Structure

As we discussed in Phase 1, we’re going to kick off our process with some of the fundamental structural items of our stock plan. These should be fairly easy decisions to make, but that doesn’t mean they aren’t important! They are just less complex.

There are essentially 4 components to setting up the fundamental structure of our Stock Plan:

1. Stock Structure. We need to figure out exactly how our stock will be setup to distribute. There are several ways we can address this depending on how we want to manage control of the company.
2. Vesting Schedule. Instead of just giving everyone all of their stock on Day 1, we will probably want to consider setting up a “vesting schedule” so that people can earn their stock over time, similar to how they earn a paycheck. This will be useful in case people don’t stick around long term or don’t meet certain commitments.
3. Option Pool. We’ll probably want to set aside a certain percentage of the company’s stock to award future employees, advisors and contractors. Setting it aside now will mean that new awards can come out of the pool, so we won’t have to keep diluting our stakes over and over. Don’t worry, if we make the pool too big or too small we can always modify it!
4. Valuation. We’ll want to establish a value of the company, even though we probably have no idea what that might be. Fortunately, there are quite a few methods that we can use to arrive at a usable valuation. That valuation will be critical for the next Phase of our process when we want to value each person’s contribution in order to determine how much stock they get.

We’ve laid out the decisions in this course to be somewhat sequential from “easiest to agree upon” to “harder to agree upon”. We don’t necessarily need to agree to all of these items right now, but it does help to at least try to focus on some of these issues so that we can get some cycles as a team in coming to a consensus.

These are decisions that shouldn’t affect any one member individually. We’ve deliberately separated this from the discussions around individual equity stakes and the conditions of managing someone’s equity so that we can isolate those discussions when the time comes.

Said differently: if we can’t agree on the basic stuff... we’ve got bigger problems.

Before we get into the weeds on some structural decisions, let’s make sure we’re good on some key terms that will come up over and over. Key terms are super boring to read, so let's keep our attention on the absolute most important moving parts. These are the pieces that you absolutely need to know if you're going to do even a basic equity split.

If some of these don’t make sense now, don’t worry. We’ll provide a ton of context as we go forward. Now let’s get on to some meatier stuff.

Not all stock is created equal. When it comes to determining how our stock structure works, we have a handful of different ways in which we can hand out our stock.

For example, we can give members 100% ownership in our company (equity) or we can just give them the option to buy equity at some later date (stock option). We can even create something called “phantom equity” that provides a financial benefit like stock but isn’t actual equity in the company. And it’s spooky.

It’s worth at least having a basic understanding of the 3 most popular types of stock we can issue even if we just arrive at the default decision of “just give everyone regular equity”. There are some important nuances in how we might want to structure our stock so that we aren’t giving away ownership or controls that we don’t need to. Most people don’t realize this is even an option, so it’s worth knowing about.

By default, the Founders of a business have equity – we all own actual shares in the company. We’re directly responsible for the welfare of the company, including things like paying taxes and covering payroll. Our employees, however, don’t necessarily need to own equity or maintain the same liabilities that we do. This is where the stock structure comes into play.

We have 3 ways we can grant employees (or partners, advisors and investors) stock in our company:

As with anything in life, there are some pros and cons to each. Mind you, most of our focus here won’t be on what type of stock the Founders get in the company – we’re focused on what everyone else gets. Chances are we’re all getting regular ol’ equity. Instead, we’ll weight the benefits and costs of how we distribute stock to everyone else.

The most basic form of offering equity is just to offer an ownership stake in our company. If we award a member a share, it’s theirs and that’s all there is to it. Sounds simple, right?

For the most part it is. If you and I split our equity 50/50 and we both own half of the company, that’s easy to understand. And millions of companies have been founded with exactly that structure in place, so while it doesn’t solve every problem, it definitely has a strong track record.

What is often lost in that translation is how equity is distributed. Simply slicing up the pie amongst a handful of co-founders is one thing, but once we start to hand equity out to a larger group of people, particularly employees, things start to get way more complicated.

There are some meaningful drawbacks to just handing out equity and that’s really the heart of the discussion.

First off, we have to make sure that handing out equity is the best way to accomplish our goals. If our goals are to reward talent with compensation in the event we sell or want to distribute profits, we don’t need to give regular equity to do it. We can, but it’s not necessarily our best or only option.

