Equity Posts

(Not so) Scary terms in offer letters

Nivi · September 25th, 2008

Offer letters are short and easy to read, as far as legal documents go. But they contain some seemingly scary terms that are (1) ubiquitous in Silicon Valley and (2) usually “no big deal”.

We’re not saying that no one has ever gotten into a conflict or lawsuit over these terms—just that it isn’t common. The offer letters from the major Silicon Valley law firms are very consistent.

Here are the seemingly scary terms from an offer letter I got from Yokum Taku at Wilson Sonsini. As always, this is not legal advice.

Options

“If you decide to join the Company, it will be recommended at the first meeting of the Company’s Board of Directors following your start date that the Company grant you an option to purchase X shares of the Company’s Common Stock at a price per share equal to the fair market value per share of the Common Stock on the date of grant, as determined by the Company’s Board of Directors.”

You don’t get your options until the board grants them at the next board meeting. But they should start vesting on your start date.

The strike price is equal to the fair market value as of the grant date (sometime after the next board meeting). But that probably won’t be higher than the FMV as of your first day of work.

“This option grant shall be subject to the terms and conditions of the Company’s Stock Option Plan and Stock Option Agreement.”

These are big documents that you’re agreeing to without seeing. If you’re concerned, request copies before you sign your employment offer.

We’ve never seen anyone negotiate exceptions to these documents. Just make sure the company doesn’t have a right to repurchase your vested stock.

Conflicts

“Moreover, you agree that, during the term of your employment with the Company, you will not engage in any other employment, occupation, consulting or other business activity directly related to the business in which the Company is now involved or becomes involved during the term of your employment, nor will you engage in any other activities that conflict with your obligations to the Company.”

The company isn’t forbidding you to work on your own business on the side.

Get a lawyer to advise you on what you need to do to own your side business. At a minimum, work on the side business on your own time and don’t use anything owned by the company.

IP Assignment

“As a condition of your employment, you are also required to sign and comply with an Invention Assignment Agreement (enclosed) which requires, among other provisions, the assignment of patent rights to any invention made during your employment at the Company.”

These Invention Assignment Agreements always seem too far-reaching but they’re rarely negotiated, especially if they’re coming from one of the major Silicon Valley law firms.

The Invention Assignment Agreement usually asks employees to carve out the IP they developed before joining the company by listing it in an exhibit. If you’ve developed a lot of IP that is relevant to the business, you might want to ask the company to list its IP instead of, or in addition to, yours.

At-Will Employment and Sundry Items

“You should be aware that your employment with the Company is for no specified period and constitutes at-will employment. As a result, you are free to resign at any time, for any reason or for no reason. Similarly, the Company is free to conclude its employment relationship with you at any time, with or without cause, and with or without notice.”

This is an offer letter, not a 5-year contract with the Chicago Bulls.

“You should note that the Company may modify job titles, salaries and benefits from time to time as it deems necessary.”

You have no job security.

“This offer of employment will terminate if it is not accepted, signed and returned by such-and-such date.”

This offer expires soon.

“This letter, along with any agreements relating to proprietary rights between you and the Company, set forth the terms of your employment with the Company and supersede any prior representations or agreements including, but not limited to, any representations made during your recruitment, interviews or pre-employment negotiations, whether written or oral.”

If it isn’t in this agreement, it isn’t happening, even if we told you it was.

Related: I have a job offer at a startup, am I getting a good deal? Part 1 and Part 2.

Unrelated: My new favorite show, Lil’ Bush:



(Video: Lil’ Bush White House Tour)

I have a job offer at a startup, am I getting a good deal? Part 1: The offer

Nivi · July 16th, 2008

We’ve been answering this question a lot lately:

“I have a job offer at a startup, am I getting a good deal?”

This isn’t a comprehensive answer—just some questions we would ask if we had an offer.

If you don’t understand your offer, get a lawyer. But—right or wrong—most people don’t hire lawyers to review their offer letter.

