1) Preferred vs Common
Historically there have been two types of stock: preferred and common. Preferred is for investors, common for everyone else including founders. When a company has an exit, preferred gets paid first before common. Investors in later rounds typically have higher preference. Two examples below recap how these dynamics work at a high level:
Example 1: a bad exit. A company raised $10M in the A, $20M in the B, and was sold for $25M. The B series holders get their $20M back, the A series holders get $5M, no one else gets anything.
Example 2: a good exit. A single investor bought 10M shares at $1 / share for a total of $10M in the series A. A single different investor bought 5M shares at $4 / share for a total of $20M in the series B. The company was sold for $250M, with 25M shares outstanding i.e., $10 / share. The B investor would get $50M (5M shares x $10 / share) which includes their $20M principal. The A investor would get $100M (10M shares x $10 / share) which includes their $10M principal. The common shareholders would then get $100M (250-50-100) back.
These examples are simplified on purpose since they are not factoring in many other variables like employee option pool (an amount of shares set aside specifically for future hires) or liquidation preferences (a 2x liq pref would mean an investor gets twice as much upon an exit).
2) Founder Shares
What people often call founder shares are actually versions of common or preferred that have become popular in the last few years.
F stock is common shares with very low purchase price since they are issued when the company is just getting started. So if a founder is issued 1M options at $0.0001 they are just paying $100 to exercise (purchase) them. Oftentimes F stock also contains provisions around right of first refusal (company has the right to buy them before the founder can sell to anyone else) and accelerated vesting (if the company has a change of control then the founder vests quicker). Mind you the tradition remains a monthly vesting, 4 years, 1 year cliff i.e., wait a year to get 25% and then 1/48 vesting per month.
FF stock have been popularized by Founders Fund and are preferred shares that can be converted into shares of a future round. Typically they are issued upon incorporation or immediately before a series A. Then the founder can choose to convert them into say series B shares, paying the price difference, and with the board’s approval.
3) Supervoting Rights
What a few entrepreneurs also do with Founder Shares is give them higher voting rights. This is essentially separating economic ownership from control. Example: a founder issues 1 F stock with 10x voting right, the investors own 4 shares, and the 5 shares are all the company has issued. Then the company is owned 75% by investors but majority controlled by the founder (10 votes / 14 votes total = 71%). Supervoting is a controversial provision. When it happens it is typically with a repeat entrepreneur (investors more comfortable) in a very hot deal (pressure to give in, otherwise investors miss on the company).
At Tau we believe balancing interests is the key to maximize the company’s success. One of our goals is that founders own ~50% of the company till series B. Another goal that is much harder to quantify is ensuring good governance. Startups are inherently risky endeavors and entrepreneurs almost by definition ambitious people. For real and recent stories of bad governance look no further than WeWork or Theranos. In both cases there are bad behaviors from founders which were enabled by the lack of safeguards or scrutiny from VCs. So whether you are doing a traditional common vs preferred, or more sophisticated provisions, or F and FF shares, caveat emptor: it’s not just about the good intentions but also the correct implementation.
Originally published on “Data Driven Investor,” am happy to syndicate on other platforms. I am the Managing Partner and Cofounder of Tau Ventures with 20 years in Silicon Valley across corporates, own startup, and VC funds. These are purposely short articles focused on practical insights (I call it gl;dr — good length; did read). Many of my writings are at https://www.linkedin.com/in/amgarg/detail/recent-activity/posts and I would be stoked if they get people interested enough in a topic to explore in further depth. If this article had useful insights for you comment away and/or give a like on the article and on the Tau Ventures’ LinkedIn page, with due thanks for supporting our work. All opinions expressed here are my own.