by Scott Kupor
So why don’t all companies issue ISOs only?
Well, there are a few restrictions on ISOs, including the fact that there is a limit of $100,000 of market value that can be issued to any employee within a single year. Of course, it is a good “problem” for an employee to have such a highly valued option grant.
ISOs also have to be exercised by the employee within ninety days of the employee’s leaving the company. As companies are staying private longer, this can create challenges for departing employees. They may have ISOs that have appreciated, meaning that the value of the stock is much higher than the exercise price, but to exercise the stock requires that the option holder pay out of pocket for the exercise price. This can prove to be cost prohibitive to many employees and thus they could be confronted with the need to let the options expire unexercised, leaving a bunch of money on the table.
As a result, more companies have been extending the post-termination option exercise period from ninety days to a longer period of time, often as long as seven to ten years. This has the negative effect of automatically converting ISOs into NQOs (because it violates the ninety-day post-termination rule that is required of ISOs), but still gives employees a much longer window in which to exercise their stock options post-employment.
We talked about vesting of stock options in the context of founders, but it’s equally applicable to the broader employee base. Remember after all that stock options are intended to be long-term incentives for employees to remain at the company, different from the short-term nature of a base salary or cash bonus.
Most startup stock options vest over a four-year period. There are various bells and whistles that can apply to stock options, but the most common we see is a one-year cliff vest—meaning that if the employee leaves before the first anniversary of her employment, she vests nothing—followed by monthly vesting over the next three years at a rate of one thirty-sixth per month. Thus, at the end of a four-year period, the employee is free to leave and take her vested stock options with her.
The New Normal for Longer IPOs
But why four years, and what do we do after that, presuming we want the employee to stick around? Well, four years is really an anachronism from the days in which companies went public in about four to six years from founding. The theory was that the average employee might join the company somewhere in the first few years post-founding, and she would have the ability to sell her shares in the public market as the options vested; with a shorter time to IPO, most employee options fit into this paradigm.
But as we talked about earlier, the time to IPO for most startups has substantially elongated, in many cases ten or more years from founding. So this introduces complexities with vesting that modern entrepreneurs need to grapple with.
So what happened along the way to getting to a much longer time to IPO for venture-backed companies?
First, the facts: About two decades ago (from 1998 to 2000), we used to have around three hundred IPOs per year. Since then, that average has fallen by more than half, to a little more than one hundred per year. As a result, the number of publicly listed stocks in the US has declined by 50 percent over the last twenty years.
In addition to the total number of IPOs declining, the type of IPO candidates has changed as well. “Small-cap IPOs”—companies with less than $50 million in annual revenue at the time of initial public offering—have declined over this same twenty-year period from more than half to just a quarter of all IPOs; more money is being raised for bigger versus smaller companies.
While the trend is clear, how we got here isn’t. Experts and those who study this sort of thing actually have differing opinions about why the dearth of IPOs, with theories ranging widely, as follows.
1. It Costs Too Much Money to Go Public
Post the dot-com bubble, the US Congress passed in 2002 the Sarbanes-Oxley Act. This legislation was designed to increase the robustness of financial disclosures from public companies to ensure that shareholders were well-informed about the true financial state of public companies. Sarbanes-Oxley was well-intended legislation but also had the effect of increasing the costs of going public and being public, mostly through additional internal financial controls and reporting required under the legislation.
Thus, the argument goes, fewer companies choose to go public because of the increased costs of regulatory compliance. And those that do go public wait until they are much larger so that they can amortize these costs over a much higher base of earnings. More importantly, dollars spent on regulatory compliance are dollars that could have been devoted to early research and development investment. This is particularly relevant for venture-backed companies, as they spend a significant amount of their expenditures on engineering development.
2. Efficiency Rules Disproportionately Affect Smaller Companies
In 1997, the SEC began promulgating various rules—Regulation ATS (Alternative Trading System), Decimalization and Regulation NMS (National Market System), etc.—designed to increase the trading efficiency of stocks. The goals were laudable: basically, the SEC wanted to increase the overall efficiency of the stock market by creating more competition and thereby reducing the costs of buying and selling stocks. And it worked: the US equities market, as a whole, is highly efficient and liquid.
But this very efficiency has disproportionately affected the trading dynamics for companies that have smaller capitalizations and therefore lower trading volume. The various rules made it cost prohibitive for those who play an important role in facilitating trading of small-cap stocks—these players include research analysts who publish information about the companies, traders who take positions in the stock, and salespeople who market the stock to institutional investors—by reducing the profits associated with those activities. As a result, the small-cap trading market is anything but liquid. And small-cap companies are loath to go public for fear of being stuck in an illiquid trading environment where it’s very difficult to raise additional capital in the public markets to grow their businesses.
