Captables 101 for Tech Startups – Matt Stapleton and Jeron Paul, Capshare
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Speaker 1: I’ll let you guys introduce yourselves, who are you?
Matt: Okay, sounds good. So, Matt Stapleton. I’m president, co-founder of Capshare. And yeah, so we make Captable Management Software. It feels a lot like QuickBooks or some of the other accounting software over on the financial side but we track a lot of the nitty gritty. Some of the details that Hal was talking about in that last conversation, we’ll track that and make it easily accessible to you and then help with just a lot of the compliancy-type stuff around that.
And so we see a lot of Captables, we’re going to focus a lot today on common pitfalls that we see for fairly early stage companies. We’ve got about 4500 Captables on the system right now. And so I see in any we’ll add about 200 companies a month. And so I see a lot of the really common companies getting started that are just setting up their information. I see all of the things that we’re going to talk about today. We’ll see at least, at least every other month I’ll see each of these come up with a company. And definitely things that I’ve seen kill a company out of the gates where they just set up something wrong, now they’re going back and have to clean that up. And that can be really painful right at the time when you’re trying to go through fundraising. You’re trying to get those other things done and this isn’t what you want to focus your time on. So that’s a little bit of the overview background. Jeron would you add anything on that?
Jeron: No, I think that’s it.
Matt: Okay, so I’ve also got Jeron, our CEO, here that will definitely cut me off a few times through the conversation. As we’re going through this, I actually didn’t bring I brought maybe, probably 20, maybe 25 minutes worth of stuff here so cut me off. I want to have you guys cut me off asking any of the questions that you have. Happy to go into some of those details on those. So with that let’s get started. All right so really quickly, I know we just got out of the conversation with Hal where he talked about some of this. But I want to give you just high level, what’s a cap table, what does it usually look like?
So at its absolute simplest this is a cap table. If Jeron and I were to go, each go 50-50 and buy a gas station, our gas station would have a cap table.
Speaker 3: I would actually need at least 60%.
Matt: Yeah, thanks. Thanks for reminding me. So this would be the gas station. Really simple, you don’t need software to manage something like this. Now, this right here is an extremely standard cap table that we’ll see for an early, early stage company. I actually prepared this before presentation for 500 Startups. This is somewhere mid-500 five Startups laid in process for a group like that. This is really standard. I see this in at least 50%-ish of the companies I talk to there.
So let’s break it down for a second. So first off, that first that I showed with me and Jeron we had 50-50 percentages. If you’ve got a corporation then rather than a percentage that’s going to be expressed as a number of shares. So instead of both owning 50% we each have a million shares for 2 million total of the common shares at this stage. And Hal mentioned a little bit, you’ve got your common shares. You’ll also have other like the options that you’ll give to your employees and the preferred shares that once you get into Series A, Series B you’ll have preferred shares on the cap table. Basically the same as your comment but they get preferential rights that your common shareholders don’t have. That preferred comes from those preferential rights.
So for example I might have an investor say, “Here is $500,000. But if I’m giving you this money I want my money back out before anyone else gets cash.” And so that protects me so that I might be giving you $500k to own 20% of the business. If you turned around and sold the company for $500k and just gave them the cash on the books, if I wasn’t preferred stock technically I’d only get $100,000 of that. I’d get my 20% and the rest would be distributed out. That’s not okay. I want, if I’m going to give you 500k I want that money out then you guys can catch up to me and they’ll put in special rights like that. But those types of privileges are what distinguish between common stock and preferred stock. On the options side these options, they’re called derivatives. They don’t have any value in themselves. Their value is the fact that an option is a right to buy common. And I’m guessing Hal covered some of that as well. But on those options you’ll get this contract that says you have the right to buy 10,000 shares for $0.10 a share. And we’ll talk about vesting. We’ll talk about some of the particulars on that but that’s how those options are set up typically given to your employees.
Occasionally you’ll see options being granted to a contractor or other things like that but most of the time you’re seeing these options that go out to your employees as the way to let them participate in the upside on the company. So this all gets summed up. I get an overall cap table based on this. I think we walked in on the conversation a little bit earlier but it sounds like there was some conversation about an option plan or an equity pool- interchangeable terms. That’s shares that have been set aside to grant to employees in the future. So you can see on this cap table I have these unallocated options, 12% of my cap table has been set aside to give to people later. And the reason companies will do that, because if we sold the company tomorrow for $10 million here I wouldn’t just get $4.2 million because I actually own more than that. 1.2 million of that, 12% of that wouldn’t just go to no one because no one actually owns this plan. It’d get distributed to the existing owners. So I actually own more than 42%. But this lets us do a few things, one, I don’t have to see my percentage adjust every single time we issue 10,000 shares to an employee. So it gives me an idea of I can predict I intend to grant this whole pool before we exit. So I can bank on that number and it gives a little bit more solidness to the numbers.