Second, we need to understand the challenges around just handing out straight equity because that is really what may drive our decision to use Stock Options or Phantom Equity to accomplish our goals.

Drawbacks of Regular Equity

Most Founders have no idea why using regular equity would have any downside because, frankly, most people have never done this before (why would we have?). Let’s look at the main costs and challenges we may face by handing out regular equity:

After reading all of those potential challenges we may say “Woah! That’s bananas. Let’s definitely not give away regular equity!” And we may be right, but let’s use these challenges as the backdrop to understand why startups consider Stock Options and Phantom Equity as alternatives to some of these challenges.

When startups want to hand out stock benefits without many of the stock liabilities – they choose Stock Options. A Stock Option is a contract that provides the holder the option to buy stock at a later date, typically in the event that the company is sold or goes public.

Since the Stock Option itself is just an option to buy stock, not the actual stock (or equity), many of the downsides of giving away actual equity shares are mitigated in the short term. However, once the stock option is exercised, the unit holder then owns regular equity (in most cases) and many of the challenges of having folks who are in the Cap Table (See “Key Terms”) all become apparent.

Strike Price

Most Stock Options have something called a “strike price” (or “exercise price”) which means the price at which the holder can purchase their options. For example, if the Strike Price were $1, we would have the option to buy stock in the company for $1 per share.

• If the company were worth less than $1 per share, our options would be worth nothing.
• If the company were worth $3 per share, such as at the time of a sale, we would buy the options for $1, sell them for $3, and make $2 per share in profit.

Startups will issue stock options with a strike price so that new employees can benefit from the increase in value of the company. If we join the company with a strike price of $1 and the value of the company never exceeds $1, chances are we’re not going to enjoy any benefit because the company didn’t “improve in value” during our tenure.

Benefits of Stock Options

Stock Options hold a handful of key benefits over handing out regular equity so let’s focus on those first:

Drawbacks of Stock Options

Generally speaking, the benefits of issuing stock options tend to outweigh the costs, but that doesn’t mean there aren’t important considerations with issuing stock options. Let’s take a look at a few of the challenges.

Overall, stock options are a great way for us to provide financial upside in the event of a sale or public offering. That said, they aren’t the only way we can accomplish this goal. We still have another way of offering upside without necessarily having to hand out equity. We call this “phantom equity”.

Aside from sounding like a really cool version of equity, “phantom equity” or “synthetic equity” is simply a contract between the unit holder (employee, advisor, et al) and the company. The reason it’s called “phantom” or “synthetic” is that it works to achieve the same outcome – paying out a share of upside – without converting to actual equity units.

Phantom Equity works very similar to a stock option in that it is typically only “exercised” when the company is sold or goes public. It can also be modified to help make cash distributions (dividends) but that’s a whole other discussion.

The reason we might choose to issue a Phantom Equity plan may have a lot to do with how we want to maintain long term control of the actual equity in the company, ranging from who will have ownership rights (like equity holders do) to how easily we want to manage the program long term.

Benefits of Phantom Equity

Phantom Equity’s benefits are really the inverse of many of the painful drawbacks of issuing regular equity or stock options:

Once again, many of these benefits are particularly useful to founding teams that would like to maintain control of the equity membership of the company long term. This tends to be common amongst companies such as professional services firms or closely-held private businesses (not necessarily small ones) that don’t anticipate adding lots of outside members such as investors.

Drawbacks of Phantom Equity

A lot of the challenge around phantom equity begins with a lack of understanding in the marketplace. Unlike regular equity and stock options which everyone has heard about, chances are when we hand a new employee an offer of “phantom equity” they will scratch their heads at first.

Similarly, investors will almost certainly balk at taking phantom equity over regular equity. However, that doesn’t mean we can’t offer investors regular equity and employees phantom equity. It’s not one or the other.

The one other caveat worth mentioning around phantom equity is that not every attorney understands it either. If we’re interested in setting up a phantom equity plan, we’ll want to work with an attorney that is well-versed in this particular type of program so that they can properly guide us through the inner workings.

