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Issue № 92

Rolling the Start-up Dice (A Survival Guide)

by Published in Business, Industry

A note from the editors: This article was written in collaboration with Lee Moyer.

What are you waiting for? Today is your day! Excellent opportunities available at amazing, fast growing internet start—up. We are looking for bright, energetic individuals… We offer pre-IPO stock options, highly competitive salaries, a casual environment, and much more!

Yes, it’s beyond your wildest imagination. Exciting work. A fast—paced and stimulating dot.com environment. The potential of untold wealth.

It’s like race—car driving. You too can be part of the pit—crew.

The unfortunate reality is a high percentage of internet startups don’t survive beyond two years, and even seemingly successful IPOs may deflate at the drop of a hat. Still, it’s a better gamble than Lotto, and if you decide to take the big plunge, we want you to learn as much as you can when you go into that interview.  Knowledge helps to make wise decisions.

How can you tell if the job is worth the risk? What are stock options really about? What other questions should you be asking, questions that look beyond “salary, benefits, and responsibilities?”

We’ve asked ourselves the same questions numerous times, and through our years of working with start—ups and established organizations, we’ve determined some essential points worth covering in your interview. Below we have compiled a list of the most telling questions and how they might be answered.

We might as well tell you right up front that, with few exceptions, internet start— ups are absolutely insane places to work. Spin—offs may be a little less unpredictable, but don’t count on it. We have worked for start—ups which have changed their product and audience focuses three times in a six month period,  repeatedly throwing the entire product development and marketing processes in disarray. We’ve witnessed quality people get hired and fired within the span of a two week period. We’ve seen managers unable to cope when a company grows from 4 people to 40 people in six months. Similarly, we’ve known CEOs who weren’t up to the task and didn’t have a clue. Long hours during evenings and weekends are the norm. If you work for a start up, expect to be very busy.

We’ve seen good things too; worked for honest and excellent managers; met really fabulously talented and hardworking people; and overall the experiences have been rewarding if for no other reason than the personal growth experienced.  Working for a start—up isn’t for the faint of heart.

Before you begin negotiations over a job, pay attention to your gut feelings. If you suspect you’re being lied to or manipulated, or you don’t trust the people with whom you are interviewing, look elsewhere. Trust and respect are the cornerstones in any employer/employee relationship. If you ignore your instincts, you may pay a price. Don’t be afraid to ask questions, and gauge the answers at least in part by your gut. It’s your future.

WHAT DO YOU WANT?

Before landing any job, it is important that you know what you want to take away from that job.

If you are expecting nothing else other than a paycheck, then don’t worry about stocks, vesting, cashless exercise, founder’s shares, etc. However, if you are looking for experience, knowledge, proceeds from an IPO and a glimpse over the cutting edge, get ready to do some research.

QUESTIONS ABOUT THE COMPANY

What is the company’s foundation? Who created it, what are the company’s goals,  and who stands to benefit most from your work? A perusal of a business plan can answer these questions quickly. If you are being wooed to help start a company,  it is important that you be granted founder’s shares. These are not options, but actual stock. They need never be purchased —— you own them. A company built on a crooked foundation will experience more problems than one based on equality and mutual support.

What is the company’s turnover rate? This is how fast employees come and go. If the rate is high, it may be a sign that employees aren’t happy, or that management doesn’t make good hiring decisions (which in turn can belie poor planning). One of us was hired supposedly with a supporting staff of three, and by the second week on the job, that support staff dwindled to one because the others were fired and were not replaced. There may be little data of this kind in the case of a new company, but it is still a worthwhile question. In a three— year—old start—up, it is not unusual for a 50% turnover rate, especially if you are in hot spot where the incentives for switching jobs are great. Hot spots are areas like Silicon Valley, Northern Virginia, Austin, or New York City.

How is the company financed, and how many rounds of financing have been raised?  A round is an occasion when a company receives investment money to support its start—up operations. Investors fall into three broad categories:

Friends and Family
Some companies hold a Friends and Family round of financing in the early stages of growth. These investors tend to bring important seed money and little else to the table.
Angels
Angels are wealthy individual investors whose connections are second only to their wallets in importance.
Venture Capitalists
A VC usually brings a lot of money and powerful connections to the table. See how much you can learn (on your own) about such a backer (try searching for the VC on the internet, talk with acquaintances already in the field, or ask people on your favorite list—serv what they might know). Are they respected in the Venture Capital field, and what is their track record? Have they invested in other companies that may offer synergies in partnership (try checking out the financiers web site to see what other companies are listed)? It is often in a VCs interest to link up several of his portfolio companies, that all may grow and create a greater return on his invested capital.

Keep in mind that the more financing that has been done and the more money raised, the less value is likely to be attached to a share of stock because of dilution (more about stocks below).

If the company is currently being funded through a bridge round, be cautious. A bridge round is often a debt instrument, and tends to be used by desperate companies raising just enough money to get them to the next valuation event,  such as a product release or partnership announcement.