The big one though is this is actually big for the investors because if I’m an investor I’m getting preferred stock in the company and I give you $1 million for 20% of this company, you’re going to take that $1 million and you’re going to go hire three new employees. And the investor doesn’t want to get that 20% and then immediately start getting diluted by the employees you just hired. So often they’ll require you to set up a plan so that they’re not seeing that dilution the same way with each subsequent hire that you make. So just based on that, the other thing I would mention, Hal was talking about convertible debt earlier. That convertible debt normally doesn’t show up on your cap table until it converts. And so you’ll raise money in the form of convertible notes, convertible securities like the Kisae. And that has terms, it has rights on the cap table but it usually doesn’t show up as a number of shares because that number of shares may vary depending on the future. Depending on what you raise next round and other specifics on the next round. That can actually change what they end up owning.
So usually you’ll see the convertible debt super applicable to the cap table but not actually showing up as a line item until it converts. So, pausing on that view, just to overview this is a cap table, any questions on any of that?
Man: Hi, so I’ve heard from a lot of places that founders should also the on a vesting schedule as well as the employee. So how would you put that? Do the founder common shares go to the options or how would that work?
Matt: Great, great question. And first, we’ll camp a little bit on that founder should vest thing. But yes I definitely agree with that. What you’ll see, no, they typically still hold common stock. So they’re not going to move over into the options or anything. The cap table itself isn’t actually going to look any different. So let’s say I might have these million shares here and on the cap table I’m still going to show a million shares. My ownership is still going to show up as 42% but technically if I were to leave, the company can buy back those shares for some preset ridiculously low amount. And you’ll see in something and let’s actually jump, here we go. So this is just a quick screen shot out of our software. But if I were to click on those million shares and dive down you’ll often see something like this. So this is that actual vesting schedule that’s going on on those shares. And what this is showing, October 1st, 2013 this individual got 10,000 shares. Options are common, it acts about the same. So you’ve got that grounded.
Initially they’re unvested shares. As the vesting occurs those move from unvested to vested. So you can see on this one we’ve got a one year cliff, that standard that I think has been mentioned already. One-year cliff, 25% of those come one year later, October 1ST, 2014. You then have monthly amounts being added on o that as of today this individual has 3750 shares vested that they own now as a founder and that no matter what they do, they could leave or anything, they keep those shares. And then the 6250 are still subject to vesting. But on the cap table itself doesn’t affect the numbers. They’ll still show their whole amount. They’re just a portion of that amount they could lose if they end up leaving or situations like that.
Man: [inaudible 00:11:47]
Matt: Sorry, what was that?
Man: [inaudible 00:11:53]
Matt: That’s right, that’s right. So the difference between common stock and options, common stock the company has a right to buy back options. The employee gains the right to buy those shares.
Jeron: Thanks, I would add it’s functionally essentially equivalent. Economically it’s equivalent. I mean yes, as a founder you’re granted all those shares upfront but you don’t really have a right to all those shares unless you stick around. And as an employee who’s granted options that is also economically true. You’re granted a big option grant but you don’t get the economic rights to those unless you stick around. Does that make sense?
You also mention something else I just want to touch on briefly. A lot of folks talk about founders stock and common stock and they get kind of confused between the two or wonder if there is a certain class of securities called founder stock.
Founder stock is typically common stock. So that is the typical stock that founders grant to each other or to themselves. And so what you’re really talking about when we’re talking about vested founders stock is actually just restricted to common stock. So common stock that can be repurchased over time by the company and that company loses its repurchase right over time. So over time you gain more and more stock that cannot be bought back by the company.
Sean: Yeah, I think I just wanted to add, a lot of founders, a fair set of founders always ask me, “Why am I vesting? This is my baby I did all this work. I should just get what it is.” But once again investors a lot of times early stage we’re making the bet on you. The business may change many times over the course of life but we’re betting on you and that you and your teammates are the ones are going to push it through.
We need some assurance that you’re going to stay and do that because the reality is when one founder leaves or all founders leave the company is pretty much done. I rarely see founders leave and companies come back. So if you were given it from day one there is not a ton of incentive, you may look down in then be like, “I just had a hard week, F it, I’m out. I still have my stock.” That’s extreme case but we’re trying to manage risk. Early stage investing is very, very high risk so we want you on the same page as everyone else. And then sorry I stepped up. Did you already talk about why don’t founders get preferred? Like they’re…yeah.
Matt: Yeah, yeah, yeah we talked a little bit about that.
Sean: Oh sorry.
Matt: The real cash elements of the preferred and those rights that they’re getting.
Sean: Okay, cool.
Jeron: Let me talk to Sean’s comment. Sean, that was an awesome comment and very important. Sean brings both a founder and an investor mindset. There is a founder mindset to the vested stock question as well. I don’t know if you want to talk about that but how many times have you seen a founder leave a company and the other founder has to stick around? So we’re going to talk about this a bit later but one of the big pitfalls you’ll often see, I’ll jump the gun a teeny bit, is say you have a co-founder team so you’re not the sole founder. If that’s the case we have frequently seen a cap share in our 4500 plus cap tables and growing. We’ve often seen situations where a founding team won’t be the team that is left at the company by the time the company ultimately self sells.
So Sean’s question was a lot of times founders will ask the question, why on earth would I want to vest myself? And the answer can actually be it might be in your best interest to vest yourself and your other co-founders all as a group because if one of your co-founders leaves early then they won’t have all the shares and you won’t be stuck in a situation that we’ve seen over and over again where if you don’t do it that way often you are left with the, let’s say you had four co-founders three of them leave, you’re left with 25% of the company. You become Uber you make a ton of money. They did nothing. And you worked two jobs and stayed up till 2:00 a.m. for five years to get your company to a successful outcome and they got all the exact same amount of rewards that you did.