During formation we probably only need to worry about the Founding team who will likely all be equity holders. We’re going to consider some provisions amongst that team around the “vesting schedule” of that equity (in the next section) and some provisions for how to manage that equity (in Phase 4) but we’ll certainly begin with regular equity no matter what.

Vesting is a way to allow members to "earn" their stock over some period of time or per specific milestones. A common "4-year vesting schedule" means that a member of the company will earn 25% of their stock per year over a total of 4 years. This is the equivalent of getting paid over time based on our contribution, like a paycheck, versus getting our 4-year paycheck up front and hoping things work out.

(If you read that and knew it was a Karate Kid reference, you’re cool in my book).

Vesting is commonly used among funded startups to allow members to earn their stock over time. This provides an incentive to stick around, but it also provides a mechanism to be sure that if folks bail (or get fired) that a huge swath of equity wasn't arbitrarily awarded without earning it.

So why would the two of us wily co-founders want to vest our own equity?

Simple - to make sure we both do what we think we're going to do over a the long haul. Without vesting stock we run into the problem of having distributed equity without being sure it had been earned - and that goes for Founders as well as employees.

If everyone is doing what they said they were going to do - vesting shouldn't be a problem and it should go unnoticed. However if problems arise (someone is let go, for example) then vesting becomes really important because we haven't given away all of the stock without a mechanism to return it fairly.

Assuming we understand the value of vesting, we have 3 big decisions to make to determine how vesting will work. Let's do a quick fly-by and then we'll go into more detail:

1. Vesting Schedule. The time period that determines how long our equity will take to be earned.
2. Cliff. A determined period of time (typically the first year) where equity cannot be granted. This allows us to make sure someone puts in at least a year before we start awarding stock.
3. Acceleration. What events would cause the equity to be earned all at once (in the event of an acquisition or sale).

Vesting Schedule

Vesting works on what's called a "vesting schedule" which simply means the amount of time until all of our stock is earned.

In the example we used earlier, if we have a "4 Year Vest" of our equity, that means at the end of year 1 we will own 25% of our total 100% stake. At the end of Year 2 we will own a total of 50% and so on. We have to stick it out for 4 years to earn 100% of our stake using a time-based schedule.

The two most common types of vesting schedules are "time-based" and "milestone-based".

There are no hard and fast rules on how long a vest should occur or what milestones we can choose. Just like negotiating compensation, we want to find a balance between being fair and “well-earned”. If we think that 2 years is enough time for the Founders to have earned our stock, so be it.

Vesting Cliff

What happens if one of our Founders, employees, advisors or other members only sticks around for 2 months? Do we really want to be vesting stock to every person that may have not even made it a year? That seems like a messy Cap Table and a recipe for disaster down the road.

To combat this, we can set up a “vesting cliff” that stipulates a minimum time period someone has to be vesting before any of their stock can be granted. This is often a year, but we can set it to be any threshold we want. Most startups use a year because that seems like a reasonable amount of time that would yield a reward for anyone. If an employee stays only 11 months, for example, they wouldn’t be eligible for any stock.

Vesting Acceleration

The last piece of the puzzle is called “Acceleration” which covers events like “What happens to everyone’s vesting of stock if the company sells tomorrow (before everyone is vested)?” For this reason, we’ll add something called “Vesting Acceleration” which often involves a “trigger event” (such as a sale).

Acceleration is the goal, but the “trigger” is what we need to determine.

In most cases if a sale occurs (this would be a “trigger”) then everyone’s stock will fully vest or “accelerate” just as if they had waited their 4 years or met their total milestone goals. Our intent here is to make sure that members feel they are treated fairly in the event of something wonderful happening.

In reality, is it “fair” that someone who worked there 6 years will have vested as much as someone who worked there for 2 years and happened to be there during the sale? Not exactly, but if we feel strongly about that we can modify the acceleration to only accelerate one year of vesting. It doesn’t have to be all or nothing.

Our special considerations for stock will come down to a few important decisions. We’ll first determine whether we want to include each provision (vesting schedule, cliff, and acceleration) and then exactly how we want to modify it for our needs.

Decision #1: Vesting Schedule.

If we choose to have the stock vest - is it based on a time period or a milestone?

