High Growth Handbook

by Elad Gil

  Obviously there are a lot of non-financial incentives to working for a startup: making their team and friends successful and contributing to the company’s mission, for example. However, it is always striking how much the financials matter, even if people claim otherwise.

  Investor sales: An opportunity to renegotiate

  As your valuation rises, early investors may want to sell all or a subset of their stock in your company. For example, an early angel may want to diversify or sell her stake, as your company’s stock may be her biggest financial holding. Alternatively, a venture fund may want to sell part or all of its stake to return money to LPs, especially if they are raising their next fund and want to ensure the participation of those same LPs.

  An investor’s interest in selling stock also presents a key opportunity for you, an opening to renegotiate prior terms with that investor. Some key items you may want to revisit include:

  Information rights. As an investor’s stake diminishes, you can argue that they should no longer receive information rights if they have them. In some rare cases I have seen the biggest sources of leaks for companies have been early investors, rather than employees, trading favors with TechCrunch. Cleaning up early investor information rights can make a difference.

  Board participation. Board representation is supposed to reflect ownership. Further, some early-stage investors are great advisors for a small ten-person company, but have no operating experience or insights for later-stage companies. As part of a secondary sale by a venture fund, you can ask that their board member step down, or you can convert her board seat into an independent seat from a preferred one. This returns control to the company and its founders and allows you to remove people from your board who are no longer helpful (or, in some cases, may be actively destructive). A large secondary sale to a preferred buyer or a tender is a unique opportunity to clean up the board, at least partially.

  Cleaning up your cap table. A secondary tender may be an opportunity to clean up your cap table. For example, you can go to all your small, early angels and offer an “all or nothing” sale, where they can sell their entire stake or none of it. This may allow you to remove multiple line items from your cap table at once and consolidate them by selling their stock to a single investor with a bigger ownership stake.

  In general, you should view investor secondary sales as an opportunity to claw back rights and clean up governance in a manner that is positive and mutually beneficial for all parties involved. The funds get to sell part of their stake and return money early to LPs, and the company gets to remove board members or information rights that have existed past their prime.

  Locking up future sales

  Any secondary sale is also an opportunity to prevent that same individual or fund from selling again without explicit company say-so. This is most important for the many companies that had sloppy initial structures in place for secondary sales (in some cases having no restrictions at all on early employees, not even a ROFR—Fenwick & West is notorious for leaving this out of their standard docs).

  Whenever any party sells its stock, you should ask them to sign a contract that will prevent future sales without company sanction. Similarly, you may change your bylaws and general employee docs to create a situation that still allows for employee sales, but avoids long-term harm to the company via random cap table additions or bad actors buying stock. Ask your legal team to draft documents that help with both approaches.

  “In general, you should view investor secondary sales as an opportunity to claw back rights and clean up governance in a manner that is positive and mutually beneficial for all parties involved.”

  —Elad Gil

  409A and RSUs

  The key balance in secondary sales is to allow for such transactions to occur without impacting a company’s 409A valuation for common stock strike price. The 409A is an analysis you do to set the price for your stock options. If large, company-sanctioned common stock transactions occur at high prices, you will need to reset your common strike price upward, impacting your ability to reward employees.

  You should talk to your legal team about the right approach to secondary sales and 409A. In addition, you should consider moving to restricted stock units (RSUs) instead of options once your valuation is over $1 billion and you are within 18–36 months of going public.

  Moving to RSUs

  At some point it makes sense for most companies to move to RSUs. Early on, RSUs tend to be less tax efficient for employees than early exercise of options and holding stock for capital gains tax treatment. However, once your strike price is high enough, the early exercise cost to an employee is so high that most do not do it—or it wouldn’t be wise for them to do so. (The ’90s saw a number of examples of stock options that were exercised, followed by a big tax bill, and then there was no upside on the actual stock. As a result, employees paid all the downsides of taxes without the upside of stock valuation increases, or in some cases without the cash to pay the tax bills.) Or, they will need to do a secondary sale just to generate enough cash to cover the exercise of all their options.

  Eventually, when your company valuation is high and you are within a few years of an IPO, RSUs have equivalent tax efficiency to options. RSUs allow both the company and its employees to avoid the complexities of trying to cover the exercise price of stock, as well as avoid the potential loss if the stock price drops over time.

  RSUs also are never “below water,” because they are effectively equivalent to shares of stock, not just options to buy that stock at a certain price. While a stock can end up trading below the option price an employee received, RSUs always have a value equivalent to the value of the stock. This means that “equity” granted to employees as RSUs will always have some value. Stock options, by contrast, may end up with zero value for very late-stage companies, if the strike price is at or below the current stock price.