It’s personally very frustrating to the entrepreneurs that go through that experience and it leads to a lot of conflict, frankly. And secondly, a lot of times investors just will have nothing to do with that. They’ll force you to get that cleaned up before they’ll invest because they don’t want that big of a misaligned incentives around the equity structure of the business.
Sean: Yeah, founder breakups are tough. Breaking up is hard to do but you’re right, people want that clean. And if you’re going through active lawsuits with your founding team that’s going to hurt you when fundraising. And ethically you have to disclose that so that’s why it’s like, “Wrap this stuff up.”
But I think as I mentioned the point of it, it gives us some security and some feeling like this is fair. Let’s say founder he or she works out months six months. They get nothing. That’s probably fair. If they all did a year but the business took five years to mature okay, they do get their 25%. So they’re getting an allocation. They’re not getting the full allocation. So I think that it’s helping us manage risk and retaining you as founders. And then I believe it’s fair for the founders as a whole based on contribution of time.
Woman: You spoke about founders leaving, what if the company gets acquired? What happens to shares if you’ll, let’s say two years into your vesting cycle and you have a remainder of three years to go if it’s a five-year vesting cycle?
Matt: Great question. So you can set up some acceleration triggers that occur in the event of a change of ownership, basically an acquisition. So you can basically say, “Okay, we’re the founders. Yeah, we’re vesting. We want to keep everyone around the table. We want those benefits. But I’m not going to sit and wait for my money if the company sells.” You’ll set up, it’s typically called a single trigger acceleration. And what that means is if the company changes control, if someone buys over 50% of this, my shares become immediately fully vested. And that’s so that you get your money out. That you’re not harmed in the event of that acquisition. The alternative, and you’ll see this often for employees and it’s something to think about, something called the double trigger where it’s not enough for the company to be bought, the company has to be bought and the person has to be terminated for them to get their shares. And Howard, correct me if I’m wrong, basically in this situation a chunk of your ownership, a chunk of your money in the acquisition would actually go to an escrow account. And does it get paid off over time basically as you continue to work for the now owning entity?
Man: [inaudible 00:18:52]
Man: We do get this question a bit at Core Key, but almost universal to see a double trigger. Single trigger is extremely, extremely rare. And if you think about it from Sean’s point of view, like wait a second here, wait, I want the guy to stick around. And so it’s usually, you’re going to see a double trigger.
Matt: The double trigger is more, makes the company more valuable because it encourages people to stick around after the acquisition. And so that’s really, really common just because it adds that value to the company that’s being bought because now as an acquirer I can look at it and say, “Yeah, most of your dev team still has two and a half years on their vesting so I don’t have to pay them as much to get them to stay around because they’re incentivized to hang out and collect the rest of their cash from the exit.” And so that’s that single or double trigger that you can set up based on your situation.
Woman: Can you put this single acceleration for founders and then double for employees?
Matt: Yeah, you can switch on the same company. Other questions or? Okay, let’s keep going a little bit. So backing up one slide. So what I’ve got basically from here, I think I’ve got five issues that we’ll mention that these are the things that I see really mess up early stage companies. So these are the, if you want to mess yourself up on the legal and cap table side these are the ways to do it. So the first one that we just hit is the vesting founder should vest. And I know Sean did a great job of taking the investor stance on that founder vesting but I’ve seen so many companies where they’ve got three founders, 33% each. One guy leaves and man 2:00 a.m. feel so much later when you’ve got 33% of dead weight on your cap table. And that’s something that I don’t know that you necessarily always pick up on as an early stage company because it’s like, “Yeah, but we’re all getting rich.”
But man, when you’re working on those, Capshare, we’re three years old were a startup just like a lot of you guys, raising money a lot like a lot of you guys. And those are the type of things, they start really mattering as you’re dialing that in and starting to realize what this value actually means.
And in our situation we’re not bad, we’ve got 2.8% of our cap tables deadweight. And I can live with 2.8%. They earned it, they vested. They got to a point where on they had those shares but man, 5% would hurt. And I don’t think that there is right numbers for everyone. It’s different person to person. But personal experience, that’s one thing. Vest as founders and vest the rest of your team. It will save you dramatic. These are the type of things that can crush a company.
Man: Yeah, if I can just add there I mean it feels like even from the perspective of the founder that leaves it’s almost even in his interests to ensure that he doesn’t have more ownership than he deserves. Because in a lot of ways then if you have handcuffs on your co-founders that you’re leaving behind in terms of being able to fundraise, being able to grant additional options that are attractive to get other talented founders help take the company higher.
So even if you leave the company after one year and you own 33% of the company, if the pie is only that small it might be, have been much more in your interest to own 5%, 10% of the company and hopefully the company is able to use that stock to grow much bigger. So you’re still going to get more money out of it. So yeah, it seems to make sense on all accounts.
