If you are the typical founder of a venture capital backed company that has a $50 million exit you probably just catapulted yourself into the echelons of upper middle class. As an eager young entrepreneur that quit your job, drained your bank accounts, borrowed your parents retirement money and convinced your buddy to do the same you may be thinking I’m out of touch with the average Joe. However, out of the $50 million exit, your bank account, statistically, will increase by about $2.5 million. Not bad if you live in Appalachia but if Applebee’s is not your standard for fine dining than you will have to continue to work. Let’s create a fictitious company and dissect your exit – all assumptions are based on average venture statistics.
As long as we are going to make up a company, let’s name it, RentaCorpse.com, “because it’s cheaper to rent than buy”. RentaCorpse was founded in 2002 and was acquired in the Summer of 2010. RentaCorpse raised 3 rounds of funding. You and your partner owned 10 million shares prior to raising money. In 2003 the company raised a Series A round of $5 million at $1/share, in 2006 the Series B was $15 million at $2/share and even though RentaCorpse did great through the down turn it was lucky to do a flat round in Q1 of 2009 for $10 million, also at $2/share. The board brought in a new CEO with the Series B and the company ramped up to 200 employees by 2010. To incent all of the new employees, executives and partners the Series A investors insisted on the creation of a 15% option pool, the Series B required another 15% carve out and some warrants (warrants are similar to options) were given to early partners, a total of about 7.5 million shares if all options are exercised. The terms of the preferred stock is participating with a 2x cap, if you do not know what this means you are not alone, but take my word for it these terms are not so bad. The dividends are non-cumulative and the Company has $5 million of venture debt.
To summarize, RentaCorpse was initially capitalized with 10 million common shares, half of which are yours, and at the time of exit there are 35 million shares, the break out is as follows: 10mm common founder’s shares, 7.95mm options/warrants and 17.5mm preferred shares. This is actually a very clean capital structure with reasonable terms. If you were wondering the Series A bought 29% of the company at the time of financing, the Series B 26% and Series C 14%. By the time of exit, A, B and C owned 14%, 21%, 14% for their $5mm, $15mm and $10mm investments respectively.
So if your 5mm founders’ shares/35mm shares total equals 14.3% and the company was sold for $50 million why don’t you get $7.1 million? That’s why we do the autopsy!
There are two types of exits for the Company; acquisition or IPO. If there is an IPO all shares usually just convert to common so figuring out who gets what is simple. IPOs generally only happen if a company is worth in excess of $250mm. In the case of a $50 million sale of a company you can be assured the exit is an acquisition. Upon acquisition determining the waterfall of payments can be tricky and depends on the terms of the investment, particularly the type of preferred stock and the type of dividend.
I’ll mix a little definition in with the dissection. For those of you new to venture capital, investments are made in the form of preferred stock. There are many flavors of preferred stock but the basic concept is that preferred stock has rights superior to that of common stock (equity). The most friendly form of preferred stock is when the investor has the choice to have his investment returned or converted to common stock. The harshest form of preferred can include a multiple of the investment returned plus the equity percentage. Common Stock gets whatever is leftover after the debt and preferred stock is paid.
In the case of RentaCorpse the common stock will get about $9.4 million, or about 19% of the proceeds. Note it is far from the 51% the common stock would own if all of the preferred stock converted to common. I can write 100 pages on the complexities of preferences but trust me, this scenario is typical. Of the $9.4 million that common is paid, about $5.2 million goes to the founders, the rest goes to the option and warrant holders. Why does the common get such a low percentage? The answer is that the preferred stock gets its money back and its percentage because the deal is money back plus percentage up until the preferred gets twice its money, at that point it converts to equity – that’s what the participating with a 2x caps means.
The acquisition will also be subject to a holdback and modest ‘earnout’, in aggregate this is usually about 30% of the payout. Assuming all of the holdback and half of the earnout are paid, the founders stock will be paid $4 million at close of the deal and another $1.2 million 18 months later.
$5.2 million is still pretty good for the founders until you consider that the founders stock is split in half so it’s $2.6 million each. After paying long term capital gains of 15% and 9% CA state tax, each founder receives about $2 million. Considering you probably gave up $100,000 per year in salary and equity elsewhere you really have to consider whether the risk was worth it.
Summary – There are lots of things to consider when calculating what the common stock will ultimately get such as post money valuation at each round, type of preferences, was there a downround and if so what were the terms of the anti-dilution clause, did the company hire many ‘non-founder’ execs, how long has the company been in business, what is the turnover, is there debt, how many founders split the stock, the list goes on and usually by the time there is an exit the founders have very little say and the capital structure has been set.
Note – Between 2002 and 2010 only 80 companies per year on average had exits in excess of $50mm. 1,500 venture backed companies were created during each of those years.