Who sits on the Board of Directors? This is the group of shareholders whose responsibility is to safeguard all shareholder investments through diligent oversight. Their connections and knowledge are among the most important resources a start—up should have. VCs, Angels, and the company’s CEO are frequently on a Board of Directors. What are their backgrounds and what expertise do they bring to the company? Some board members are active and actually work to assist the company. Some are passive, and are of value to the company mainly because of their connections. If the company has a Board of Advisors, what are their skills? If no Board exists, is one being put together?

Who will lead the next round of financing? Will it be their current backer or some other group? How soon will the next round take place? How much cash will be on hand when the next round is being raised? The more cash on hand, the better a company’s negotiating position. Who else is on board to back the company financially in the next round: other financial groups, angels, or venture capitalists? The more interest in the next round, the better.

What is the company’s burn rate? In other words, how fast do they go through money each month? It should be relatively simple to determine how long the company has to live before a new infusion of capital is required. It is always important to remember that in most start—ups, your job is largely dependent on the fund—raising skills of your CEO and COO.

Who is in charge of fundraising, and who is in charge of daily operations?  Ideally these should be different people. Both jobs are crucial; each alone demands a person’s full attention.

What percent of the company is sales staff? A large percentage is often best. An understanding of sales is critical to a new firm’s growth.

If the company stock is still private, does the company view itself eventually making an initial public offering (IPO play) or entering into a merger or acquisition (M&A play)? A good answer could be “it depends on the situation.”  Immediately after an IPO, some companies have shown strong returns. Since a company, it’s founder/owner, and its investors can rake in a lot of cash from an IPO, there is likely to be an emphasis on hitting the IPO home run. Remember,  however, that an acquisition may be just as lucrative, so don’t let all the press about IPO successes prejudice you unduly.

HOW STOCK OPTIONS WORK (simplified):

When you are given stock options, you are actually being granted the option to buy stock in the company at a pre—determined price. Your stock option agreement should provide a time frame for when you will actually be able to exercise the option to purchase the stock. That purchase date is the date the stock is vested. If you lack the cash to purchase your vested stock, your contract may allow you the cashless exercise method. This gives you the ability to use a portion of your vested stock to acquire the remaining shares. Think of it as trading a portion in to get the rest. This is a fair way of letting employees (who might have taken a pay cut to work in a start—up) buy their vested shares.

You will be given a legal document describing the stock option agreement. Read it carefully.

Here is an example:

January 1, 2001: You start working for a company, and are given 10,000 stock options at a price of $1.00/share. The stock will become fully vested on January 1, 2004. On that date, or anytime thereafter (according to your agreement specifics), you will be able to exercise the option to purchase the stock.

At various intervals between 2001 and 2004, a pre—determined percentage of your stocks may vest. If it’s a three—year contract, as we may imagine in this case,  one third of the stock may vest on January 1 of 2002, 2003, and 2004. On each of those dates, or thereafter, you can exercise your option to purchase the available portion of your stocks. Or you can choose to wait in the hopes that the stock price will rise.

January 1, 2004: The last of your stock vests. It just so happens that the company stock is now worth $10.00/share. But according to your stock option agreement, to exercise your stock options you only have to purchase the stock at $1.00/share. So you pay $10,000 for the stock, and it’s automatically worth $100,000. You’ve just made $90,000 dollars.

Now, keep in mind that the stock price may remain low, the company might fail,  or you might get laid off. A lay—off is never a good thing, but a cashless exercise clause included in your contract may lessen the blow by allowing you to buy your vested stock as described above (also check your agreement). There are lots of caveats that could be included in your contract. It may or may not cover specifics such as being laid off before your stock vests, recourse if the company files for bankruptcy, and time—frames in these and other scenarios. Be sure you understand what situations are covered, and how the option process works in each of those situations.

If the company is bought out before all of your stock vests, your resulting opportunity (or lack thereof) is determined by your contract:

  1. If your agreement doesn’t state any conditions surrounding this circumstance,  your timeline for vesting your remaining shares may stay the same, or may be renegotiated by the new owners.
  2. If your agreement states that ALL your stock vests immediately in the case of a liquidity event. Your stock vests and you have the option to purchase it then and there. It is always best to have such a clause in your stock option agreement. Again, a cashless exercise (if available) can help you purchase your stock.
  3. If the company’s stock is still private (not traded on any stock market), and then they have an IPO, the price of the stock may skyrocket (depending on the type of business, at least for a while). It would be great if your stock vested at such a moment, rather than having to wait for some future vesting date, by which point to value of your stock may have dropped precipitously…