Table of Contents

The Offer (answers follow)

  1. Can you give me the offer in writing?
  2. How does my compensation compare to my peers in the company?
  3. What are my options worth?
  4. What percentage of the company do my options represent on a fully diluted basis?
  5. Can I exercise my unvested options early?

The Company (see Part 2)

  1. How much money do you have in the bank right now? How long will it last?
  2. What was the company’s post-money valuation in the last round?
  3. What are the investor’s preferences?
  4. Who is on the board and whom do they represent?
  5. Would I hire the CEO and board to increase the value of my options?

1. Can you give me the offer in writing?

The only good answers to this question are,

“Yes, an offer is on the way.”

and

“Let’s work out the major points and we’ll give you a written offer. We don’t want to start things off on the wrong foot with an offer that is way off the mark.”

2. How does my compensation compare to my peers in the company?

Some companies pay more, some companies pay less, but an offer is fair if your compensation is in line with you peers’.

Your total compensation consists of salary, options, vesting, cliff, acceleration, bonuses, and severance. And a peer is someone who (1) joined the company at roughly the same time as you did (e.g. halfway between the Series A and Series B) and (2) has roughly the same title you do.

Most employees have a 4-year vesting schedule with a 1-year cliff, no acceleration, no bonuses, and no severance. The exceptions are for Vice-Presidents and higher (and founders).

By the way, your cliff may be longer than the company’s runway, but c’est la vie.

3. What are my options worth?

First you have to know how many options you have and how they vest. Let’s say you have 1000 options and they vest over 4 years. So you get 250 options a year for 4 years.

Now you have to guess what an acquirer would pay for your shares. Let’s call this the acquisition share price. Setting the acquisition share price to the preferred share price of the last round is a good start—let’s say it was $1/share.

Now multiply your options (1000) by the acquisition share price ($1) to calculate the acquisition value of your options: $1000. Since the options vest over 4 years, the annualized acquisition value is $250/year. And while the acquisition value of your options might be $1000 today, you’re naturally hoping that the company’s acquisition share price increases over time.

If the company has gained a lot of value since the last round, you might set the acquisition share price higher than the preferred share price. If the company has not has not done well since the last round, you might set it lower. Either way, you will have to ask the company for the preferred share price in the last round. Or if someone has offered to buy the company for $50M since the last round, I might use $50M to calculate an acquisition share price.

Finally, you will have to pay for your options—they’re not free. Options have a strike price—that’s what you pay for your options. Sometimes it’s much lower than the acquisition share price and can be ignored. Sometimes it’s high and can’t be ignored—high strike prices are becoming more common due to high-valuation rounds (Facebook), founder cash-outs, and high 409A valuations.

4. What percentage of the company do my options represent on a fully diluted basis?

Most people think this number is important—it’s not. You care about the value of your options, not your percentage of the company. Your percentage will decline over time but the value of your options will hopefully increase.

Focus on the how many options you have and the acquisition share price (see question 3 above). Terms like percentage ownership and valuation can fool you.

5. Can I exercise my unvested options early?

This is for advanced Venture Hackers only. Don’t do this without an accountant and/or lawyer.

Exercise your options early if you want to start the clock on capital gains tax eligibility for your stock. Startup pros usually exercise their options early to lower the expected value of the taxes on their stock. In certain cases, you will pay less taxes in an acquisition or IPO if you exercise your options early.

Use an accountant or lawyer. Don’t sue us if this blows up in your face.

This post continues in Part 2.

Related: Other folks who have tackled the topic of “questions to ask before you join a startup”: David Beisel, Dharmesh Shah, and Guy Kawasaki.

Everything you ever wanted to know about advisors, Part 2

Nivi · February 27th, 2008

Here are more frequently asked questions about advisors. See Part 1 for the rest. If you have more questions, email us at ask@venturehacks.com.

Frequently Asked Questions

General (from Part 1)

  1. What do advisors do?
  2. Should I put together a board of advisors?
  3. How do I get good advice?
  4. How do I apply advice?
  5. How do I find advisors?
  6. How can I tell if an advisor is any good?