Jeron: I think that’s a great point. I mean a lot of what you’re hearing is there are certain rules and standards and practices that have emerged over time around investing and triggers and all these things. And they’re there not only to protect investors, they’re there to protect you.
And I love your point. A lot of times, again to your point, I mean even the founder leaving the team, sometimes if they, let’s say you had 50% dead weight on your cap table, there is no way an investor is going to let that stand when they invest money into your company. So you’re almost un-investable often if you messed up your cap table really badly.
When I say un-investable there are lots of ways to fix that problem. But basically some hard form of a solution will be presented to you that will have to fix your cap table if you’ve gotten it that messed up. So, yeah. And it’s funny because we meet with a lot of early stage companies that are going through this. And it’s amazing how often there is almost a social dynamic of like, they’re like, “Yeah, but we’re the best friends ever,” type of thing.
And I know all people chuckle at that and say yeah, that’s dumb. People do it all the time with pretty legit companies. And I get it, both our wives make fun of us as having second spouses with our relationship but it’s not uncommon. Things happen in these situations, it really does protect both of you.
So moving on from that, any other questions on the vesting thing? I think we’ve hashed it fairly hard.
Man: I was just going to ask when you have a single founder is there anything you want to say should be done differently or if somebody who’s you have to find a cofounder they’re starting off?
Matt: Good question. Those tend to behave differently on this. I think Sean might have more of an opinion and might encourage the vesting stronger from an investor’s standpoint. But it depends. What I’ve seen historically is usually when you’ve got a single founder the amount of founder vesting that I see going on does decrease pretty dramatically. That’s probably more a conversation between founder and investors, I think like founder and co-founder.
Jeron: So investors can do things retroactively as well. They can come into a new round and say now that we’ve just invested in you and you’re the sole founder we want you to impose some investing on yourself. So things can be somewhat fixed after the fact. It’s not like you’re in a complete and total disaster situation if you’ve chosen not to vest yourself, you’re asshole founder and an investor wants to invest in you. I don’t think that would be anywhere near a deal breaking situation at all. Usually, like Matt said usually it’s in group founder situations that you’ll see founders really want to actually insist on investing to protect themselves against the possibility that one leaves. And certainly doing so will make you look smart in front of investors and should make that whole fundraising process a lot easier.
Matt: All right, let’s go to the next one. Non-papered promises. I see these, I used to say I see these on at least half. I see these on at least four fifths of the early stage companies that we talk to. Which means most people in this room will make this mistake.
So right here this is a conversation that I’ll have at least, probably not once a week but close to it where a CEO, we’re going through, we’re setting up their cap table we’ve got everything tied out and then they’ll be like, “Oh yeah, yeah there was that, we promised John 3% to get us these three large contracts and he got one of them but then he got another offer and he ended up taking off.” And that’s not reflected in anything.
And so they’ve got other agreements that they’ve created that are based on share amounts but those share amounts are now slightly different because you’ve got this guy with a percentage that you set up 12 months ago, two rounds ago and now you’re asking the question, “Does he get 1% of what was outstanding then, does he get 1% of what’s outstanding now?”
Get things figured out. This is a big one that, no this is less killer. I don’t see companies completely dying on this but you’ve got to get these types of things worked out. These things will cost you dramatically. And these create a lot of the news line headline cap table issues where you’ve got un-papered promises to co-founders that, giving the example of Facebook. You’ve got, the Social Network movie is about this type of stuff and other situations.
Get these types of things papered up. I see a lot of startups that are avoiding the legal fees and go on and on and on avoiding. And that’s great, you’re trying to conserve money. You’re an early stage startup and you’re trying to make that X, 100,000, 50,000 or whatever stretch as long as you can. If you’re going to end up being successful, which is your goal, this will cost you. So it’s one of those situations where it’s like, “Yeah, I get the wanting to save money,” but all you’re doing is you’re making success dramatically more painful. This is one of the things that’s worth, and it’s been mentioned before you don’t need to run up drastic legal fees on something like this. It doesn’t have to be crazy expensive. There is a lot of really great options to get stuff like this put in place on the cheap. But it is worth doing. Yeah?
Man: [inaudible 00:29:53] options, right. Do you recommend any type of SaaS solutions for cap tables that in order enable transparency amongst the co-founders and say your legal counsel?
Matt: Ours. There’s a number of good…we’ve got some great competitors. There it is, where is the promo code? I mean Capshare’s software is built to make transparency. You can share everything out, you can make it available to everyone. A great question. And then on the legal side as well there is a number of products like clerk key that will help with some of these fees. There are the online contracts. The freely available things. I know Oric has some really good start up. There are start up library where they’ve got a lot of good forms.
Man: Can you talk about the point is specifically what do they need to do [inaudible 00:30:57]?
Matt: Yeah, so a few things. You need to get something signed between you really understanding the details of what you’re agreeing to. On that understanding the details there’s some terms around what was the date on this. The biggest though that I see is get out of percentages as quick as you can.
What’s often happening as I mentioned a C corporation is expressed as a number of shares. And so what happens is you’ll express a percentage with someone because you’re negotiating and it’s easier and it means more frankly than some random arbitrary share count. But get to the shares fast, get that agreed on and signed. That will go a long ways because then you don’t have these, well is that 1.5% of then or now. It will solidify the numbers for when you’re trying to do things in the future, you’re working with the real thing. That’s the biggest thing I see.
