{"id":6913,"date":"2016-07-14T15:49:44","date_gmt":"2016-07-14T15:49:44","guid":{"rendered":"https:\/\/www.monsterindia.com\/career-advice\/the-basics-of-equity-stakes-shares-that-every-startup-entrepreneurs-should-know-6913\/"},"modified":"2023-03-29T10:50:09","modified_gmt":"2023-03-29T05:20:09","slug":"the-basics-of-equity-stakes-shares-that-every-startup-entrepreneurs-should-know","status":"publish","type":"post","link":"https:\/\/www.foundit.sg\/career-advice\/the-basics-of-equity-stakes-shares-that-every-startup-entrepreneurs-should-know\/","title":{"rendered":"The Basics of Equity, Stakes & Shares that every startup Entrepreneurs should know"},"content":{"rendered":"\n

Alok Kejriwal is one of the mentors on\u00a0MakeIndiaWork – the startup ecosystem<\/a>\u00a0by MonsterIndia.com to support and encourage startups. Here Alok shares the basic of equity,stakes & shares.<\/span><\/p>\n\n\n\n

 <\/em><\/span><\/p>\n\n\n\n

The tone is a bit Fictional \ud83d\ude42 Just to make serious stuff a bit less heavy \ud83d\ude42\u00a0<\/span><\/p>\n\n\n\n

Part 1<\/strong><\/span><\/h2>\n\n\n\n

Once upon a time, in a land not so far away, two dynamic entrepreneurs – Bakra and Bakri got together and started up an amazing e-commerce business to sell sheep wool online!<\/span><\/p>\n\n\n\n

Within a few months their business was rocking; orders were pouring in from all over the world, page views & comScore numbers were soaring and the servers and the site were happily crashing. This was indeed a great start up.<\/span><\/p>\n\n\n\n

 <\/span><\/p>\n\n\n\n

\"\"\/<\/figure>\n\n\n\n

<\/span><\/p>\n\n\n\n

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One day, on a midsummer night, they heard a knock on their cottage door, and when they opened it, a dark skinned man in a black suit, black shoes and black umbrella, with gelled black hair, holding a black satchel greeted them.<\/span><\/p>\n\n\n\n

\u2018Hi\u2019 he said, \u2018My name is VC, and I am here to fund you\u2019. <\/span><\/p>\n\n\n\n

Over the next few days, VC patiently explained how he would invest his humongous dollars into Bakra and Bakri\u2019s start up, so as to scale it and make it profitable and \u2018Nasdaq\u2019able\u2019. <\/span><\/p>\n\n\n\n

On the final day, VC didn\u2019t meet them, but sent them a terse mail that read \u2018Term Sheet attached. Sign and Return\u2019.<\/span><\/p>\n\n\n\n

Bakra and Bakri were innocent entrepreneurs and decided to forward the same mail to Rodinhood \u2013 the Robinhood of Entrepreneurs who lived in the Forest of Enterprise.<\/span><\/p>\n\n\n\n

When Rodinhood read the term sheet, he found the same 3 clauses embedded inside the document. These if left untreated could damage Bakra and Bakri\u2019s economic progress. <\/span><\/p>\n\n\n\n

This is what he identified:<\/span><\/p>\n\n\n\n

The ESOP carve out Clause<\/strong><\/span><\/h3>\n\n\n\n
\"\"\/<\/figure>\n\n\n\n

<\/strong><\/span><\/p>\n\n\n\n

 <\/span>In the clause of \u2018ESOP\u2019 or employee stock option plan, the term sheet stated that the entrepreneurs (B&B) would carve out 10% of the share of the Company PRIOR to the funding. The weapon was the word PRIOR. It meant that B&B would have to further dilute 10% of their OWN stocks to make way for future employees, (who would work for the Company and actually benefit all the owners).<\/span><\/span><\/p>\n\n\n\n

In his explanation Rodinhood wrote to B&B that carve out of ESOP’s PRIOR to the funding was unfair on two counts: <\/span><\/p>\n\n\n\n

  1. a) It should come from the share of every owner of the company\u2019s share and hence POST not PRIOR to the funding since the benefit accrues to all owners as the company grows <\/span><\/li>
  2. b) In case of non-allotment of the complete 10%, the Investors would share the residual shares as well! Hence this was an indirect ploy to get more shares of the promoters under the guise of an ESOP plan. <\/span><\/li><\/ol>\n\n\n\n

