Thursday, March 11, 2010

VCs & Starter Stock - Why & How to Ask for "FF Shares"

This blog post was inspired by a question I answered on Quora....

What is Starter Stock or "FF-Shares"
  • A class of shares separate from common stock that entrepreneurs can receive when founding a company.
  • These shares can be sold into a financing round allowing an entrepreneur to cash out a subset of their shares without impacting the value of common stock (which is usually worth about 1/4 the value of preferred and, if vanilla common stock is sold into a financing event would negatively impact option grant prices for employees)
  • Starter stock works by being a special share class that converts into preferred stock being sold at the financing event
  • This is a recent innovation, so some lawyers even at well respected firms may not know all the details about Starter Stock. Orrick is a law firm with a lot of expertise around Starter Stock. Ping me if you want an intro.

Why Would You Want Starter Stock?
Ooga Labs posted a good summary as to why every entrepreneur should want Starter Stock or FF-Shares. The gist of it:

You are going to be working your butt off for many years and your life will change a lot. Taking a small amount of money off the table in a big financing round will impact your life substantially with minimal impact to the company if done right.

Do VCs Support the Use of Starter Stock?
Starter stock is gaining more and more acceptance by the venture world, particularly if it represents only a fraction of the stock that the founder receives (e.g. 10-20%).

Some funds have embraced this wholeheartedly (e.g. Founders Fund) while others are slowly adopting it as more and more entrepreneurs ask for it (I recently helped one entrepreneur negotiate Starter Stock with a VC who had not done it before).

Unfortunately, a subset of VCs argue against Starter Stock, much to the entrepreneurs detriment, without real upside for the company (and hence the VCs ROI)

Arguments some investors make against Starter Stock are:

  • The entrepreneur should not have liquidity until everyone has liquidity (i.e. incentives should be aligned between entrepreneurs, employees, and investors).
  • The entrepreneur should be "kept hungry" to keep them working hard (I think this is really a bad way to think about it -see below)
  • The entrepreneur will get suddenly distracted by the wealth created from selling Starter Stock (since Starter Stock is only a fraction of shares, this is not true)

The arguments for Starter Stock are:

  • The board needs to approve sale of Starter Stock, so the investors will always have a say as to when, and how much of it, is sold
  • The average M&A exit takes 6.5 years. The entrepreneur will have major life changes during the time (e.g. may need to buy a house, send kids to school, etc.). The ability to cash out e.g. $1 million at a high valuation in a funding round allows the entrepreneur to deal with these life changes without forcing them to either leave the company or sell the company to make this happen
  • The majority of the founders net worth will still be in company stock (assuming the company is doing well enough to sell Starter Shares) and he or she will still be hypermotivated to increase the value of the company as much as possible
  • Ongoing financial pressure on the entrepreneur is typically a bad thing. There is a difference between "hungry" and "starving". You do not want the person running your company to eye their dwindling bank account in despair as they may start to act irrationally rather then focus on the long term success of the company.

If You Get Starter Stock, Do It Early
There are tax reasons to get Starter Stock as part of your initial stock grant. Talk with your lawyer to learn more (or, if they don't know much, ask Orrick)

Any entrepreneurs or investors out there who want to comment about their experiences with starter stock? :)

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