And then getting that papered up. There are those libraries, there’s those people that like the Aurochs startup forms that will help you fill in all of the blanks on these. Those are good but I guess my caution there would be be careful. We used some free forms on our first convertible debt round it’s costing us, because there was some bad language in those forms. And it’s not dramatic. It’s not a deal killed but I’m paying like eight, I think it’s like 6k in taxes that I wouldn’t otherwise. But yeah, I can live with 6k, but I’m not rich. I’m not making material wealth in any form and so that means a lot.
Man: What about [inaudible 00:32:59]
Matt: It’s better than nothing. I mean, there is a spectrum. There is a spectrum, is my response here. And boy, it’s better than nothing. There should be something legitimate around, especially if it’s like an option grant there is usually a notice of option grant document that will go through and it will specify things like the vesting. And it’s not hard to get that set up.
Jeron: Again, shameless plug here but I mean I think that this is a direct question. And I don’t need to just plug our system. We automate option grants, that’s a big part of what we do and a lot of companies come to us precisely for that reason. They want to have an electronic representation of something that is typically done in a paper process. And it’s very inexpensive because you can set up an automated template grant and then you can issue it to as many people as you want. And you can do that in concert with your law firm or your lawyer. We you have lots of law firms and a lot of lawyers that work on Capshare and our competitors do as well.
So to answer your question, I actually would say what we’re specifically talking to about non-papered promises certainly goes beyond option grants. But that is a big area where we often see it. In fact that’s probably the most frequent area, is you’ll bring on a consultant, they’ll often have what’s called milestone base vesting, we haven’t touched on that. But there are two main types of vesting. There’s time-based vesting which just occurs naturally over time as you stick around at a company. There is another form of vesting called milestone base vesting, which is, “Hey, I brought you on as a consultant to help us generate our first 100,000 in sales. If you generate 100,000 in sales we’ll give you 50,000 shares. If you generate 200,000 we’ll give you 100,000 etc, etc. Those can all be automated and papered.
So papered might not be the right word because we actually eliminate paper and put it into an electronic medium. But they can be electronically signed and both parties can have a copy permanently and they can be backed up on Amazon S3 which our system is. And so a lot of these issues just go away. I hope that helped answer your question.
Matt: Any others on that? Cool. All right the next one, competing equity records. We see a lot. And so often your law firm will have one record of who owns what, usually founders. And often I’ll see a couple of members of the management team with their own record of everything. And eventually as you grow you’ll have a valuation firm with some record. You might have an accounting firm outsourced CFO with some record.
It’s really common to see these disagree. And so this again I’m going to go straight for the shameless plug here but find a platform where everyone can work on the same data so that you don’t have these issues. Because that can be, I was speaking to the senior attorney at a public company who said this has killed acquisitions for them because they go to acquire a company, there’s different versions of the equity information and they don’t want to deal with the liability. There’s going to be payouts that come with this acquisition and they’re not okay with that liability and so they walk from the deal. And so that can be even more dramatic than running into issues on a potential fundraiser because someone lost out on what would have been a pretty awesome acquisition.
Jeron: Can I speak to one thing on this? Often I would say on this one particularly, often it’s not the end of the world situation but companies often are doing things out in advance of their law firm. And so they’ll hire someone and they won’t get around to telling the law firm about that and until several days or months later.
Sometimes they will have someone leave or go on maternity or paternity leave and their vesting will be altered but they won’t communicate that back to the law firm. That’s the problem that electronic cap table solutions are trying to help solve. That’s one of the big problems, is to keep everything updated real time tied in with your HR records etc. so that at any given time the people who have a right to that equity information or who need to consume it like your law firm, your investors or US founders or frankly even to the folks that you’ve granted equity to can get onto an accurate system that’s up to date at any given time.
Matt: Awesome. All right, let’s go, okay, I think this is actually is that, yeah.
Jeron: I touched on this.
Matt: Yeah. I think a lot of this is been touched on already. So this is my compliance page where there are a number of things that you don’t necessarily need to understand perfectly what’s going on here. I do want to touch on all of these because as founders I think what’s valuable here is know what you don’t know and know when you need to go look these things up. I think that’s the valuable. If you know when to go track these down that will go a long ways. So first one sounds like it’s been covered in detail, 83B, elections. Any additional questions on that one?
Okay, next one, ISO 100k limit. So there’s two different kinds of options that you can give people. Incentive stock options, or ISO’s or non qualified stock options or NSOs or N quals. So ISO has tax advantages over NSO. And not going to go into it on a detail there. The trick with an ISO is you can’t give an employee more than $100,000 worth of ISO options that become exercisable in a given calendar year. And I use that language very specifically.
Basically what that means is let’s say I give someone an ISO worth 200k. If it vests immediately that’s not okay. It can’t be an ISO. You have to treat part of it as a non-qualified stock option. There’s some tax implications to that. If it vested over four years I’d be fine because at 50k a year of that 200k I am below the 100k.
