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Comment by bluehex | Hacker News Reader

Another thing to understand (and this will sound obvious to many of you) is that your options may be worth nothing, even after a multi-million dollar acquisition if there are priority stock holders (the investors) ahead of you in line.

As a young and naive engineer I learned of this fact the day the first startup I worked for was acquired. First I read the big number that was to be paid for the company, was ecstatic, and immediately starting doing "x-million times half a percent" in my head followed by a sinking feeling as I read the clause stating that common stock holders would get $0.

In retrospect it sounds obvious that if the company sells for less than the money the investors put in, your x percent is worth nothing. But it's easy to get carried away thinking you actually own a percent of the company, and that a sale means a pay day for you. Don't let the first word of acquisition get you too excited, the come down sucks.

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The segregation between common and priority stock can be painful. I learned about it the hard way after I left the startup and paid money to exercise the vested options. When the company was acquired, all the common stock was worthless (but the execs with voting power got millions of dollars of bonuses so they didn't care) which meant I had lost the money required to exercise the options.

What annoyed me more than the couple $K I lost from the options was the opportunity cost of not leaving the job earlier. Like all startups, the company paid below average wages (since startups pay a significant proportion of compensation in the form of options) so if I left earlier, I would have gotten a large pay bump from having joined a non-startup that paid a normal salary.

Another trick is hidden dividend accrual for preferred stock. The dividends are triggered at liquidity event, so the cap table you thought you were looking at suddenly gets diluted with a bunch of freshly issued stock which is still senior to common.

Pure evil. Which companies have done that?

From reading "Venture Deals" I got the impression it's something a big VC firm tries to negotiate on a fairly regular basis. See, for example, the "Dividends" section of Houzz round http://techcrunch.com/2014/06/02/houzz-on-fire/

TLDR: If you're an average Joe, the people holding the money bags are actively looking to screw you (while waving their philosophical hands and going "these are not the droids you're looking for").

>In retrospect it sounds obvious that if the company sells for less than the money the investors put in, your x percent is worth nothing.

that is what i've been wondering about. If going into startup i take a $50K/year salary hit wouldn't it mean that i'm actually investing $50K/year and thus should get the same quality and price of shares (not options) what the early investors do?

what should happen and what happens legally are two different things. though it's your choice to take that risk, no one is forcing you to work for sub market rates.

How did that happen? The acquirer just purchased a certain class of shares, i.e. preferred stock and didn't care about owning 100% of the company?

It's called a "liquidation preference". http://www.investopedia.com/terms/l/liquidation-preference.a...

The mechanics & technicalities are beyond me, but the consequence is as described above.

Basically, the investors (with preferred stock) get paid out first, sometimes at a multiple of their original investment. The amount "left over" goes to the common stock holders. Sometimes that amount is zero, so they get nothing.

I had this happen to me in a previous start up. I wasn't really surprised.

It works as follows, there is a line of people who need to get paid,

If the startup took on any debt, at the front of the line is a bank. Their 'note' usually gets paid first. $POOL -= $BANK

When people invested in the Series A, B, C, ... their stock came with a 'liquidation preference' (which can have a few variants, but the two most common are, the investor chooses if they want the liquidation preference or the common value, the investor gets their liquidation preference and the common value. Note that these numbers are in $dollars not in $shares, so if VC A puts in $1M dollars with a 2X liquidation preference they get back $2M dollars. $POOL -= $LIQUIDATION

Sometimes at the same level, or just behind the investors, are convertible note holders, who gave money or equipment in exchange for shares. They often have the choice of getting either their money back, or the shares. $POOL -= $NOTE.

At this point, if there is anything left in the pool it gets distributed to common shares.

A nice rule of thumb is that the most common liquidation preference is 2X (these days anyway) so if the price is < 2X the amount of money raised to date, the common stock will not have any money allocated to it.

And in those situations it makes no difference if your stock 100% vests on acquisition or not, it is still worth 0.

Tell me if I have this right: given a list of all the investors and note holders and their liquidation preferences, you can calculate a fixed dollar amount that gets subtracted from $POOL before it's divided up among the common shareholders.

In the example above, if you've got $2M in $LIQUIDATION and $NOTE is $1M, that means that common shareholders dreaming about buyout money should simply subtract $3M mentally from any sale price they hear.

That about it?

Yes, pretty much. It is always possible to work backwards from the capitalization table and the termsheets from previous funding and other notes, to figure out how much has to be subtracted off before common sees any return.

The implicit question is—where the acquisition allocates $0 to common, in what sense are the board of directors fulfilling their fiduciary duty to common shareholders in approving the deal?

Well, their fiduciary duty is to all shareholders and common generally holds a minority ownership interest.

