entrepreneurship

This page is based on personal experience, and is based on what I know of American tax law. I am not a lawyer, however, and can not claim that this information is currently accurate. Use it at your own risk.

• Terms to know
• Cash flow & liquidity of stock and options
• Tax implications of stock vs. options
• Big “gotchas” of taxes around stock and options.
• What happens if the company never goes public?
• What happens if new stock is given to new investors?
• What if the company gets bought out while I own stock or options?
• How much should I ask for?
• They offered me 3,000 options. Is that a good deal?
• Does the company care if they give me stock or options?

Terms to know

stock	Ownership of part of a firm.
options or ‘non-qualified’ options	The right to buy or sell stock at a predetermined price. For example, you might have an option that gives you the right to buy IBM at $100/share, even if it’s selling for $150/share..
strike price	The price at which an option lets you buy stock. In the above example, $100 is the strike price of the options.
market price	The price at which stock is selling on the open market. In the above example, $150 is the market price of IBM stock.
vesting	You rarely receive stock or options all at once. Rather, you receive shares/options as you meet certain milestones. Stock whose milestones you’ve met are considered “vested.”
vesting schedule	The schedule over which shares or options vest. Often, a person receives a certain number of shares each quarter or each year. A typical vesting schedule might be, ËYou receive 10,000 shares over 4 years. 2,500 shares vest on your first anniversary, and the remaining 7,500 shares vest in equal monthly amounts for the following three years.Ó
dilution	When new shares are issued in a company, it ËdilutesÓ the value of the existing shares. For example, if you own 100 shares of a company with 1,000 outstanding shares, you own 10% of the company. If the company issues an additional 1,000 shares to investors, there are now 2,000 outstanding shares. Your 100 shares are now only 5% of the company. This is called dilution.
registered shares	When a company is public, its shares are registered with the SEC. Private companies issue non-registered shares, which often can’t be sold or turned into money.
incentive stock options (ISOs)	Options which get special tax treatment: they create no tax event when exercised, but are taxed when the stock is sold. if the stock is held for more than a year, they are taxed at the long-term capital gains rate, rather than the normal income rate. When exercised, ISOs can subject the owner to the “Alternative Minimum Tax,” which can be substantial.

You can get paid in stock or in options. If you get paid in stock, you actually receive shares of a company’s stock. If you get paid in options, you receive the right to buy the stock later, at a set price. If the stock is selling on the open market for more than the strike price, you can exercise the option, buy the stock for the strike price, and then sell it immediately for the market price, pocketing the difference as profit. The lower the strike price, the more profit you make.

Options are often issued with a strike price equal to or 10% lower than the market value of the stock at the time the options are issued. That means that the maximum profit the option holder can realize is movement in the stock price after the time options are issued.

Cash flow & liquidity

With stock, there are no cash flow concerns. Once you own the stock, you own it. With options, however, you need to come up with the money to exercise the options. This isn’t always easy. If you have 10,000 options with a strike price of $5, it will require $50,000 to exercise those options and buy the underlying stock.

“But why is that a problem?” I hear you ask. “After all, you’d only exercise options if the stock were selling for more than the option strike price. Can’t you then just sell enough of the stock to cover the $50,000?” Ah, if only it were that easy…

Liquidity

You can’t sell stock in a non-public company. So unless your company is publicly traded, the stock you get (either directly or by exercising options) is just pieces of paper, unless the shareholder’s agreement gives you permission to sell it to third parties. Rarely—and never in a venture backed by professional investors—will you be given that ability.

As I write this (8/99), there is also a holding period on shares of stock in non-public companies. The holding period can range from 6 months to 3 years. Even if the company goes public during that time, the holder of pre-public shares can’t sell until their holding period expires. The intent of this is to prevent monkey business in which insiders are allowed to purchase pre-public shares immediately before an IPO and then turn right around and sell them. In fact, there is currently a strong movement in congress to eliminate the holding period.

[Author’s editorial opinion: eliminating the holding period will probably encourage all kinds of game playing and profit-taking. Philosophically a believer in businesses being value-creators, rather than transient-paper-profit creators, I favor keeping the holding period. Yet as someone who may someday be in a position to benefit from its elimination, I find my principles put sorely to the test.]