A couple of things to think about here though, you can make your options early exercisable. Meaning they can actually exercise them before they vest and then they go into that whole restricted stock that can be repurchased by the company. If it’s early exercisable the whole thing is exercisable as soon as it’s granted and so you could run into this problem. The other thing is this is per individual not per grant. So I could give someone one grant, two years later give them another grant and run up into this when you get the aggregate between the two. Yeah.
Man: [inaudible 00:40:54]
Matt: So it’s with a USC corporation. ISOs have tax advantages that the NSO doesn’t. Basically with an ISO if you exercise it on you don’t have to pay taxes right then. With an NSO you do. So let’s say you get an NSO for $1 a share, value goes up to $5 a share and then you exercise it. You pay $1 to buy the stock and then you have to pay taxes on $4 worth of compensation per share for an NSO. For an ISO that compensation waits until you actually sell the shares, which is when you have the money to pay the tax. Any questions on that one?
Jeron: These are really technical intels for odd numbers and probably you can be more focused on rolling your business employee. I mean, this is great for you to know, it’s good information but if you get weighed down in these details the bigger point I’d like to ride out of the chutes here it’s know what you don’t know and know when you’re treading onto some client’s stuff where you might go get some [inaudible 00:42:14] for each of the updated aggregate.
These are great conversations to bring up with your law firm, your law firm will [inaudible 00:42:24] if you’re using a online platform like Capshare we’re going to notify you if you ever run into these types of situations there will be automated notifications so you can [inaudible 00:42:35].
The bigger issue here as founders and as entrepreneurs is to just know there are some compliance issues around equity grants that you should generally be aware of so why can so you can avoid some problems down the road and you can when to get outside of.
Matt: Yeah, yeah. And so just wrapping up the last three really quick, rule 701 technically if you stay below a few thresholds when granting your stock you don’t have to tell the government that you’re granted that stock but once you get over those thresholds you do. And the nice one that as long as you’re granting less than $1 million worth of stock per year you’ll always be fine on this rule 701. But once you get above that you may be fine, you may not, take a look, is the quick story on that one.
Stock option expensing, until you have audited financials this doesn’t matter. Once you have audited financials there is an expense you have to book on your profit and loss statement that has to do with your cap table you want to look into called ASC 718 or stock option expensing.
The last one here and this is pretty big, pretty early on 409A. When you grant options you’re required to grant them out the money, meaning that the value of your common stock today. And the reason this exists back in the old…
Jeron: I apologize I’m interrupting, the job required to there are tax penalties if you don’t. And the tax penalties can be pretty bad.
Matt: It’s basically ordinary income on the difference, on the spread, plus the 20% fee, penalty. So yeah, it can get…
Man: [inaudible 00:44:36]
Jeron: Can I add something? Is I wanted to add, is that okay? So we’re actually this, this week, by the end of this week we’re actually putting a free 409A calculator online. So check that out. It’s a great question because it’s and it’s a sophisticated question. Whenever you grant stock options, Sean and everyone, you actually have to specify a strike price on those stock options.
Technically you need to have some form of validation for why you chose the strike price that you chose. In other words it can’t just be a, “Hey, I thought we were worth $0.20 a share. Put $0.20 a share on there.” The government doesn’t like that and if the IRS ever got involved which they have not, they’ve never ever to my knowledge gone after any early stage company for a violation of 409A.
Most people believe that this regulation was implemented to protect against companies that are much more obviously valuable than the earliest stage startups. That said, most people do not want to mess with the old phrase about death and taxes. Those are the two worst things that can happen and so most people want to be very careful.
So what we typically see is if you have not raised, if you only have common stock and you have no preferred, you have not raised a lot of money and certainly have raised no institutional capital you may have some convertibles or maybe some founders that put in some cash, then you can perform your own 409A valuation. You can go online and use a calculator or you can talk to a financially savvy person like a director on your board, one of your angel investors or give us a call we can make some referrals.
There are folks who can do this in a very, very inexpensive way i.e. potentially even free or those early, early stage, like brand new startups. For any companies that have raised an institutional round we typically recommend that you get an actual 409A, that you actually have a firm provide that 409A.
And most companies that have raised an institutional round of funding will want to do that because the risk reward starts to really shift for hey, we offer a $99 a month 409A package.
And once you’ve raised an institutional round, even a small series A the risk reward of if the IRS did come after me and if they did want to see some documented evidence of a valuation starts to look a lot more attractive when you’re talking about saving $1200 a year at a stage where you’ve raised a lot of money versus when you’re a brand new start up and $1200 might be the difference between you eating dinner that night or whatever.
And so that’s typically what we see Sean, I don’t know if that answers your question but bright line around the time you raise an institutional round.
Sean: [inaudible 00:47:41]
Matt: Good question and that’s one of those things that one of the advantages of having someone do this is they’re good at getting that value lower. Which is good for your…
Sean: You get a lower strike price?
Matt: Yeah, you get a lower strike price it makes those options more valuable. The reason you can get away with it and the reason that a valuation firm would be able to justify that is things like the preferences we were mentioning before. Because the preferred shareholders, the investors have rights that the common doesn’t have. We can spread that gap between what they paid and what the common stocks were.
Sean: I thought just Silicon Valley investors are dumb and they pay a massive premium so there’s that…yeah. All right so I don’t run too long because we have lunch and my tum is rumbling. I can hear some grumbles out here. How much more is on the deck to go through?
