Saturday, January 30, 2010

How to figure out what those VC terms mean for your equity

My friend Chris Dixon wrote about what everyone should know about their equity grants. Following up on that, I wrote a simple python program that helps you simulate what your stock would be worth in the event someone buys your company. The reason it's not just as simple as purchase_price * your_percent_ownership is that many times VC deals include things like preferences and anti-dilution provisions. These are basically mechanisms where by the VCs may get more than their percent ownership.

Even though I'm currently working on my third VC backed company I found I still had to spend a lot of time looking up the definitions of terms and thinking through how they affected various outcomes. This was a really good exercise for me and I highly recommend it for anyone else raising VC funding. As a side note, I find that writing a program to simulate something is the best way to see if I really understand something.

The code is available at https://code.google.com/p/startupequitysimulator/ along with some extremely basic documentation. I know that I haven't gotten all the scenarios exactly right, so contributions or improvements are definitely welcome.

Preferred Stock Background

The key point that everyone in a VC backed company should understand is the difference between the stock VCs buy (called preferred stock) and the stock you and I get (common stock). Preferred stock is called that because it gets preferential treatment over common stock. As far as dividing up the proceeds from the sale of a company, that preferential treatment usually falls into two broad categories: preferences and anti-dilution provisions.

If there are multiple rounds of financing, each new round of preferred stock sold is called a "series" with the most recent series being "senior" to the older series. Debt is usually the most senior in a company's capital structure. Then higher seniority stock holders get paid before more junior stock holders. Common stock is the most junior of all.

Preferred stock almost always has the right to convert to common stock. Conversion causes the investor to lose any special privileges that the preferred stock holds. The preferred shares may not necessarily convert 1-to-1 into common stock depending on anti-dilution provisions. Typically, investor A will have the right to convert each preferred share into more than one common share if subsequent investor B paid less per share than A did.

There are several different standard ways to calculate how A's conversion ratio from preferred to common should be adjusted when B invests at a lower price. The two most common forms are called broad-weighted and full-ratchet. The former averages A and B's prices while the latter fully adjusts A's price down to B's price.

When people talk about percent ownership, they're really talking about the "as converted to common" percent ownership. This is a hypothetical number of common shares that would result from adding together all the preferred shares if they converted into common shares, all the stock options or warrants issued plus any other common stock granted.

Preferences give the preferred stock holder the right to get some multiple of their investment off the top without regards to the percent ownership that stockholder has. Participating preferred gives the preferred holder the right to take their preferences off the top of the deal AND then still get a cut of what's left based on their percent ownership. Non-participating preferred means that preferred stockholder can EITHER take their preference off the top OR convert to common and participate on a percent ownership basis only. Capped participating preferred limits how much a preferred holder can make through their preferences.
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