Tax implications

To make matters worse, taxes can cause a cash flow issue in all of this. Here’s a summary of how the taxes work:

	early tax hit	later tax hit
options	When you exercise the options, the difference between the option strike price and the market price of the stock is treated as normal income, taxable at your full tax rate.Your full tax rate can be quite high, once state and federal are both taken into account. For example, if you exercise 10,000 options to buy XYZ at $5, when the stock is selling for $7, that counts as $20,000 of taxable income even if XYZ is a non-public company.	When you sell the shares you acquired by exercising your options, any up or down movement in the share price since the date of exercise counts as a capital gain or loss. Capital gains/losses are taxed at a much lower rate than ordinary income. If you later sell your XYZ shares for $9, that counts as a $2 capital gain (the fair market value was $7 when you acquired the shares).
incentive stock options	No tax hit when exercised. Possibly subjects you to the alternative minimum tax (AMT).	When you sell the shares, the difference between the strike price and the share price is taxed. If the shares have been held for less than a year, the normal income tax rate is used. If they have been held more than a year, the capital gains rate is used.
stock	If you are receiving actual stock shares that vest, the moment they vest, the amount vested becomes treated as normal income, taxable at your full tax rate.	When you sell your shares, you realize a capital gain or loss on any movement in share price from the time that you acquired the shares.

The big "gotcha" type tradeoffs:

If you want compensation that vests over time in a private company, stock may be a poor choice. As each block of stock vests, it constitutes taxable income equal to the fair market value of the stock at the time of vesting (not at the time the contract is written). So if the company is doing really well, the 5,000 shares that vest this quarter could be worth $10/share, giving you $50,000 of taxable income. But since the company is private, you can’t sell the shares to pay the taxes. You have to come up with the cash to pay the taxes some other way.

Options are more palatable, but they introduce a quandry. In a private company, you would like to exercise your options as soon as possible. You will start the liquidity counter ticking early, so your holding period will be over by the time the stock is tradeable. And if your options are not incentive stock options, they will generate a normal income tax rate hit. You also want to take that hit (which happens at exercise time) on as low a stock value as possible, and have most of your gains happen as a capital gain or loss.

But on the other hand, you might not want to exercise your options until the company goes public. The shares you receive from the exercise will be fully liquid, and you can trade them immediately. But your entire gain (market price minus strike price) will be taxed as normal income. That can be a huge incremental tax burden.

Whether to exercise options while a company is still private is a complicated, individual question. The answer depends on your regular tax brackets, your capital gains brackets, how long you think it will be until the stock goes public, and how much money you have to pay taxes on the options exercise.

Other Questions

What if the company never goes public?

Well, then you have to find someone to buy your shares if you want to make any money off them. Sometimes the shareholder’s agreement will let you sell your shares to anyone, while other times it only lets you sell your shares back to the company or to other shareholders.

What happens if more stock is issued to give to new investors?

Your shares get diluted. If you are in a very powerful negotiating position, you may be able to get an anti-dilution provision, which lets you maintain your percentage ownership in the firm even when new shares are issued. If this is your first job out of college, don’t bother asking.

What if the company gets bought out while I own options or stock?

This depends on your agreement and the terms of the sale. An IPO or acquisition can drastically change a company, effectively making it a different place than you signed up to work in originally. If you can swing it, the safest thing to do is to require that your options or shares vest immediately upon a public offering or acquisition.

How much should I ask for?

As much as you can get. A few very, very rough rules of thumb: by the time a company goes public, the VCs and investors will own around 70% and the original owners and employees will own around 30%. What matters is not how many shares you have, but what percentage of the company now and at IPO/acquisition time you own.

If you believe that the company will be worth $100,000,000 someday, and you will own .5% of the company at that point, your share will someday be worth $500,000. If you took a $20,000 pay cut for 5 years in exchange for that equity, you essentially exchanged a guaranteed $100,000 salary for a risky $500,000 in stock. It’s up to you to decide if that tradeoff is worth it.

Think this through! I have seen people take a $30,000/year pay cut in exchange for stock that was worth $60,000 after two years. They effectively traded salary for equity without getting enough stock to compensate them for the risk they took or for the fact that it took two years before they saw the money.

Keep in mind that subsequent funding rounds will dilute you. What matters is the percentage you own when the company goes public or is acquired. The percentage you own today may be less relevant.