Matt: No, I think we had a pitch page after this.
Sean: Okay, can we go through the rest and then if you have a few more questions? And then are you guys available to hang out for a bit? And so I would say if you have a very specific Cap table question, if you want to show them your cap table grab them and just get some time outside and they can go through that individually.
Matt: Yeah, yeah, because I was just going to my last one just so that you guys get a sense here. Capshare is free for companies with less than 20 shareholders. So for everyone in this room the software is free. There is some advanced stuff where you can project out a new round. And we, our typical pricing is $2 per shareholder per month. So for early companies like you really doesn’t add up to that much.
The other mention there we mentioned the 409A. Jeron mentioned $99 a month will cover that 409A. There is few other things that we do like the stock option expense thing I mentioned. But it’s just doesn’t apply to you guys. But yeah, let us know where we can be useful. For most of you guys it’s not going to be an expensive thing. Yeah.
Sean: And just to be fair, we use you guys because we like you, you’re easy to work with. Who else is out there? There is E shares, is there a third?
Matt: E shares is a big one. The others, there’s a couple that we just don’t really ever actually see. Share Wave though.
Jeron: Share Wave, okay.
Matt: But the other big one is a…There’s a bunch on the public side that have private offerings but they’re built for public companies so they’re heavy, yeah.
Sean: Expensive, it sounds like. Okay, yeah got it. It’s okay, we’re recording this, we just tweeted that out but yeah, it’s okay.
Jeron: But I will say that solely in at one pool cap which is now and am here.
Sean: Yeah, we must excel but that’s where you have this challenge where all of a sudden you have two docs and you have to start doing timeline okay, when was this created? What were the events? And this is when the legal costs go up and fights happen and people yell. All right let’s…we want to, go ahead.
Woman: Sorry, very quickly. This presentation that you just showed us, will this be available or emailed to us after?
Sean: Yeah, I think for simplicity and to produce emails, let’s do everything together. And so unless that email becomes too big but we’ll set every doc and any other information one single email.
Woman: Perfect, thanks.
Sean: Yeah, other questions?
Woman: [inaudible 00:51:54] being able to prove out your strike price? So why do you need to do that on a monthly basis.
Jeron: You’re covered for 12 months, typically. The regulation is that you need to establish a strike price once every year and then you’re covered. With some key exceptions if there’s a significant value changing event in your company you may actually need to get it more often than a year. And so that’s why we do monthly. The pricing works out to roughly $1200 a year. And you’re fine to pay upfront if you prefer to do that but the idea is that we actually ensure that we’ll keep your valuation updated should you have a value changing event. And we’ll actually look for those proactively by managing your cap table so we’ll see if there is a value changing event and we’ll notify you. And so that helps you to stay compliant with 409A.
It’s more of a pricing strategy for us because your startup, a lot of startups like to just pay in smaller monthly increments but to be frank, it doesn’t matter if you want to pass all upfront or if you want to pay us $99. We are going to contractually obligate you to pay us at least a year’s worth so that we can recoup the cost. And that’s typically…
Sean: Can we clarify valuation events?
Sean: That doesn’t mean grandma said this is good and it’s for something. It means…
Jeron: A new around.
Sean: An equity round took place.
Sean: The evaluation was set by an investor.
Jeron: Yes, for most of you it’s going to mean a new round but it could actually mean, it could be something different. And it’s important to probably spell out what that could be but that also specifically in equity around, not necessarily an note or could a note drive it?
Sean: A note could drive it.
Matt: Okay, because there is a valuation cost.
Jeron: Any significant valuation indicating event which could also be, let’s say you’ve got a term sheet to be acquired by a public company or you and…
Sean: And you execute it.
Jeron: And it wasn’t executed but then you said no. Unfortunately if it was like $300 million term sheet those could be construed especially if there is evidence of this happening. Those could very much be construed as hey, you’re not worth the $2 million that you were last year, you’re now worth $100 million.
Sean: I probably should sign that [crosstalk]
Jeron: You should probably exit at that point but another one just really quickly Sean is if you’re a brand new garage start up and then you have no revenues, you get a 409A or you use a calculator or something because you’re like, “Hey we’re nothing, we’re two people on a garage,” whatever, and then you start to get revenues, that would also be a value changing event because now you’re actually showing some traction.
So it’s a significant change. And there’s really only those three, a liquidity event, a fund raising event or a major business milestone that has been achieved. So we’re going to be in one of the three categories.
Man: Just an add on question there actually, from an investor perspective do you need to worry about the strike price setting a precedent around valuation? So if I want to issue some options and obviously I want to have the low strike price to make sure that the shares are as valuable as possible but then I go to raise a round, are investors going to look and say oh well, you just valued your company three months ago and you issued these shares at this. So that’s a valuation, right?
Man: Is that a danger?
Sean: No the 409 is super conservative and the investor is paying massive premiums that the pricing is based on the on the future with 409’s pricing and more realistically on today. And so no, I think the investor will always pay much more. And then typically what I’ve seen too, the 409 happens after the investment. So the investment’s made and then you run the process. So the investors have already done and then the 409 is sort of, like they were talking about just to be compliant because there has been a change in valuation.