3. Mutual Funds Are Bigger, and Therefore Like Bigger Companies
Mutual funds, such as Fidelity and Vanguard, are the major way that most people access public stocks. The funds get paid based on the total amount of assets they are managing, so the larger the asset base, the more money they get. And the amount of assets being managed by the mutual fund industry has indeed grown: sixteen times from 1990 to 2000 (reaching $3.4 trillion in assets) and another five times since 2000 (topping $16 trillion in assets in 2016).
Why does this matter? When mutual funds get big, they are motivated to focus on large-cap, highly liquid stocks because they need to be able to put large amounts of money to work in individual stocks. Doing so in smaller capitalization stocks just doesn’t scale very well. As a result, mutual fund holdings tend to be concentrated in large-cap companies at the expense of small-cap ones.
4. There Are Alternative Forms of Private Financing Out There
We’ve of course been talking in this book all about venture funds as the primary funders of startup companies. And that is true. Over the last five years, though, as startups have been staying private longer, the landscape of private investors that now invest at the later stages of a private company’s development has increased to include public mutual funds, hedge funds, private equity buyout firms, sovereign wealth funds, family offices, and even traditional endowments and foundations. This availability of private capital, some argue, has supplanted the need for companies to go public.
The phenomenon is real, but it doesn’t answer the question of cause and effect—that is, have public market investors entered the private markets because companies are choosing to stay private longer and delay entering the public markets? Or, if going public were more palatable to private companies, would they in fact choose to go public and obviate the need for these large, private rounds? While it seems to be a bit of a chicken-and-egg question, the data point toward th
e former, as the average age of companies from founding to IPO started increasing (from six and a half to ten and a half years) and the annual number of IPOs started decreasing years before robust late-stage private financing became available.
5. There’s Too Much Pressure on Public Companies These Days
The lack of IPOs has also been partly blamed on the rise of activist investors. These are investors who purchase stock in a public company and try to agitate for change designed to increase the value of the stock. Such changes often include introducing new board members, who in turn can make changes to the leadership of the company. So why navigate these public company pressures if there’s enough capital available in the private markets to stay private longer?
Staying Private and Staying Motivated
Regardless of how we got here, the critical thing for you as a founder to think about is that it’s likely that you will be a private company for substantially longer than you might anticipate. As noted above, it’s likely that you will be private for ten or more years.
So if it takes that long to get the company public, we presumably want good employees to stick around longer to help get the company to that milestone. Thus, the whole idea of whether a four-year vest still makes sense is up for debate. But knowing that it’s hard in a competitive employment market for startups to be out of market by introducing longer vest periods, we don’t often see companies extending the vest period.
In lieu of longer vest periods, however, most companies utilize some form of refresher option grants for high-performing employees. That is, perhaps at the end of year two (when half of the employee’s original stock option grant has vested), the company may award her a new option grant that will vest over a four-year period from the new grant date. Thus, good employees may often have some amount of options always continuing to vest, providing a greater economic incentive for longer-term retention.
While the “refresher” grants are often smaller than the initial grants, Tesla has been rumored to have turned this a bit on its head. Tesla’s view is that we know least about an employee’s capabilities when she is first hired; after all, most companies rely on interviews, which research has shown to be largely not predictive of an employee’s ultimate success in a company. We know a lot more about the employee once she has actually started working in the company, producing (or not) value to the organization. Thus, Tesla generally provides smaller stock option grants to its employees upon hiring and, for top-performing employees, grants increasingly larger amounts of options as part of their refresher program.
All right, we’ve now formed our C corp and have figured out the initial allocation of equity among our cofounders and the employee option pool. Time to raise money from a venture capitalist. For half of you reading this, that phrase gets you fired up and excited. For the other half of you, you just broke out in a nervous sweat. Don’t worry—I’ll walk you through it and offer up truth, transparency, and insight that, I hope, will help your next meeting with a VC go smoothly.
CHAPTER 7
Raising Money from a VC
Before you get too excited thinking this is where I give you Marc Andreessen’s secret email address, this chapter simply asks the fundamental questions: Should you raise venture capital? If so, how much? And at what valuation?
Once we’ve covered that, in chapter 8 we will get into the more prescriptive (and, for some, sexier) how-to approach of pitching to a VC.