Compensation (answers follow)

  1. What should I pay advisors?
  2. What are advisory shares?
  3. Why should I pay advisors?
  4. When do advisors get terminated?
  5. Should I give advisory shares to my investors?

Compensation

7. What should I pay advisors?

Nothing—get them to pay you. Ask advisors to invest. You get money, save stock, and amplify the advisor’s social proof in the process. But lots of good advisors can’t or won’t invest, so…

7.5 What should I pay advisors if they won’t invest?

Advisors are not paid by the hour—they’re paid for results. They’re not paid for their inputs—they’re paid for their outputs. If an advisor can uncork a million dollars of your company’s latent value with 15 minutes of conversation or a single introduction, you should pay him appropriately.

There are roughly two types of advisors—we’ll call them the normal advisor and the super advisor.

Normal advisors

The normal advisor gets 0.1%-0.25% of a company’s post-Series A stock. Normal advisors do something important for the company and aren’t expected to do much beyond that. For example, they introduce the company to a key customer or investor.

Normal advisors are also assembled by naive entrepreneurs who think the mere presence of an advisory board will create social proof and help them raise money. But investors don’t take these mock advisory boards seriously.

Super advisors

The super advisor can get as much stock as a board member: 1%-2% of a company’s post-Series A stock. Super advisors help make your company happen. They know all your prospective customers intimately. Or they raise your money for you. Or they bring you a handful of great employees. They can even add more value than an independent board member because they don’t have to deal with corporate governance.

If you find a super advisor, you want to incent him as much as possible and push him to help make the company happen. They can be much more effective than 5 or 10 normal advisors.

Most super advisors are unique and Y Combinator is a great example. YC takes about 6% of a company in return for $15K-$20K. Although most of their companies can survive with the small investment, the money is effectively meaningless—it’s an artifice. Most of their companies would probably give 6% of their shares to YC for free, just to participate in the program.

YC acts like a super advisor, not an investor—and YC makes their companies happen by helping develop the company’s product, introducing them to investors, and branding their companies.

Advisor compensation

Whether you’re hiring a normal advisor or super advisor:

  • Advisory shares are usually issued as common stock options.
  • The options typically vest monthly over 1-2 years with 100% single-trigger acceleration and no cliff. Although the advisor is on a vesting schedule, you should expect them to add most of their value up-front—that’s normal.
  • Many advisors want options they can exercise immediately—that’s fine.
  • If your company hasn’t raised a Series A, increase the advisor’s equity by roughly 30%-50% to account for dilution from seed investors, Series A investors, option pools, swimming pools, and the like.

Finally, there is a beauty to paying in equity rather than an equivalent amount of cash. If you pay for a service in cash and you want that service again, you have to pay again. If you pay in equity, you pay once and keep getting served ad infinitum. Equity is the gift that keeps on giving. Your shareholders own you, but you also own them.

8. What are advisory shares?

Advisory shares are normal common stock. There is no legal concept of ‘advisory shares’. The Supreme Court has never heard a case regarding advisory shares. Chief Justice Roberts doesn’t give a shit about advisory shares.

9. Why should I pay advisors?

“Make sure that, for the people that count to you, you count to them.”

— Warren Buffett

If someone helps your company succeed, it is only fair to share that success with them. If you want to do repeat business with people, you need to treat them right the first time around.

Equity also keeps advisors on the hook: you can go back to them again and again for help. If they were helpful once, they can probably be helpful again. And people with a financial interest in your future tend to return your calls.

Equity also incents advisors to keep working for you in the background whether or not you ask them to. They’ll bring you leads for customers, employees, and investors.

If you’re an advisor, don’t do it for the money. The opportunity cost is probably too high. You want to get paid so (1) you can own a little piece of the company in case it happens to be the next Google and (2) so the company signals that it values your time and contribution.

10. When do advisors get terminated?

Advisors can get terminated when they don’t add value at the level they originally agreed to. They can also get terminated if the company is “reset”, e.g.