• Time Period
  • Will the stock vest each month (incrementally) or each year (annually?)
  • How many years will the stock vest over? (3 - 4 is common)
• Milestone
  • What milestones will need to be met in order for the stock to vest?
  • What percentage of the stock will vest at each milestone?

Decision #2: Cliff.

Do we want to invoke a period in which the stock can’t be awarded? A typical window is 1 year.

Decision #3: Acceleration.

Would we like stockholders equity to be automatically vested based on a triggering event such as a sale?

We will then take these decisions to our attorneys as the basis for how we would like our agreements to be set up. These will be the 3 most important moving parts that our legal team will need to craft our team agreements.

Once we divide up our own stock, we’ll likely want to award stock to future employees and other contributors down the road. There’s just one problem – it’s a huge pain in the ass to divide up the pie and recalculate everyone’s ownership stakes every time we add another person!

Instead, we can save ourselves some headaches and allocate what’s called a “(Stock) Option Pool” for future awards. Here’s how it works.

Now the 4 obvious questions that come out of this setup are:

1. How do we know how much to allocate? It doesn’t matter. 15% is fairly standard. If we run out we can simply allocate more, and if we don’t use it all, it will return back to the original stakeholders.
2. What if 15% isn’t enough? There’s no way we could possibly know how much to allocate until we actually give it all away (or don’t) so think of 15% as just a placeholder to get the process started. Again, we can always change it later.
3. What happens if we run out and need more? When Sandy and Ritika first allocated the Option Pool, it came out of their stake. However, at a later date when the option pool is setup again, it will likely be pulled out of the current holder’s stake, which may include many more people than just Sandy and Ritika. For this reason it may be wise to not make the Option Pool too big because it may disproportionately dilute the early members versus fairly diluting all members when it’s created later.
4. What happens if we have some left over? Typically, any remaining stock that isn’t allocated to members is returned to the original contributors. However, read the fine print on any 3^rd party agreements (like investor terms) because they don’t all automatically state that!

If we wind up raising capital from professional investors they will almost certainly require an Option Pool to be established, and here’s the kicker – they will require it to come out of our portion of the stock, not theirs. Oh, you sneaky investors!

Ah, the valuation. We could write a whole book on how startup valuations work. Actually, we probably will. Until then, let’s tackle this wildly misunderstood and generally insane thing that is “startup valuations”.

The “Valuation” of our business is how much the business is currently worth. Now, if we’re sitting there saying “How would I possibly know that?” then we’re asking the right question. The answer is that we don’t, and neither does anyone else. And yet, we’re going to establish a number anyway.

If we’re just splitting up the equity between ourselves, chances are we don’t need a valuation. My contribution is valued relative to your contribution. So if I contribute $50 and you contribute $150, you own 75% of the stock ($150 is 75% of our combined $200 contribution). Not a bad investment of $150.

During formation, the valuation doesn’t really come into play. It becomes more of an issue the moment we start issuing stock to anyone beyond us. It’ll also come into play if we add other co-Founders later on down the line, although we may still be able to grandfather them into our early math of valuing our equity relative to each other’s contributions.

So for the time being, as we discuss valuation, just think about it in terms of how “other people” will have their contributions valued.

It may sound odd that we’re valuing a company so early, especially if it’s just at the idea stage when no tangible product exists. However, valuing a startup at this stage is absolutely critical to helping us understand how to value the contributions of non-members, such as employees, contractors or advisors.

Valuations put a dollar value on the business so that people can determine how much the market value of their contribution would earn from the company.

Let’s start by establishing a few fundamentals here. First, there is no magic slide ruler or calculator that we can use to get a Kelly Blue Book Value for our startup, especially in the formative stages. Many Founders have some foggy idea of what a business valuation looks like when someone calculates a “multiple of revenue” or “20x EBITDA”. They are thinking about the valuations of mature businesses with lots of known quantities. This ain’t that.

Instead, we’re going to take a look at each valuation type starting with the most “data based” and finishing with the wild-ass-guess methods - all of which are actually used.

