Startup Business Plan

The Value of Stock

Employees often ask for stock…. equity…ownership. Yet rarely fully understand what they are seeking. What does that mean? What rights and liabilities come with ownership? Basically, there are 3 benefits to stock ownership:

  1. Control – Typically in startup employees who receive stock are not going to hold stock in sufficient quantities to control the company. Founders and/or investors will rarely give up over 51% of the stock and he who has 51% of the votes controls the company. Therefore, if you’re asking for control, it isn’t happening.
  2. Distributed Profits – Startups are typically unintentional nonprofits or if they are profitable, profits are reinvested in the business and not distributed. Those who control the company, control the distribution of any profits. Therefore if you’re thinking you’re getting a share in the profits… think again.
  3. Enterprise Value – In startups, it is usually a share of the enterprise value that people seek and that creates Google Millionaires. Shareholders receive their pro-rata share in any of the spoils that remain from a liquidity event.

Let’s dig into the types of equity or stock.

Types of stock:

  1. Preferred – Venture Investors usually purchase preferred stock. Preferred shares are more valuable than common as Preferred Shares in a startup may or may not come with a combination of dividends. preference and/or participation defined as: Preference – Preferred shares have priority in return over common shares. As an example, if an investor invested $1M and the company is capitalized with 50% preferred shares and 50% common. In the event of a $1.5 million dollar purchase of the company, the preferred holders would receive the first $1M and the common would share the remaining $500K.Dividend – Preferred shares often will have rights to a “guaranteed” dividend usually paid out in the form of additional common stock during a liquidity event. As an example, if an investor holds $1M of preferred stock for one year and the company sells, the preferred shareholder will receive their dividend as if they held $1.1M dollars worth of stock.Participation -Participating preferred shares give the holders the right to have their money returned to them in the event of a liquidly event which then converts the preferred share to common and in effect allows investors to double, triple or more dip depending on the participation. So in the case of a $2M exit for a $1M 1X Participating Preferred for an investor that owns 50% of the total stock, this preferred shareholder will receive the first $1M from the exit, and this would convert their shares to common leaving the Participating Preferred investor to share in their pro rata share of the remaining cash. or the additional $500K.  Had it been 2X Participating Preferred, it would the investor would get the entire $2M which would convert their shares to common allowing them to share in the zero dollars left 50/50 with the common shareholders.
  2. Common Stock – A share of common stock that usually adds value to the holder if and when there is a profitable liquidity event. This is what employees are usually asking for when they demand stock. The issue with handing out stock is that stock has value and when an employer gives stock that has value to an employee that creates a taxable event. What happens when the company, like most startups, doesn’t make it? The employee is stuck with a tax bill for receiving stock that returned no value and that brings us to the advantage of Stock Options.
  3. Stock Options – Stock options grant the right to purchase stock (usually common) at some future date at a fixed defined value. Since stock options have no value if not exercised (paying the defined value) and the defined value is usually deemed as fair value there is no taxable event when granted or exercised. The taxable event occurs when the options are sold in which case the taxes would be on the difference between the strike price of the option and the sales price.  Stock options are usually granted with a vesting period, typically over 4 years. A 10,000 share stock option granted vested over 4 years would give the holder of the grant the right to accumulate the right to purchase 2,500 shares per year.

Lastly, with real ownership comes real responsibility. Owners often have to personally guarantee loans, collateralized with their homes and other assets.  Owners have liability in terms of taxes and other legal obligations like making payrolls, paying taxes, and following state and local regulations. With real ownership comes real responsibly. Maybe you just want options.

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