HEIDI: Welcome to The Startup Solution, and “The Case of the Millionaire Mirage.”
Hello, I'm Heidi Roizen from Threshold Ventures. The Startup Solution is a podcast where we unpack the “oh shit” moments faced by entrepreneurs and then find the best ways to get through those moments alive — and with a little luck, maybe even better off.
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For most of the cases we unpack here, we try to find a way through the pain to a better outcome. Unfortunately, in today’s case, we can’t fix what happened, but at least we can learn from it.
As a reminder, this and all cases covered in The Startup Solution are about real situations — but we change the names and details to protect identities. So we’re going to call this person Nate. He’s a star alum from the fellowship I teach at Stanford. And he was definitely not in a happy place when he called me.
NATE: Hey, Heidi, it’s Nate. Um, can I buy you a beer sometime? I could really use a shoulder to cry on right now from someone who understands first-world problems. Remember that startup I joined a few years back as VP of engineering? Well, good news, they got acquired. Yay. Bad news is I’m getting almost nothing for my equity, which kinda floored me. I think I got about two percent when I joined. They raised $20 million back when we raised two years ago, valued the company post at $50 million — and yeah, I had already bragged to my mom about being a millionaire, on paper at least. I understand... I think it sold for about that same valuation, so I was pretty psyched about buying a house when it closed, but I ended up making only about 50K. Like I said, my first-world problem, but I’m really shocked by the outcome and could really use your help understanding what happened. Uh, so, drinks? Maybe … you buy? Talk soon. Bye.
HEIDI: Sadly, in this case, the ship has sailed, the company has sold, and Nate has already received his smaller-than-expected payout. But, while there’s nothing we can do to help Nate now, we can unpack how he ended up here so that next time, he’ll know what to take into consideration in calculating equity payouts.
Let me begin with my first tenet of “startup math”: There is only, ever, 100%. It’s a bit of a fallacy to talk about any original grant as a percent of the company, even if that is calculable at the time the grant is given. Why? Because companies almost always issue more shares as they grow — shares they need for new employees and for refresher grants, as well as the shares they sell to raise more money.
Because Nate’s company did raise money after he joined, it likely authorized, issued, and then sold more shares to do so.
And because of that, Nate’s 2% was probably no longer 2%. That’s called “dilution,” and it’s natural and common in the world of startup financing. But you do have to account for it when trying to figure out the value of your equity.
Next, we need to understand what kind of shares companies usually sell, versus the kind founders and employees get. They’re different, and that matters.
Most companies have two general types of stock, called “common shares” and “preferred shares.”
This construct has come about over time because it has advantages both for investors as well as for founders and employees.
Investors who typically buy preferred shares usually get some downside protection for the money they put in. This often comes as a right to receive that same amount of money back in a sale of the company, before the common shareholders get anything.
This construct also has advantages for the founders and employees who receive those common shares. Because preferred downside protection has a real value, the common shares that don’t have it can be valued for less. And in turn, because they are less valuable, management can give out more of them. In addition, there are also tax advantages to common shares that preferred shares don’t enjoy. When all goes well, each class of shares has its own benefits.
But, in Nate’s company’s case, all did not go well, which is why downside protection came into play.
How do I know? Because of a major clue in his voicemail.
NATE: They raised $20 million back when we raised two years ago, valued the company post at $50 million. I think it sold for about that same valuation.
HEIDI: Nate said the company raised $20 twenty million two years ago at a $50 million valuation. Yet, two years later, it sold for that same value.
What that means is the company ran along for two years, and burned through the capital it raised, but didn’t grow its value as a result. And that, my friends, is not a good outcome.
Because while no new value was created, that $20 million carried downside protection, and that still had to be paid in an outcome.
And if one collection of shareholders has some form of downside protection, the only place that protection can come from is some other collection of shareholders who don’t have it.
Now, we still need to finish the story of Nate’s company right up to the point of sale in order to calculate what his equity would be worth. Because unfortunately, even more dollars went in.
In this case, after the company burned through that $20 million, they still couldn’t figure out how to turn a profit, and so they went back to the market for more capital. Unfortunately, they didn’t get any offers, at least none they felt were reasonable at the time.
And so, some of the existing investors negotiated with the board to provide a loan. The good news about loans is they don’t dilute the equity since no shares were sold. But the bad news about the loan was that the best deal they could negotiate came at a guaranteed 2x payback — if and when it could be paid back, that is. And, as is also normal practice, because this money was the last money in, the providers negotiated that it would need to be the first money paid back out — even before the preferred shareholders would get their 1x on their shares.