    Rodinhood\u2019s final advice was \u2013 Try and negotiate esop dilution after funding and limit the commitment to 5% to begin with, since no one knows at the start of a business what really the esop pool requirement will be. <\/span><\/p>\n\n\n\n

    The Liquidation Preference Multiple Clause<\/strong><\/span><\/h3>\n\n\n\n
    \"\"\/<\/figure>\n\n\n\n

    <\/strong><\/span><\/p>\n\n\n\n

     <\/span>The term sheet stated that on liquidation of the Company, the VC would receive 2x of the money invested. <\/span><\/span><\/p>\n\n\n\n

    This meant that upon Liquidation (and this interpretation could include an exit), the VC would first take home not just the amount invested in the Business but DOUBLE of the same \u2013 so 2x of the investment! <\/span><\/p>\n\n\n\n

    Hence, no matter what the outcome, the VC would enjoy a 100% return on his investment; Bakra and Bakri would be left with what remained if anything at all.<\/span><\/p>\n\n\n\n

    Rodinhood\u2019s comment was that if VC means Venture Capital, it should remain Venture Capital and not Vampire Capital. Hence, the fair multiple was 1x of the principal back and NOT 2x or 3x etc., etc., in favor of the VCs. 1x ensured return of Capital and nothing more if the Company was sold in extraneous circumstances. <\/span><\/p>\n\n\n\n

    The Preferred and Participating Clause\u00a0<\/strong><\/span><\/h3>\n\n\n\n
    \"\"\/<\/figure>\n\n\n\n

    <\/strong><\/span><\/p>\n\n\n\n

    In this Term Sheet, the clause \u2018Preferred and participating\u2019 made Rodinhood’s Marwari blood boil. This was the trap aimed at the entrepreneurs.<\/span><\/p>\n\n\n\n

    It meant that in case of a sale, FIRST the VC would take home 2x of his investment. Then, on the remainder, the VC would take his legitimate %.<\/span><\/p>\n\n\n\n

    So, assume that Bakra and Bakri\u2019s Company raised Rs 100 from VC at a 30% dilution.<\/span><\/p>\n\n\n\n

    Also let’s assume that after 4 years, the business would sell at Rs 800. <\/span><\/p>\n\n\n\n

    Logically, VC would take home 30% of Rs 800 or Rs 240? Correct? <\/span><\/p>\n\n\n\n

    Wrong!!<\/span><\/p>\n\n\n\n

    Under the preferred and participating this is what would happen: As per the \u2018Preferred\u2019 clause, VC would first take home 2*100 (2x liquidation preference) = Rs 200. <\/span><\/p>\n\n\n\n

    As per the \u2018Participating\u2019 clause, OF THE MONEY THAT REMAINED \u2013 Rs 600, VC would take home 30% or Rs 180. <\/span><\/p>\n\n\n\n

    Hence the total money that the VC would take home would be 200+180 = 380 instead of 240! <\/em><\/span><\/p>\n\n\n\n

    In other words, the Equity of VC just became 47.5% rather than the original 30% only because of this particular Clause.<\/em><\/span><\/p>\n\n\n\n

    Rodinhood sent his comments back to Bakra and Bakri with the above explanations and the final advice \u2013 \u2018no matter what anyone tells you, including myself \u2013 do what\u2019s right for yourself and your business. Just try and remove or disengage these weapons as best as you can. Always remember \u2013when you have a good thing going, capital chases entrepreneurs and you must negotiate justly and hard\u2019. <\/span><\/p>\n\n\n\n

    Part 2: <\/strong><\/span><\/h2>\n\n\n\n
    \"\"\/<\/figure>\n\n\n\n

    <\/strong><\/span><\/p>\n\n\n\n

    Bakra &Bakri (B&B) \u2013 two successful entrepreneurs had just started an e-commerce business to sell their sheep wool online and were a happy lot. They had negotiated their term sheet with Mr. VC and were sitting back in their cottage backyard, nursing single malts. They always drank \u201cBallantine 17 years\u201d.<\/span><\/p>\n\n\n\n

    Bose\u2019s garden speakers were playing \u2018don\u2019t stop thinking about tomorrow\u2019 by Fleetwood Mac.<\/span><\/p>\n\n\n\n

    Bakra\u2019s iPhone beeped; a message from the VC read \u2018Check mail. SHA attached\u2019.<\/span><\/p>\n\n\n\n