• Comparables to Similar Startups. If we’re in a space that has sufficient comparables and publicly-available information about similar startup valuations, that’s ideally the best place to start. This is most common when we have investors who have consistently put money into similar startups. While they may have invested at later stages (meaning they were likely worth more) it can at least provide a guideline as to what our startup might be worth.
• Investment Stage-Based Valuations. Investors tend to invest at specific stages of a startup’s growth, from early stage (seed) to late stage (venture capital). As such, they tend to write similarly sized-checks at those stages and expect a similar investment. For example, many accelerators take a 6% stake of a business for $20k in cash invested at the idea stage, presuming a valuation of about $350K for idea-stage companies. It’s possible to use comparable methods of how actual cash has gone into similar deals at a similar stage to get a ballpark range for our valuation.
• Floating Valuation (Slicing the Pie Method). A different method of creating a valuation is to “accumulate” the valuation over time by constantly adding up everyone’s contribution and then providing a percentage of that combined total. If we both invest $100 then the valuation is $200. We both own 50%. If you then invest another $200 and I invest $0, then you’ve contributed $300, I’ve contributed $100, and you own 75% of the pie. We go into this in a bit more detail later when we talk about splitting up the equity.
• Contribution Value. Often a startup is valued based on the amount of equity a contributor perceives to be valuable. In this case it’s the tail wagging the dog. If an investor puts $50k into our startup and believes that a 10% stake is the minimum they would accept (based on very little data) then the valuation of the business is $500,000. We’d be banking on a subjective “feeling” that the contributor has about what a stake is worth. This gets used more often than you’d expect.
• Set a Base Value. Another way to set the valuation is by using a “Base Value”. This means that if the idea or startup is worth anything, and if it were ever to be sold, it would have (at some later date) at least this much value. For example, if we set the “Base Value” of our startup at $1 million, we’re not saying that it’s absolutely worth $1 million today. We’re saying that $1 million is the minimum that the company could be sold at in order to have any marketable value. Said differently, if the company isn’t worth at least $1 million at some point, the stock is probably worthless anyway.
• You can literally make it up. It kills me to even write this, but I’d be lying if I didn’t say it because it happens all the time. Similar to the price of artwork, many startup valuations are a reflection of a number that the Founder(s) pulled out of the air and somehow someone else magically agreed to it. The purpose of explaining this isn’t to suggest that we have zero data, it’s to point out that price isn’t entirely calculated every time.

We didn’t say this would be easy!

We may look at all of those and say “Wow, that’s great and all, but we still have no idea which valuation method to use!” Ideally, we will move down that list sequentially until we find a methodology that we can agree on the most. We should first focus on the approach we like, then we can determine what number to arrive at.

Let’s say we decided that an “Investment Stage-Based Valuation” makes sense to us. We know some other companies that have been valued like this, so we can at least agree it’s an outcome we’d like to share with them. We may then say, “As a starting point, let’s use the same valuations most incubators give to new ideas and set it at $350k.” Remember if we’re just splitting equity amongst ourselves, the valuation doesn’t matter as much. The amount of equity we get among the Founders will be relative to each other’s contribution. But if we’re giving others equity, this is a safe place to start.

If we can’t come to an agreement right now, and it does happen, it is possible for us to punt the decision until later. This is actually a fairly common practice amongst startups and investors when negotiating early stage investments.

The thinking goes that neither party can fairly determine the value of the company now, but they really want to do a deal. What they do know is how much the investor is willing to invest. This type of structure is known as a “Convertible Note” which simply means that the investment amount will “convert to equity” at a later date when a real market valuation can be established - such as the next round of financing.

The point is that it’s possible to defer this decision for a minute while we make more near term decisions. But it’s helpful to have the context of what valuation will mean to us as we distribute our hard-earned equity.

It may not sound like it – but that was the easy part!

Up until now we haven’t had a lot that we couldn’t agree on because all of the terms affected each member of the company in the same way. Whether we chose to do straight equity or phantom equity – we both get the same benefit.

These decisions put together a very basic framework for how our stock will get set up, but it still doesn’t tell us “who gets what”. That’s where the challenge starts to brew, and what we’ll discuss in the next section.

It’s advisable that before we get into splitting the equity, we try to get some real consensus on all of the formative decisions in this Phase first. This isn’t necessarily sequential, but it does give us more things to agree upon before moving forward. Like any good negotiation, creating some momentum around agreement is key to overcoming the moments where we differ.

And we may be about to differ. Let’s find out.