They offered 3,000 options. Is that a good deal?

Maybe. It depends what percentage that is of the company. If there are 30,000,000 outstanding shares, you’ve been offered .01% of the equity. If the company is the next AMAZON.COM, you’re set for a lifetime if you’re a careful investor. If the company is Joe’s Garage and Fried Chicken Joint, you might want to reconsider. (See the essay on Equity Distribution to get an idea of what percentages are good percentages.)

Remember: it’s the percentage you own, not the number of shares that matters! If they say they can’t reveal how many shares are outstanding, or won’t tell you what percentage ownership your shares represent, run, don’t walk, in the opposite direction. You are investing your time and reputation with the company. Any aboveboard company would instantly reveal those numbers to a monetary investor. If they won’t reveal them to you, it’s probably because they are making a lousy offer.

Without knowing the percentages, you can not evaluate the value of your options. Period. Companies split their stock immediately before going public, or they reverse-split their stock, to adjust the share price. You may have 30,000 options today, but a pre-IPO reverse split of 1-for-2 will leave you with just 15,000 shares after the IPO. (This happens. It’s rare, but it happens. Two companies whose IPOs I’ve been privvy to had pre-IPO reverse splits. One was 2-for-3, the other was 1-for-2 reverse split.)

Once you know what percent you own, find the value by multiplying the expected company valuation by your percentage ownership at IPO. Remember that the IPO itself dilutes all shareholders. Then multiply the result by 2/3 to find out how much you’ll have once you’ve paid your taxes.

I’ve heard companies say, “The percentage doesn’t matter. After all, regardless of percentage, 3,000 shares when the stock hits $100/share, is $300,000.” True. But how do you know that 3,000 shares today will still be 3,000 shares at IPO? And what would the whole-company valuation have to be to justify a $100 per-share price? That’s why it makes more sense to talk company valuation and percentage ownership at IPO.

Does the company care if they give me stock or options?

They may, but if they do, it is only because of the accounting treatment or administrative overhead of giving out stock. Either way, they are giving you ownership or an option of ownership in the company.

How likely are you to go public, anyway?

“We have the greatest e-commerce idea in history. We’ll be the Amazon.com and e-bay of industry X. We plan on raising venture capital in the next three weeks, and we will have our initial public offering within 18 months…by the way, do you know where we could find some good technical people, and maybe a CEO?”
—Several anonymous entrepreneurs

The sentiment I hear from new entrepreneurs is wonderfully optimistic. Incredibly inspiring, visionary, and touching. It’s especially touching in its naivete. Here are some statistics forwarded from a friend of mine in the financial services industry. Think about them before you blithely declare your intent to IPO in the next 18 months…

The number of listed companies is:

NYSE – 3,088
NASDAQ – 4,895
AMEX – 786
TOTAL 8,769

Interesting Fact There are currently 10,719 mutual funds available for investment, almost 2,000 more than there are stocks to buy!!

The number of IPO’s over the last several years:…

This article is continued in the Entrepreneur’s Companion volume 1. Click here to purchase.

Taken from a write-up I did for Wharton’s entrepreneurial community

Rather than attempt a comprehensive write-up of creating a new venture, which would fill several books, here are some practical, immediate tips you can apply. At the end of this article is a URL you can use to ask further questions, publicly or privately.

DISCLAIMER: I’m an angel investor and coach, not a VC. The below is based on my experience reading and responding to business plans. I can’t guarantee that VCs pay attention to all the same things.

• Tips on opportunity recognition
• Tips on writing the plan
• Tips on implementation & life

What investors are looking for in a plan

Investors—whether angels or VCs—are looking for the same things when reading a business plan. They want to know how big the opportunity is, whether this is the right team to exploit the opportunity, who the competition is, what the risks are, and why they can expect this team to implement successfully.

Your job in writing the business plan is to address these questions convincingly and clearly.

Also make sure to check out Notes from a VC Panel Discussion.

Tips on Opportunity Recognition

The size of the opportunity depends on the market

“Opportunity size” is a very rough concept; there is no precise definition. You can think of it as roughly the number of potential customers times the expected percentage who can be captured as customers times their average purchase times their average purchase frequency. You can find huge opportunities by selling small things to many people over and over, by making huge sales to a few people, or anywhere in between. Know why your opportunity is the size that it is.