It depends heavily on circumstances, but in a less than amazing sale the acquiring company often wants an incentive for employees to stay. So the acquisition offer will ensure that common gets nothing but they'll be covered by an earn-out over the next year(s).

As you can imagine the negotiation gets very tricky because investors do not generally participate in the earn-out.

This 2009 case from the Delaware Chancery Court seems on point: In re Trados Incorporation Shareholder Litigation (http://courts.delaware.gov/opinions/download.aspx?ID=193520)

The whole thing is well worth reading for anyone involved with VC funded startups. It involved an acquisition with a management incentive plan and preferences that together left nothing for common.

Among other things the court held that where there is a conflict of interest the board must prefer the interests of common shareholders over those specific to preferred (the interests of preferred over common being contractual). It also found that the board had acted procedurally unfairly and in several places suggested outright dishonesty. For those reasons it applied the harshest standard under Delaware law (entire fairness).

In the end however, it found that the company's value as an ongoing concern though not nothing, was not enough to overcome the large liquidation preference and cumulative dividend. Thus, since prior to the deal common stock was worthless a deal valuing them as worthless was fair within the meaning of Delaware law. Note that the litigation lasted 8 years, and at the end of the linked decision it was an open question whether the defendants were going to have to pay plaintiff's legal fees despite having won. (I couldn't find any information on what was ultimately decided there.)

You're not understanding the situation. The board isn't choosing where to allocate the money from the acquisition. The money goes to different classes of shareholders based on previously signed contracts.

Yes, but...

The board decides whether or not to take an offer and that offer includes a set of destinations of funds. In particular, the offer may be $Z = $X1 for retention bonuses and $Y1 for purchasing the equity. Or, the offer may be $Z = $X2 for retention and $Y2 for purchasing the equity. The management - who are likely on the board - may want more of the money to go to retention bonuses for senior execs, while the external board members may want more of the money to go to shareholders. And, in many cases, a board member may be involved in negotiating the deal with the acquirer and may push for a particular deal structure.

tl;dr - The board can have significant impact on how the funds get split up, regardless of the previously signed contracts.

If the startup took on any debt, at the front of the line is a bank. Their 'note' usually gets paid first. $POOL -= $BANK

Debt holders do not have priority when the debtor is sold, as the debtor remains in existence. Creditor priority generally matters only where an entity's debt structure is being altered, such as in a bankruptcy, liquidation, or debt restructuring. However, your example is correct if the bank held convertible debt, exercised the option to convert the debt to equity, and the converted equity carried a liquidation preference. (Note that "liquidation" shows up twice in this paragraph but the two usages have very different meanings. "Liquidation" refers to the termination of a corporate business and the distribution of its assets to its creditors and shareholders; "liquidation preference" refers to the maximum return a preferred stockholder may receive when it "liquidates" its holdings in a company as part of an exit event before the common shareholders or subordinated preferred shareholders receive their returns. In the Non-VC world, liquidation preferences are almost always fixed numbers; in the VC-world, liquidation preferences are usually multiples.)

It would be more accurate of me to say that "In my experience, banks require terms in their lending contract to a startup that results in their notes being paid before anything else."

Clearly there are legal regulations around a company going through bankruptcy and/or restructuring, however when an acquisition is occurring outside the structure of dissolution, which is to say the company is being sold to another entity while it is nominally a going concern, the bank's note may (and my experience does) have specific language to cover that situation and its primacy with respect to where the funds from such a sale might be disbursed :-). The good news is that can also keep a bank from "forcing" a company into default which starts to limit what options they have going forward.

I'm genuinely curious, is a 2x multiple really common these days?

All of the recent raises I've been involved in have been Non-Participating Preferred at a 1x multiple. Or at least capped. I was under the impression that was where everyone had sort of settled these days?

I'm basing this almost entirely off personal experience and the cooley report. http://www.cooley.com/files/104854_vf2014q2.pdf

That has been my experience too.

Suppose the following scenario:

A VC invests $10MM at a $100MM valuation and owns 10% of the company with preferred shares. For simplicity, we'll assume they are the only holders of preferred shares.

An employee is given $500,000 in common stock, equal to 0.5% of the company at the same $100MM valuation.

The company then sells itself to an acquirer for $11MM, substantially below the $100MM valuation. The VC, with preferred shares, gets paid first. So they get their $10MM back. The remaining $1MM would then be divided among common stock holders. The employee above would get $5,000, instead of the $55,000 that 0.5% of $11MM would imply.

In the real world, founders, executives, and VCs often get preferred shares, which ultimately screws regular employees.

Correct up until your last sentence. Founders & executives do not often get preferred shares.

I too have been in this situation. It was obvious that we weren't going to be a massive success, but it was still very disappointing to get zero.

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