  • You hired a video game expert because you were building a video game but now you’re building a photo sharing site. The company has left the line of business where the advisor added value.
  • A naive entrepreneur hires the wrong business advisor and a major new investor asks the entrepreneur to clean up the dead wood.
  • The company is acquired, recapitalized, or otherwise restructured and the advisors are no longer useful or desired.

11. Should I give advisory shares to my investors?

“Board members and (good) investors are always de facto advisors.”

— Paul Graham

Angels or seed investors may ask for advisory shares. They might argue that they will be more helpful than the other investors, so they should get advisory shares.

But every investor thinks he will add more value than the other investors. We would like to propose a shareholder’s code of conduct: if you think you’re doing too much, you’re probably just doing your share.

So, how do you decide whether you should give advisory shares to an investor?

First, determine how many shares you would give him if he were just an advisor. Then subtract the number of shares he is buying with his investment. If the balance is significant, say, more than 50% of the shares he is buying, give him the balance in advisory shares. If the balance is under 25%, the additional shares won’t really matter to the investor and they aren’t worth the trouble of trying to justify the advisory shares to the other investors.

(This is why you never give advisory shares to venture capitalists nor do they ask for them: the balance for VCs is zero since they are buying so much of the company anyway.)

If the balance is not significant, you should just say no:

“All of our investors will be advising the company. That’s what good investors do. If I gave you advisory shares, I would have to give them to all the investors. And that wouldn’t make any sense—our valuation already takes the investor’s value-add into account.”

But if the balance is significant, you need an argument that makes sense to the other investors or they will also ask for advisory shares and lower your effective valuation:

“We want to hire him as an advisor. Fortunately, we don’t have to give him all the shares for free because he’s also going to invest as much as he can.”

You have to be able to convince the other investors—that’s the test. Or you can just “burn the boats at the shore” and give the advisory shares to the investor with the agreement that he will invest a minimum amount in the financing.

Should I give my lawyers equity?

Nivi · December 30th, 2007

Summary: When lawyers defer their legal fees, they expect equity for the risk of not getting paid. If their risk is low or they’re not deferring fees, you can say no. In any case, offer them the right to invest $25K-$50K in your financing instead of giving them free equity.

A reader asks:

“I wonder if I could pester you briefly for lawyer advice. We are talking to a law firm and I’ve got their standard letter of engagement which asks for the right to purchase 1% of common stock at the same price as founders. Their other terms seem reasonable but this term seems pretty tough. What do you think?”

This is a common ‘ask’ by lawyers.

It’s also an example of a negotiation axiom: you get what you ask for. Particularly when one side is relatively clueless about industry norms, the other side’s strategy is to ask and expect their clueless opponent to say yes.

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Lawyers want equity for deferring their legal fees.

If your lawyers are not deferring their legal fees, you should just say no. You’re already paying them for their services, right?

If your lawyers are deferring their legal fees, they can ask for whatever they like: equity, backrubs, your car, whatever. They want compensation for the risk of never getting paid. That’s fair.

But if your financing is imminent or nearly certain, the risk of not getting paid is low and you can still say no. Or give them the minimum equity you would give an advisor: roughly .1% vesting monthly over 1-2 years with no cliff.

Equity doesn’t incent lawyers to work on your case.

Most law firms spread the equity to (1) just the partners or (2) across the entire firm. In either case, the partner on your case receives nearly zero equity and the associate who does all the work receives even less.

Unless you hire a one-man law firm, equity doesn’t incent lawyers to work on your case.

Let your lawyers invest instead of giving them free equity.

In any case, if your lawyers ask for a piece of the business, you can offer them the right to invest $25K-$50K in your financing instead—don’t give them the equity for free. They get equity, you get money.

This unfortunately incents your lawyers to drive down the share price of your financing, but this conflict of interest is small relative to their existing conflicts of interest:

Most law firms do a lot more business with VCs than they’re likely to do with you. VCs hire law firms. VCs refer new clients to law firms. Lawyers make money by executing transactions and your investors simply provide more transactions than you do.

So don’t sweat this minor conflict of interest.