  The secondary stock sale: The employee’s perspective

  The previous few sections have focused on how to regulate secondary sales from the company perspective. The focus of this section is the employee perspective: How to sell your stock on secondary markets.

  1. Understand if you can sell stock.

  Check your stock option plan, company charter, or other company documents to see whether you can sell secondary stock. If your company has a general counsel, you can also ask her about the details of what you can or cannot do. Alternatively, some later-stage companies have a person on the finance team dedicated to secondary transactions; even the CFO may be the right point of contact.

  From a process perspective, most companies will have a 30- or 60-day right of first refusal (ROFR). This means that once you’ve negotiated a price with a potential buyer, the company can decide if it wants to purchase your shares at that price, instead of the buyer. If the company declines, existing investors in the company may also have a ROFR and will be asked if they want to buy your shares. If everyone passes, then the original buyer can purchase the shares from you. If the company or its existing investors want to exercise their rights of first refusal to buy the shares, they will pay you the same price you negotiated with the buyer. So even if a ROFR is invoked, you will be able to sell your shares.

  It typically takes about 30 days for your company (and investors, if applicable) to waive their ROFR. But in some cases it can be longer, so you need to plan for this when selling stock.

  Remember, right before an IPO, a company will often halt trading in its shares—which means you may not be able to sell for a few months before the IPO and then another six months after the company is public.

  2. Decide how much to sell.

  The decision on how much to sell may be driven by a few factors including:

  Employment status. Most companies require you to exercise your stock options within 90 days of leaving your job with the company, or you lose all the options you worked years to obtain. In this case, you need to start thinking of how to do a secondary sale shortly after leaving the
company. You will need to decide whether to sell enough to just cover taxes on the full set of options you exercise, or if you want to sell more to take some money off the table as well.

  Diversify your portfolio. If 99% of your net worth is tied up in company stock, you may want to take some money off the table to protect yourself from a black swan event that would cut your net worth dramatically all at once. I know a number of people from, for example, Zynga who saw their net worth drop 70% with the stock price.

  Cash needs. Even if your company is close to going public, you may want some short-term liquidity to buy a house or car, pay for your kid’s school, or the like. Remember: Just because your company files for an IPO does not mean it will quickly go public, and even after it goes public you will probably be prevented from selling your stock for six months, which means half a year of uncertainty.

  Taxes. There may be large tax considerations to selling your stock, depending on the timing. For instance, a number of people sold secondary stock in 2012 to avoid the tax hikes of 2013. Talk to an accountant before making any sales.

  Many people end up selling 20–50% of their stakes pre-IPO for the reasons above. If you really need the cash or just want security, you may be able to sell your entire stake in a secondary transaction. Of course, that limits your potential upside if the stock does go up after the IPO. But that’s the trade-off you are making with an early sale: the security of cash now, or the possibility of a larger return later.

  3. Find a legitimate buyer.

  Buyers of secondary stock are diverse. There are dedicated secondary funds, hedge funds, family offices, angels, dentists, and a random assortment of yahoos (aka individual investors) who operate in this opaque market. (See the previous section on secondary sales for more on this.)

  In general, you want to find a buyer who:

  Has the funds available. If you are doing a large transaction, ask for proof of funds or make sure the person or entity is a well-known investor.

  Will move quickly. Avoid situations where there are multiple decision-makers between the purchaser and the person offering to buy the shares. For example, some secondary funds will have a decision-making committee that only meets periodically.

  Has invested in private securities before. If you are dealing with high-net-worth individuals (versus funds), make sure the buyer understands the secondary process, the risks involved, and the various steps needed to close a transaction quickly.

  Won’t be a pain in the butt to the company. Adding a dentist from Ottawa to the company’s list of shareholders may do your employer a disservice. The dentist may be willing to pay more for your shares than a professional buyer would. But random buyers may also have volatile properties (e.g., they may sue your company for no good reason). This can hurt the value of any remaining stock you don’t sell, and it will certainly hurt your relationship with your employer. Only transact with random people if you don’t mind burning bridges with your employer.

  Your company will approve quickly. Optimally, you want buyers your company knows or is willing to add to the cap table quickly. Some funds have had problems with the SEC in the past around secondary purchases, which means your company may not want them to buy your stock.66

  4. Figure out the price you want.

  Private market transactions are highly illiquid and volatile.67 There are always rumors that somebody got higher or lower prices on their stock. Or, illegitimate buyers may suggest prices for stock that they can’t or won’t really pay to test the market. Often these transactions don’t go through, and they muddy perceptions of real market prices.

  To get a sense of the market for the stock, ask colleagues what they are getting for their shares in transactions that have actually gone through. That means transactions that actually closed, versus offers they have received. Unclosed transactions are often meaningless.