    Even while he was pulling away the wool from his eyes, Bakra forwarded the sms and the mail to Rodinhood who was a friend of all the Bakras and Bakris who guided and consulted entrepreneurs in their start up life.<\/span><\/p>\n\n\n\n

    Rodinhood read the message and immediately got down to work.<\/span><\/p>\n\n\n\n

    As he opened the SHA (shareholders agreement), he took a deep breath. This was the most important document for any entrepreneur and he was determined to be thorough and fair in his perusal and remarks.<\/span><\/p>\n\n\n\n

    1)   Definitions.<\/strong><\/span><\/h3>\n\n\n\n

    First Rodinhood carefully went through the \u2018Definitions or \u2018Recitals\u2019 \u2013 the bullet like descriptions of key terms in the beginning of the agreement and made sure that they were in order. For instance, Rodinhood checked the definition of \u2018FMV\u2019 (Fair Market Value) and checked it read fairly. The recitals are important because there are acronyms used multiple times across the agreement and these acronyms are detailed in the recitals.<\/span><\/p>\n\n\n\n

    Rodinhood considered the definition of \u2018Control\u2019 and checked if the explanation defined Control as 50% or 51% or was it a loose, under defined meaning. Each interpretation of the definition of control for instance had a different outcome in the long term. <\/span><\/p>\n\n\n\n

    \"\"\/<\/figure>\n\n\n\n

    <\/span><\/p>\n\n\n\n

     <\/span>To keep himself relaxed, Rodinhood was sipping Perrier on the rocks, in his favorite rock glass, garnished with a twist of Lime. Beethoven\u2019s Emperor Concerto was playing in the background. The atmosphere was \u2018cordial\u2019 enough to come to terms with an SHA.<\/span><\/span><\/p>\n\n\n\n

     <\/span><\/p>\n\n\n\n

    2)   Pre Emptive Rights.<\/strong><\/span><\/h3>\n\n\n\n

    Swiftly, Rodinhood came across \u2018Pre Emptive Rights\u2019 (the terms that allowed existing shareholders to participate in a new issue first) \u2013 and they seemed fine. But he still went through the section once again.<\/span><\/p>\n\n\n\n

    3)   Representations and Warranties.<\/strong><\/span><\/h3>\n\n\n\n

    On Reps and Warranties \u2013 Rodinhood made a side note to ask Bakra and Bakri if they had \u2018shared\u2019 everything with Mr. VC.<\/span><\/p>\n\n\n\n

    Rodinhood always believed that it was most prudent to reveal everything about the Company to an investor BEFORE taking in their money. If there were secret promoters or other shareholders, they ought to be made public and given shares before the Company was finally structured. Also, if the Company had received some vague legal threat or was under the cloud of potential litigation, it was most important to reveal it all to the VCs. Thinking \u2018let me handle this after I get the money in the bank\u2019 is suicidal for entrepreneurs.<\/span><\/p>\n\n\n\n

    In Reps and Warranties, Rodinhood wondered how Bakra and Bakri had reflected their personal loans invested in the Company and what was their agreement with the VC. Rodinhood personally had a view that all \u2018moneys\u2019 of entrepreneurs into their own Company be treated as loans and returned gently over a period of time; post funding. Rodinhood felt that his concept was right because the entrepreneurs were putting in their sweat, blood and tears into this startup which was way beyond a few lacs of money. Besides moneys taken from relatives, friends and even piggy bank savings were best returned to entrepreneurs so that they could focus solely on the business.<\/span><\/p>\n\n\n\n

    The rock glass was sweating as the ice and Perrier got acquainted. The lime slice was quickly become the stranger in the mix.<\/span><\/p>\n\n\n\n

    4)   Restrictions on Transfer of Shares.<\/strong><\/span><\/h3>\n\n\n\n

    Was the next section that made Rodinhood sit up? This SHA locked 75% of the entrepreneurs\u2019 shares in an escrow to be earned back by the entrepreneurs over a period of 3 years.<\/span><\/p>\n\n\n\n

    While Rodinhood accepted that VCs needed to \u2018lock-in\u2019 entrepreneurs by locking in their entrepreneur shares over the next few years in the Company (post it\u2019s funding so as to protect the VC\u2019s from founders just walking away), Rodinhood always had the following tenets for entrepreneurs:<\/span><\/p>\n\n\n\n