One other thing to keep in mind…the basic rules of investing still apply. In addition to the possibility of receiving stock options, you may also have the opportunity to purchase additional stock in the company. It is unwise to put all your eggs in one basket. Buying stock in the company you work for may, in hard times, leave you both without a job and holding a worthless investment. Been there, done that, got the tee shirt, the mug, the notepad, pencils, pens, the hat, all emblazoned with the corporate logo. The $1000 personal investment is now worth (at last count) $34. Ah, to be young…

HOW TO BETTER POSITION YOURSELF

How big is the employee stock pool (stocks reserved for employees as options)?  How much stock and how many stock options are in investors and employee hands?  How many hires does the company foresee in the next 6—12 months? The company will want to avoid excessive dilution of the stock pool, because this lessens the value of all stock. However, keep in mind that future hires mean anticipated growth, and isn’t necessarily a bad thing. Use these questions to determine what percent of the company you will own, and whether that percentage will be diluted significantly over time.

How soon will your stock options vest? Biannual vesting periods or tranches are the norm. The length of vesting is largely dependent on the industry and location of the company. Two years may be an ideal answer in a speed play (a company whose plan is a quick sprint to market), but four years is the norm.  Will stock options likely vest before or at a liquidity event? A liquidity event includes an IPO (if the stock is still private) or a merger/acquisition.

If the company wants you badly enough, or sooner than you’re normally willing to change jobs (e.g. without 2 weeks notice), will they vest a portion of the stock options immediately? Or will they give you a cash signing bonus?

OTHER NUTS AND BOLTS

Be sure to negotiate for your desired hardware/software (if applicable) before accepting a job. If you’re a designer and like working on a Mac, or an application developer who likes Linux, make sure you’re going to get what you want.

Have a lawyer go over any contract before you sign it. Consider crossing out all boilerplate verbiage unless you see it as essential to your agreement. Do NOT sign something you don’t agree with or don’t understand.

WHAT DO YOU BRING TO THE PARTY?

Any company that wants to hire you has probably seen your resumé. They may have a good idea about your skills, but probably lack an understanding of your connections. A start—up can be a meritocracy. If you can recruit your colleagues, know a group of angels, have good relationships in the press, are related to Investment Bankers or VCs, or hang out with possible partners for the company, you may find yourself one of the key figures in your company. These intangible assets can be as important, or more important, than the job for which you are hired.

CONCLUSION

These suggestions may seem like a lot of work, but if you neglect this now, you may have to deal with it later. In our experience, it is better to make an informed decision in the beginning, seeking help from friends and experts, than to deal with the fallout of a bad contract/situation down the road. If a friend is enticing you to become a co—worker, we would advise you to do your own independent investigation. Making a poor job choice is one thing, losing a friendship is another.

That said, keep in mind: even the best questions asked and answered in an interview still may not paint an accurate picture of a company. Yes, you could be lied to about turnover rate, funding, and everything else; like anything,  taking a job is a risk. Find out as much as you can, and pay attention to your gut feeling. One last bit of advice: without your interviewer standing by, try to talk with a couple of the current employees in the company to see what they think about their working environment and the company’s management team.

Remember: everything is negotiable. Choose your fights wisely.

The best of luck!

GLOSSARY

Angels — Wealthy individual investors whose connections are second only to their wallets in importance.

Bridge Round — Sometimes a debt instrument used by cash—strapped company to raise enough money to get them to the next valuation event.

Burn Rate — The speed with which a company goes through its capital.

Cashless Exercise — Trading in a portion of your vested shares to acquire the rest.

Dilution — The degrading value of a share of stock due to increased grants of stock options and founders shares, as new hires are made.

Employee Stock Pool — The amount of stocks reserved for employees as options.

Founder’s Shares — Actual stock (not options) granted to you when you are hired/promoted. Usually only given to the earliest and most valuable of employees.

Investment Banks — Banks which seek to invest in companies.

IPO Play — A company’s attempt to reach the point of making an Initial Public Offering (an initial offer of stock to the public).

Liquidity Event — An Initial Public Offering or a Merger/Acquisition.

M&A Play — A company’s attempt to be acquired by another company by Merger or Acquisition.

Rounds (of funding) — The number of times a company has raised investment money.

Seed Money — Money which is used to help start a company.

Singing Bonus — A bonus given to a new employee by their new employer,  immediately upon the signing of a contract with the new company.

Speed Play — A company whose plan is a quick (usually breathless) sprint to market.

Stock Options — The granting of the ability to purchase stock in a company, on or after a predetermined date, for a predetermined price. These are beneficial if the stock price has dramatically risen when the stock option is exercised.

Tranches — A biannual vesting period.

Turnover Rate — The percentage of employees who leave the company during a given period of time. Usually expressed as a percentage per year, or as low, moderate,  or high.

Valuation Event —Usually a product release, partnership announcement, or influx of capital.

Venture Capitalist — An investor or group which seeks to invest in start—ups and young companies, with the hope of significant returns when (if) the company succeeds.

Vest — The date you may exercise a granted option to purchase a company’s stock.  (Vested, Vesting)

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