  Don’t be too greedy. Focus on speed of closing at a price you are comfortable with. Unless you are selling a very large block, a difference of five cents a share won’t make much of a difference if the stock is at $18 a share.

  A few rules of thumb:

  Common stock is often discounted from the last preferred stock price.68 This is on the order of 30%. For example, if your company just raised at a $240 million valuation, you can expect to sell your common stock at a price based on a $160 to $200 million valuation. If the round took place many months before your sale, and the company has made progress since then, you can typically sell at the preferred stock price.69 You should by all means ask for the last preferred valuation, but investors may not be willing to pay that much. As the company matures and gets more valuable/later stage, the spread between common and preferred stock will disappear.

  IPOs breed volatility. There is typically a sharp run up in secondary prices in the weeks before a company halts secondary transactions, which is directly before an IPO. In some cases, those secondary prices will be higher than the post-IPO stock prices (see, for example, the first year of Facebook’s public stock price70). If you want to sell, don’t get overly greedy during this period. Prices are rising so quickly that you might be tempted to hold out for an even better one. Remember, though, the price is moving quickly because the company is about to stop all secondary trades. If you over-optimize and don’t sell, you may be prevented by the company from doing so for an uncertain period of time.

  The root of this uncertainty is that not every company that intends to go public will do so immediately. After filing for an IPO, a company may wait for many months (or quarters) before going public, due to market conditions. Once the company does go public, you will be locked up for another six months. If the IPO gets delayed, you can end up with a bunch of illiquid stock and ongoing market risk.

  Expect things to move up and down in a semi-random fashion. In a market with limited numbers of buyers and sellers, prices may move all over the place. For example, if one of your company’s founders dumps a large block of stock at a low price to diversify, it can depress prices for everyone.

  Don’t forget taxes. Talk to an accountant. Selling in one year versus another may impact the taxes you pay. Similarly, if the company was a qualified small business when you bought your stock/exercised your options, there may be very large benefits to holding the stock longer, or there may be future tax breaks depending on how you reinvest the money you just made.

  5. See if the company wants to have their legal counsel run the transaction.

  Many companies will have a stock purchase agreement (SPA) they want you to use to sell their shares. If not, you can use one of the major Silicon Valley firms to put together the paperwork.

  Regardless of who does the paperwork, you will need a stock purchase agreement. Sometimes, you may need additional paperwork such as a third-party legal opinion that you legitimately own the shares you are selling. (This is usually only needed if there is a large secondary market for a company’s shares, with lots of buyers and sellers. At some point you can get people acting badly in the market and selling shares that don’t exist, which creates the need for this extra layer of legal work.)

  6. Terms to include.

  You want to make sure the paperwork for your secondary transaction includes basic items such as:

  The buyer is obligated to fund the shares within X days of being able to do so. For example, if she does not wire money to you within a week of the sale closing, you can void the transaction.

  The seller is obligated to sell the shares and can’t back out.

  If the company blocks the transaction or exerts its right of first refusal (ROFR), the contract is voided.

  I am not a lawyer and am completely unqualified to give legal advice. So talk with your lawyers about this.

  7. More complex transactions.

  Some secondary funds will offer more complex transactions that allow you to benefit from the upside of your stock in the future while cashing out today. In some cases, you take a loan out against your shares and then split the upside of the stock
with the lender. Alternatively, you outright sell them the shares, but have a contract in place that if the stock goes above a certain dollar amount you split the upside. For example, you might sell your stock for $25 per share, but then split any appreciation of the stock above $30 per share. So if the stock sells for $32, you end up with $26 a share ($25 plus ($32–$30)/2).71

  IPOs: Taking a company public

  A common characteristic of companies from the 2007–2012 period is that many of them are focused on taking as long as reasonable to go public. While there are some drawbacks to being a public company, there are also a number of benefits.

  Benefits of going public

  1. Employee hiring, retention, and conversion. Compensation packages at companies sometimes go down after an IPO, with a higher conversion rate of candidates to employees. In general, this is due to the employees valuing stock as a liquid currency, as well as the perceptual de-risking of the company. Retention goes up on newer employees (who have more future value in the company) and often will go down for old-timer employees (who may have made millions or tens of millions and are now liquid and able to leave). In general, the old-timer contingent will be small and likely to leave eventually anyway.

  2. M&A. A liquid currency provides the ability to buy companies without haggling around what the acquirers stock is really worth.

  3. New capital sources for the company. Public markets can provide outsized funding for companies after an IPO. For example, Tesla’s ongoing rise may have been difficult to support without the broader based global capital flows of the public market. In a lose capital environment this seems like a minor point. In tight capital markets this can be the saving grace for a company. For example, Opsware went public in 2001 as private market sources had all dried up.