Because the alternative at this point was to go out of business, the board agreed to move forward, took the 10 million dollars, and used it to meet the company’s expenses until they could either find a buyer, get profitable, or raise more money. In this case, that took another eight months to sort out.
Now we have most of the variables, we need to do the math and arrive at Nate’s payout. I know math is a bit hard to follow in a podcast, but trust me, you’ll still get the punchline. So here we go:
Add up 10 million of debt, times 2, which is the agreed-upon multiple for that debt. That’s 20 million. Now add the 20 million from the A round, plus the five million from the seed round. So that’s 45 million dollars off the top, before the common shareholders see a single penny of return.
But wait, there’s more — and it’s not a good more.
Generally, lawyers and bankers are involved in getting these deals done. It is not uncommon to run up hundreds of thousands of dollars in legal fees, and then carve off a percentage of the deal — say, 3%, to the bankers. So that’s 3% of 50 million, which is $1.5 million, and say 500k in legal fees, so that’s another 2 million in total.
And, in many cases where the common shares are likely to have little or no value, the board may institute something called a carve-out agreement, which is basically a kind of bonus paid to employees to stick around ’til a deal gets done. Nate didn’t mention one, so I’m not going to include it here, but these, too, would typically come out of the proceeds of a sale before the common shareholders benefit.
So, that 50 million dollar acquisition — after you pay the debt, the preferred share preferences, the bankers, and the lawyers — leaves only 3 million dollars for the common shareholders.
Your mileage may vary even further, due to even more terms. These include required cash balances, earnouts, retention bonuses, participating preferred, and a whole bunch of other stuff you can Google. Or better yet, if you’re an entrepreneur, hire an experienced lawyer to walk you through all these options.
Anyway, as for Nate, he sure wasn’t getting 2% of 50 million. He was getting a little over 1% of 3 million, which in his case turned out to be about 50k. It’s better than nothing, but it’s a far drop from what he bragged about to his mom.
So, what can you learn from “The Case of the Millionaire Mirage”?
First, remember there’s only ever 100% of any company, and likely, over time, whatever percent you had in your original grant will go down as a result of dilution — even though you still have the same number of shares.
Second, most companies sell preferred shares to raise money. Those shares usually have some form of downside protection, which, in a sale, will come into play. That’ll need to be paid before the common shareholders can participate in any remaining proceeds.
Third, there could also be debt, which further adds to what would need to be paid out in any company sale before the common shareholders can benefit.
You’d need to know all these numbers before you can actually calculate the value of your equity. Knowing these numbers is like knowing how big the mortgage is that you have to pay off before you can enjoy the upside on your house. Without the data, you can’t really do the math.
Finally, here’s the biggest point I want you to take away from this case. Most startups raise money to use it to grow their enterprise value. But that doesn’t always end up happening. If you spend $50 million to grow a company that ends up selling for $50 million, you actually didn’t create any value — at least not in an economic sense. And so, there’s no economic reward, either, sad as that might be.
Look, I think one of the great things about tech startups is that many are structured to provide equity to most, if not all, employees. So, if your company is a hit, you get to share in some of that upside.
However, for your own sanity, I think it is good advice to consider your equity as pure risk upside — that is, count it as zero until it’s real.
As my good friend, the famed VC Brad Feld, likes to say, it’s not money ’til you can buy beer with it.
In Nate’s case, it may not have been a ton of money, but his mother still loves him, and he can definitely buy us a beer or two. And I think we’re both ready for that now.
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And that concludes “The Case of the Millionaire Mirage.” By the way, I know this episode had a lot of jargon and a lot of math. It’s actually a complex topic. I’ve written a few blog posts about this that go into far greater detail, which you can find links to at threshold.vc/millionaire.
Thanks for listening to this episode of “The Startup Solution,” a podcast from the venture capital firm Threshold Ventures. We hope you have enjoyed this episode, and if you did, please leave a rating or review in your favorite podcast app. I’m Heidi Roizen.
My own post that covers the details in this podcast and even more: How to build a Unicorn from Scratch and walk away with nothing
Here’s a blog post I wrote a few years ago that explains the math in a similar situation to Nate’s
Another good post by Rishi Raj Dutta on understanding preference stacks
Great article from Scott Belsky on how prospective employees should think about stock options or grants as part of their compensation