 337 million shares could be allocated to brokerage firms like TD Ameritrade, Charles Schwab, E*Trade, or others catering to small investors. Here is the general process to participate:
- First thing you should do is call your brokerage house. The brokerage should have an IPO department. This department will first see if your account is qualified, confirm you’ve read the prospectus, and understand the risks. For Charles Schwab, qualifying means having over $100,000 in household assets or having traded more than 35 times in the last year. Sometimes you’ll be asked to fill out an additional IPO form; I know E*Trade does this.
- Place a conditional offer to purchase IPO shares. Tell your broker the number of shares you want to purchase and the maximum price per share you are willing to pay.
- Once the price is set by FB’s underwriters, everyone has to reconfirm their conditional offer. The window for the reconfirmation is small (sometimes 1 trading day or 8am to 4pm EST) so make sure you check your IPO center and sign up for email updates. You will be able to change the price OR quantity of your conditional offer while the window is open. Remember, this also means changing the quantity to 0.
- Distribution of shares will depend on the allocation of shares your brokerage receives, demand for those shares, and finally how valuable you are as a client in terms of length and assets.
- Standard commission rates will apply. You can’t, however, flip the IPO. If you’re planning on selling your shares the first day, think again. The brokerages will be upset and possibly penalize you (refer to your broker’s policy) by freezing your account. Normally, you will have to hold the security for 30 days after the IPO date.
Demand for shares will influence if shares will pop or drop on IPO day. FB is likely oversubscribed, meaning there is high demand and the syndicate of underwriters will not have to support the price. So now let’s talk about one of the factors driving demand, the valuation.
Opinion: FB Valuation
Now that you know if you’re eligible or not, let’s talk about FB’s $100B valuation. Firstly, not many IPOs have been successful (refer to the image).
There is a lot of information and opinions on the valuation. Below are a few points that have influenced my opinion in the recent weeks:
- There are 2 main sources of revenue for FB: payment integration and advertising. The ability for payment integration has created an opportunity for companies like Zynga to thrive. When you have 3rd party developers building apps, it increases interaction of your platform like it has for Apple. At the same time companies are users to sign-on using FB making the business pervasive like Microsoft. On the other hand, because of the information supplied by users, advertisers can have more targeted campaigns than possible on Google. Both of these have great potential for growth.
- Zynga and other developers are diversifying onto other platforms. Additionally, many services allow you to sign-on with Twitter instead of FB.
- It is cheap to start a social network, but costly to run one. More employees, servers, and infrastructure will need to be added in the future, decreasing margins.
- I don’t like the FB interface. Zuckerburg boasts about FB’s hacker mentality - creating a program with the minimum viable features and letting the user decide if it’s successful. Personally, I think FB needs a much better design. This culture is great when a company is just stating out and the innovative users are excited about the product (see next pt.); however, as the company grows, it should better its products.
- As the number of FB users increases, the coolness factor decreases. Many have thought that is the sole reason for $1B Instagram purchase. The market is only going to grow more competitive and so the number of acquisitions will have to increase. That compared with social media fatigue will impact revenues and time spent on FB. On the other hand, the more people on LinkedIn, Twitter, and Tumblr the better the service since people want to connect, follow, and increase their exposure. The more friends you have the less you can interact with each of them and FB is a personal network first.
- I believe the valuation is too high. You can test your own valuation using this FT valuation tool. Refer to the table below for my logic:
- FB had an awesome move made about the founder and the company: The Social Network. This matters because the glorification of the company has an impact on the oversubscription of IPO shares. People who have never bought an IPO before, will seriously think about participating in this one.
- Users are important to FB and it’s priced at $1.11 per user and around $1.50 per active user based on a $100B valuation. That is much less than the $33 per Instagram user. Plus, the market potential outside the US is still great. Even in the US, young people create accounts and use them almost as soon as their born.
All in all, I may participate in the IPO if I’m confident the pop on the first day of trading will be large enough. For that to materialize, the shares would have to be priced at the very bottom of the range. At the same time, I believe the shares will drop significantly in the short term (60 days or less) presenting a buying opportunity well below the IPO price. Furthermore, in the next five years, the market capitalization has the potential to reach Google’s size.
I’ll be posting my thoughts and final decision on Twitter as the IPO date moves closer. Tweet me and let me know what you think. Also, read the investment disclaimer.
*Update 5/15*: Shares are 25 times oversubscribed according to a recent NYT Dealbook article. Subsequently, FB is raising their price range to $32 to $38.
Additionally, Bloomberg predicts online advertising to grow to $10 billion within the next year. Plus, FB is planning on adding diversity to their company by searching for female executives. The changes in management will be announced after the IPO.
Finally, today is the last day to decide if you would like to purchase IPO shares.
Visualizing Mark Zuckerberg’s Letter to Investors
I finally got around to reading Facebook’s S-1 Filing. 30 of the most frequent words in the letter. Notice any themes?
Source: Mark Zuckerberg’s Letter to Investors in the Facebook S-1
This isn’t the kind of place where doing what everyone else is doing would be considered successful,” says Maris, who launched Google Ventures in the spring of 2009 to invest some of Google’s prodigious cash hoard in startups. “We’re trying to do something completely different, not because it’s different, but because we’re looking for a different outcome.
Very interesting graphic depicting social media average minutes per visitor. This is a much better metric than number of registered users.
I’m sure Tumblr and Pinterest are rapidly growing in both visitors and time per user since both of the platforms allow for easy content creation and compilation.
Update: californiachillwave makes a good point. Pinterest is catching on fire because it is easier to organize other peoples thoughts into your own profile. In my opinion, Tumblr is a blogging platform so you share content keeping your followers in mind.
Source: The Wall Street Journal