Image Source: My Cousin Vinny

The Equity Equation

Nivi · July 19th, 2007

As this nuclear winter of venture hacks continues, I thought you might enjoy our thoughts on Paul Graham’s The Equity Equation. Paul says,

“Whenever you’re trading stock in your company for anything, whether it’s money or an employee or a deal with another company, the test for whether to do it is the same. You should give up n% of your company if what you trade it for improves your average outcome enough that the (100 – n)% you have left is worth more than the whole company was before….

“In the general case, if n is the fraction of the company you’re giving up, the deal is a good one if it makes the company worth more than 1/(1 – n) [Ed: This is the equity equation].”

Read the rest of The Equity Equation first; it is great. As usual.

We have some additional thoughts. As usual. =)

Summary: 1. You have to pay market rates regardless of the equity equation. 2. Consider the opportunity cost of spending shares on employees and investors. 3. Offers from top-tier firms increase your valuation.

You have to pay market rates regardless of the equity equation.

In practice, you raise money or hire an employee because you need to, not because you want to. And you have to pay a market rate no matter what the equity equation says.

Say the equity equation tells you to pay a prospective hire above market. You should still pay the hire a market rate and save the company some equity.

Say the equity equation tells you to pay a prospective hire below market. The hire will simply argue that the market values her higher, and that you should pay her a market rate. It’s tough to fight this normative leverage.

When you’re hiring, first figure out the market rate for the position. We previously posted a table of market rates for employees. When you evaluate a candidate, ask yourself whether she is likely to increase the next round’s share price (include the dilution of her market rate options). If the answer is yes, she is a possible hire. If no, she is a no hire. This approach forces you to think about building value, not filling a position.

# Consider the opportunity cost of spending shares on employees and investors.

“One of the things the equity equation shows us is that, financially at least, taking money from a top VC firm can be a really good deal. Greg Mcadoo from Sequoia recently said at a YC dinner that when Sequoia invests alone they like to take about 30% of a company. 1/.7 = 1.43, meaning that deal is worth taking if they can improve your outcome by more than 43%. For the average startup, that would be an extraordinary bargain. It would improve the average startup’s prospects by more than 43% just to be able to say they were funded by Sequoia, even if they never actually got the money.”

You need to consider the opportunity cost when you spend equity. You should only give out equity if it increases your share price optimally. You can buy a lot of things with your equity—buy things that increase your share price the most.

Is selling 30% of your shares to a top-tier firm the most effective way to spend your shares? What if another investor will give you the same terms for 20%? Should you take it? Could you spend the remaining 10% on killer developers and sales guys? Could you spend the savings on great advisors? Could you spend the saved equity on the best board members money can buy?

Entrepreneurs should think about unbundling money and value add. Get money on the best terms and get the best value add.

Would you hire an investor to serve on your board if he didn’t bring money with him? If the answer is no, his value add is literally worthless. If the answer is yes, then put a price on that value add and adjust their offer (in their favor) so you can compare it to other offers apples-to-apples.

(Note: This is not an argument not to take money from top-tier firms, we have raised money from top-tier firms.)

Offers from top-tier firms increase your valuation.

“The reason Sequoia is such a good deal is that the percentage of the company they take is artificially low. They don’t even try to get market price for their investment; they limit their holdings to leave the founders enough stock to feel the company is still theirs.”

When a top-tier firm offers to invest, the market price for your company immediately goes up. Firms tend to invest in herds and everybody wants to steal a deal from a top-tier firm.

The last-and-final offer from a top-tier firm will be slightly less than market. They will argue that they should pay less because they bring a lot more value than their competitors, they have a brand, et cetera. But overall, an offer from a top-tier firm increases your valuation.

Top-tier firms try to avoid increasing your valuation when they make an offer. For example, they may give you an exploding term sheet. But, in practice, in this market, we rarely see exploding offers from any firm.

Many firms add lots of value and help like crazy. But entrepreneurs should understand that the top firms pick the best companies, they don’t make the best companies. They say so themselves.

The top firms are mainly in the business of making money for their limited partners by picking the startups that are going to succeed with or without their value add.

I would love to hear your thoughts…