For example, RenalTech is a company which manufactures filters for dialysis machines. There are 320,000 people on dialysis in the United States. If they know how many filters per year those patients use, multiplied by the price per filter, they can have some idea of the size of their opportunity.

Choose a huge market

Especially in the internet world, venture capitalists are looking more at the market than at the detailed specifics of your financials. Choose a market that is big enough to be an obvious good opportunity.

A business which targets teenage girls who listen to music and has a reasonable chance of capturing 90% of the girls that are online is a huge opportunity. A business which targets net-savvy SAAB mechanics who need prosthetic limbs is not.

Find a business with great fundamentals

Choose excellent business models which have sound business fundamentals:

• lack of competition
• recurring revenues
• low fixed costs
• low asset requirements
• a compelling reason other than “brand loyalty” why customers will stay with you once they join

If your business requires $30 million worth of advertising on an ongoing basis to keep bringing people back to the site, make sure to factor that into your pro formas.

You can think of product ideas as being either candy, vitamins, or pain killers. Candy is fun, but a luxury. Vitamins keep you healthy. Pain killers ameliorate an immediate problem. VCs like to invest in pain killers. If possible, addictive pain killers. People in pain are strongly motivated to buy, which isn‘t necessarily true of people buying vitamins.

If you like risk, ignore the fundamentals

In late 1999, plans don’t need a sound business model to attract capital. Plans with no business fundamentals and inexperienced 27-year-old management are raising money with valuations of $12 million. The IPO market is also going crazy: WebVan just went public on revenues of $395,000, losses of $35.1 million, and they have a market capitalization of $8.45 billion.

The market’s faith is keeping these valuations afloat, betting that (a) losing huge money building a brand will someday turn into much huger profits; and (b) someone will buy the business for its strategic/intangible value, rather than its cash-generating value.

If you’re comfortable making those bets, go for it. And of the 60,000 companies started this year, one or two will likely see those bets pay off.

Know why customers stay

If you show growing revenues year after year, but your customers have no natural reason to stay with you beyond a single purchase or two, think through why you expect the revenue number to grow. Are you somehow encouraging more purchases, or are you managing to attract completely new customers to fill the shoes of old ones?

Prepare to throw several ideas away

Discard non-superb ideas, ruthlessly. VC firms read 10,000 business plans a year to find 20 good investments. Warren Buffet waits years to find a single investment that meets his standards. You’re investing your time, energy, and reputation for years. You own it to yourself to have high standards.

Many entrepreneurs get an idea or two, latch onto them, and then rationalize away any serious holes in their plan. If you don’t go through a couple of ideas before settling on one, you’re either very lucky or your standards for a good opportunity are too low.

Research the competition, even in the pipeline

At the very least, do an internet search for similar ideas and companies. There are few things more embarrassing than presenting a business plan for a “new concept” only to find that concept up and running elsewhere.

And remember, there may be competitors who haven’t launched, yet. Have a plan to deal with the possibility that such competitors will crop up.

You always have competition.

Your competitors aren’t always in exactly the same business; they may not even be companies. Scott Cook, founder of Intuit (maker of Quicken) defines the competition for Quicken as being a pencil and paper checkbook. And using that definition, Scott has built a company that has dominated every financial software market it has entered.

To find your competition, ask the question: if people don’t have our product/service, what will they do instead to meet their needs? That is your competition.

Tips on Writing Your Plan

Let your elevator pitch drive…

This article is continued in the Entrepreneur’s Companion volume 1. Click here to purchase.

Boston Business Journal, Sept. 2003

Stage 1: you have an idea. Stage 2: you’ve developed the business. Stage 3: you’re making money, it’s for real, you’re successful … so why is everything sudden chaos? This article helps you understand that Stage 3 entrepreneurship requires real changes in how you do business.

Read the full article in Boston Business Journal at
http://www.bizjournals.com/boston/stories/2003/09/22/smallb2.html.

Boston Business Journal, Dec. 2003

Thinking of going into business with friends and family? Think twice. It may not be the smooth ride you imagine. Read Stever’s Boston Business Journal article Think Before Mixing Business, Buds, and Blood.