Matt: And investors generally get. They’re like, “This is a tax think, the goal is to get it low.”
Man: Right, right. So it’s pretty common to see, I go raise around at a $10 million innovation and then I can actually, for whatever reason, this is what I’m doing 409 issue at a strike price of a $5 million valuation. Can you actually issue at a lower strike price than your value at the price?
Jeron: And I would maybe, I would say the effective answer is yes, but whenever you’re dealing with compliance stuff that’s what a great valuation service will do for you because technically you don’t want, again you don’t want bad fact patterns when you’re dealing with the IRS. And you want to be compliant and so no, I would say actually if you just raise money at a $10 million round you want to find a 409A firm that will take that into account and actually put that in their report and have it bear on their report but still find compliant ways and safe ways for both you and of them with regard to the IRS to get your common share price value down as low as can be defended. And that’s really important. You want it to be defensible because no one wants a situation, in fact, in tying I would actually say even your investors don’t want you to be granting stock at an un-defensibly low price. That’s bad for everyone. So does that make sense?
And I completely agree with Sean though, most, I mean it’s almost laughable a lot of investors will just be like, they don’t even care what your 409A valuation says in terms of how they think about your own valuation. But they do want to see that you’re getting them done because they want you to be compliant. So yeah.
Sean: Yeah, also it’s harder for them to value these companies. Like, what if you’re really cutting edge or like the freaking drone based VR application on the block chain and it’s like, that’s hard to put value on. Investors will be like, “Yeah, yeah, yeah. Those are all the buzzwords I like,” boom, pay a lot. But the 409, not so much. But yeah, it probably exists.
Woman: This might sound really basic but who has the right to see your cap table? And how early should you just so investors, service providers, potential employees?
Sean: Yeah, I struggle with that. Like service providers know. Employees, it depends. And C level maybe you want to include them. Lower level I don’t know if they’re going to really understand what this means. People you’re bringing on as potential later co-founders should have full access and be able to look at it as well. Vendors, I can’t think of a reason why a vendor would, other than like a debt, a venture debt fender or like somebody who…
Jeron: Yeah, maybe sometimes like a bank or a lender.
Sean: But I think that employees should be able to ask you how many, like, because you’re going in to say I’m giving you 10,000 shares, let’s say they should be able to go to you and say well, how many are outstanding? They should be able to ask you these questions to figure out percentages and determine that. You don’t want to hide this type of stuff from them. But yeah, I love your answer. I don’t know, this is where I go on founder side where I’m like, “Yeah, let’s just be transparent. We all love each other, let’s get in the open.” But then there’s probably other issues to think about.
Jeron: This is a hot topic in our space which is an interesting but cool entrepreneurial space. It’s a hot topic around, we call it a cap table transparency. And we actually posted up a blog article on it which I can share with you later on if you’re interested. But I actually, I agree wholeheartedly with what Sean said. There are some interesting nuances around decisions that you might want to make. There are some, I think a buffer actually I think post. They just went crazy transparent.
Sean: They’re scary transparency. They put salaries.
Jeron: Yeah, and I think it’s, I honestly personally would, we have certainly have not chosen that level of transparency even at Capshare, not even close. But there are some choices that you can make here and most of our competitors and we offer solutions around granting transparency at whatever level you want to.
Sean: I think let’s talk really quick on investors, they may ask for that. And so I think that this is also tough but if you really like them you’re really close and they just want to check to confirm, then yes, let them see it. Don’t hide. What they’re looking for is like, mainly they’re looking for you as the founder, how much equity do you have? Are you long term vested? Oh, do you only have a single digit? Because that means are probably not going to go the long run.
They want to make sure you have good equity. They want to make sure there is no weird stuff going on too. What I’d be concerned about is small angel, was like yeah, like Randall person from Angel List, “Yeah, I’m going to give you $5000.” For $5000 they barely have the right to email you, let alone to get all this stuff, just being honest. But once again really, really good firm like Intel Capital or like a real fund is like they want to see it, it’s like yeah, give it to them. They have the right to and they can make a big impact and they’re going to be with you long term. But be careful about the angels but then anyone that you really want a good relationship or they’re a really good fund I would give it to them. They’re going to have access to.
Matt: And make sure to mark it “confidential” always. That helps.
Sean: But they won’t share it so much. It’s mostly like I’m looking for like did the founders get screwed? Because I really want to make sure they’re long term vested here. And I want to make sure there’s not some scary weird, oil money or something like hiding in there, some weird fund or something like that.
Jeron: I like that. Maybe when we go raise money we should have thresholds where like if you give me more than $5000 I’ll let you email me twice.
Sean: It is and it’s like the fogginess dissipates and you can see it.
Sean: There you go. All right, well if there’s more questions I want to take them but I’m also hungry too, is anyone else? More questions? All right, so these guys will hang out. If you have questions definitely grab them. As I mentioned being super candid, I raised a bunch of money. I didn’t know how Cap tabled work at bit me in the butt a little bit. You do not want this happen to you. I would say that if you grab them while they’re here just take them outside so we can keep going with the session or talk to them at lunch. But I thank you, very helpful. Thank you.