But you’re not ready for your pitch until you know what you want, how much, and why.
At first blush, the answer to these questions seems fairly obvious—raise as much money as you possibly can at the highest possible valuation in order to grow your business. John Doerr famously compared fund-raising to attending a cocktail party. When the waiter comes around with the tray of mini hot dogs, you should always take one. The reason being that you never know when in the course of the remainder of the cocktail party the waiter will make it back to you. In similar fashion, the right time to raise capital is when the capital is available; who knows if the fund-raising waiter will ever make it back to you when you decide you are in fact ready to raise money.
But let’s talk first to see if you’re even at the right cocktail party . . .
Is Venture Capital Right for You?
Let’s start with the decision to raise money in the first instance, and specifically, since you’re reading this book, the decision to raise from VCs. Hopefully you now have a better sense of the “company–venture capital fit” for your business. Just as with product-market fit—where we care about how well your product satisfies a specific market need—you need to determine whether your company is appropriate for venture capital.
We talked earlier about the cardinal rule of VC investing: everything starts and ends with market size. No matter how interesting or intellectually stimulating your business, if the ultimate size of the opportunity isn’t big enough to create a stand-alone, self-sustaining business of sufficient scale, it may not be a candidate for venture financing.
Rules of thumb are overgeneralizations and crude ways to simplify complex topics, I admit. But, as a general rule of thumb, you should be able to credibly convince yourself (and your potential VC partners) that the market opportunity for your business is sufficiently large to be able to generate a profitable, high-growth, several-hundred-million-dollar-revenue business over a seven-to-ten-year period.
There is no magic to any of these numbers, but if you think about what it takes to become a public company, these financial characteristics (at least in today’s market) could support a public market capitalization of several billion dollars. Depending on the VC’s ultimate ownership level of the company at this time, the returns to the VC on this investment should be meaningful enough to move the needle on the fund’s overall economics.
What If Your Market Isn’t Huge?
So, what if the market opportunity just isn’t of that scale? That doesn’t make you a bad person or your business a bad business. It’s unfortunate how many founders can feel that way. You could be running a multimillion-dollar business with great profits and be living a happy, wealthy, influential life. Your business might be helping people, enriching lives or even saving them, and still not be the right fit for raising VC. All that means is that you might need to think differently about where and how to raise capital, and come up with a different approach.
For example, there are smaller VC funds (often with less than $100 million fund sizes) that do invest very early in companies and for which the business model is to exit companies largely through acquisitions at lower ultimate end valuations. That type of firm might be more appropriate for your opportunity if the market size can’t support a stand-alone business. Not every small fund adopts this strategy; there are many angel and seed investors who, despite their smaller investment amounts, are also playing the at-bats-per-home-run game. So make sure you understand the core strategy of your potential partner up front. And we talked earlier in the book about debt financing from banks as well as another potential source of capital in such situations.
The point is simply that venture capital may not in all cases be the right source of capital for you. It might not be the right tool for the job.
What does that mean? Well, as you’ve hopefully learned from reading this book so far, VCs are people, too, and they respond to the incentives that are created for them. Those incentives, simply put (and boiled down to financial ones only), are:
To build a portfolio of investments, with the understanding that many will not work (either at all, or will work only with constrained upside) and a small number will generate the lion’s share of the financial returns for a given fund; and
To further turn those large financial returners into cash within a ten-to-twelve-year period so that the cash can be paid back to their limited partners, with the hope that the limited partners will then give that cash back to the VCs to play the g
ame again in the form of a new fund.
That’s the venture cycle of life we discussed earlier.
And even if your business is appropriate for VC (because of the ultimate market size opportunity and other factors), you still need to decide whether you want to play by the rules of the road that venture capital entails. That means sharing equity ownership with a VC, sharing board control and governance, and ultimately entering into a marriage that is likely to last for about the same time as the average “real” marriage. (It turns out that eight to ten years is about the average length of real marriages in the US . . . make of that what you will.)
How Much Money Should You Raise?
Now, assuming you made the decision to raise venture capital in the first place, how much money should you raise? The answer is to raise as much money as you can that enables you to safely achieve the key milestones you will need for the next fund-raising.
In other words, the advice we often give to entrepreneurs is to think about your next round of financing when you are raising the current round of financing. What will you need to demonstrate to the next round investor that shows how you have sufficiently de-risked the business, such that that investor is willing to put new money into the company at a price that appropriately reflects the progress you have made since your last round of financing?