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Comment by american158931 | Hacker News Reader

Can someone help me understand...

Let's say an employee was granted 10,000 stock options at $1/share. They're all vested.

Does this mean that each share will be worth $9? So if exercised and cashed out, the employee would essentially earn $80,000 (before taxes)?

Trying to understand how the economics of all of this works.

Also, does this mean there are 300,000,000 shares? (How many shares do start-ups usually start with before funding rounds and what not? Seems like Square must've started with 100,000,000 or something.)

So many questions.

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It all depends on the start up. Some start ups have a lot of authorized shares and some have less. This is all reflected in the capitalization table (https://en.wikipedia.org/wiki/Capitalization_table) of the company. The cap table also contains information such as the number of preferred shares and different rounds of preferred shares (Series A, B, ...).

What people sometimes don't realize are the liquidation preferences on the preferred shares. The liq pref is usually 1-3x depending on who has the negotiating leverage. Out in SF, most liq prefs are 1x. This means on an acquisition, the investors get 1x whatever they invested first before any common shareholders get paid. This means that many acquisitions are not successful. A good recent example is Rdio (https://www.crunchbase.com/organization/rdio#/entity). They got acquired for 75M, but investors put in 126M. This means the investors lost money, but common shareholders (shares from stock options) got nothing.

A good scenario would be an acquisition where everyone makes money. A good recently example is Business Insider,investors put in 55M, but the company got bought for 343M easily clearing the investor liq pref (https://www.crunchbase.com/organization/business-insider#/en...). Employees with common shares also probably made a good amount as well.

One thing that also hurts employees are the AMT taxes that are associated with exercising the stock options before a liquidation event. In the examples above, employees have to pay taxes on the spread of the strike price to the fair market value of when they exercised. If an employee had a lot of shares, the taxes could end up quite high.(http://employeestockoptions.com/amttax/)

What you may not realize is that in a qualified ipo the prefs go away. It's basically the one time when prefs turn irrelevant. (there are still other shenanigans like ratchet to min price sometimes).

In practice the qualifier on the ipo means the prefs only vanish on a big (well above the pref stack) ipo number. But still an ipo is at the moment it's done on paper much better for common holders.

I'll answer what I can: First, you're correct on the valuation. If they are exercised and cashed out at the IPO price, the employee would earn $80k pre-tax. However, historically most IPOs are priced to get a "bounce" on opening day also there are usually restrictive covenants around the number of insider shares that can be cashed on IPO day. (This is meant to give investors warm fuzzy feelings about the stock.) In all likelihood the employee will have to wait some more time and will probably cash out closer to $10/share.

The Pricing and Valuation implies 300M shares. However there can be many classes of stock, both common and preferred that grant different rights and ownership. If they have different classes they could have a different number of shares, but the different share types are valued differently.

Shares are just objects granting different rights around the company within certain legal limits. (Ownership, Governance, Profit share, etc.) If you have agreement from the controlling body you can instantiate, remove, or restructure shares at any time. The point is that they could have decided with their bankers that 300M was a good number of shares to have at an IPO and decided to split or reverse split as part of the transaction. It has no bearing on the number of shares today or a year ago.

I guess what I'm getting at is something like this:

If you're given 1% of the company in the form of stock options as an employee, how can one get a grip on what that's worth should a company IPO? Like, if I came in as a high-level hire at Square. Early in the game. Jack gave me 1% of the company in the form of employee stock options. Now I'm vested. What would that mean to me now, after an IPO? How does one even begin to pick that apart if shares can be created or destroyed whenever?

Maybe I'm asking stupid questions. I'm just trying to understand since in my I'm constantly hearing numbers thrown around and, as a non-finance person, it can be hard to know what's really going on. (Which makes it easy to feel like I'm being taken advantage of.)

You would have been given an option to purchase an absolute number of shares, not a percentage. Let's say 10K. That may have been worth 1% when you were granted them, but as more shares are issued in subsequent funding rounds / IPO, your 10K will constitute a smaller percentage of the bigger pie. This is called dilution. You still have 10K shares, though, and they will still be worth $9/share at the moment the company IPOs. (And maybe significantly more or less after that moment. Typically employees have a wait a bit after an IPO before they can sell.)

They cannot be "destroyed" (under normal circumstances) once you are fully vested, although with certain types of options you may need to exercise (purchase) them if you were to leave the company, if you don't want to lose them.

The proceeds from your 10K options is easy to calculate once the company goes public: it's simply the stock price, minus what you have to pay to exercise the option (the strike price). Perhaps the trickier thing to calculate is taxes because of things like capital gains.

What I was saying with the "destroyed" was something like a reverse stock split. (Your proportional ownership stays the same, but your number of shares reduce.) The idea I was communicating that the number of shares itself is not a meaningful judge of anything unless you understand what those shares represent.

If covenants are not in place, you could also "destroy" the proportional ownership of shares by diluting down to a negligible value.

I guess what I'm saying is that people should always be sure they can trust management, ask for a cap table and probably consult a lawyer.

Stock reverse splits don't "destroy" value anymore than exchanging four quarters for a $1 bill. You do not have less value just because you own 1 unit instead of 4, because the value of the unit increased proportionately.

You can dilute proportional ownership, but there you just shifted the meaning of the term "destroy" and are using it in a funny way. Dilution does not decrease value. The reason your percentage of the pie decreases due to dilution is because the pie is getting bigger. You still have the same absolute amount of pie on your plate. Nobody destroyed any pie.

So I think you're mixing up my two points. A reverse split destroys the stock object, reducing the total number of shares but the proportional value remains the same. We both agree on this (per my previous comment).

Destroy can be used in both ways because language is context sensitive and the definition is somewhat broad. You can destroy value through dilution by getting less than you give. Example: If my company is fairly worth $100 and I own two shares and you own one, you own $33 worth of value. I can then issue my friend bob another share because he gave me a great lunch recommendation and I thought it was a big morale boost, something I can do because you don't have a covenant in place. My company is still worth $100, you now own one of 4 shares and only $25 worth of value. I have now destroyed $8 worth of your value. It's an ownership shift relative to the company, but a value destruction relative to you.

Effectively, yes. If an employee has 10,000 options with a $1 strike that means they can purchase 10,000 shares for $1 each. Since the shares are worth $9 the employee can then sell those shares immediately for an $8 profit, or $80,000.

As far as how many shares Square has, it's much more than 300k. That's just what they're offering to the public. That percentage is listed in their S1 filing somewhere

How many shares they started with. Who knows. Doesn't really matter.

I'm seeing reports that Khosla led a Series A round of $10 million at $0.22/share (http://www.cnbc.com/2015/11/09/square-ipo-will-net-big-win-f...). At a $40M valuation.

$40M/$0.22 = ~182 million shares at that point? So they've almost doubled the number of shares they started with if they're IPOing at 300 million shares. Does that sound like a reasonable bit of math?

At a $40M valuation, Khosla got 25% of the company at that time. They have $10m/$.22 shares or ~45M shares of the 182M shares you mention. They're netting $945M (sale)-$10M(invested)=~$409M.

Between Series A and IPO they had roughly 40% of their stake wiped out through dilution. (45M/182M=25%-> 45M/300M=15%) The dilution happened because, during that time Square issued 118M shares to investors in trade for the investor money. The company valuation at each round was determined by: Investment/shares issuedTotal shares outstanding after transaction.

A lot of startups start with 10m or 15m

Feels like an insane amount of dilution for early employees.

Just ignore the extra zeros.

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