Are you a VC backed startup, or hoping to become one? Do you have stock options and wonder what they might be worth someday when your company sells?

1. Demystifying Stock
Options
John Rodkin
MD/GM @ Samsung Accelerator SF
Eric Hanson
Counsel @Wilmer Hale, Palo Alto

2. Agenda
• Some vocabulary
• Economic preferences, or valuation terms the media never mentions
• Convertible notes and SAFEs
• Some calculations (algebra heavy!  )
• Q&A

3. A little bit about John
• Engineering/JD/MBA Degrees
• SerialVenture-backed Entrepreneur
• Venture Capital Lecturer
• LBO/PE/VC Experience
• Small Business Owner

4. A little about Eric
• Counsel in Corporate Practice Group of Wilmer Hale in Palo Alto
• Venture Investments and Fund Formation: Over 100 venture transactions, representing issuers, venture
venture funds and strategic investors, totaling an aggregate of well over $3 billion in transaction size.
• Mergers and Acquisitions: Over 20 mergers and acquisitions, representing both buyers and sellers,
totaling an aggregate of over $2.5 billion in transaction size, in transactions sized from $10,000 to over
billion.
• Capital Markets: Several capital markets transactions representing companies, underwriters and
venture funds in connection with initial and follow-on public and 144A offerings.
• Northern California Super Lawyers “Rising Star” 2013-2015
• Former software engineer, Electronic Frontier Foundation, the University of Washington and
IBM’s T.J. Watson Research Center.

5. Why I Teach
• There are a lot of sharks in this field
• Know what you’re doing and the sharks won’t get you
• I learned the hard way and am lucky to have had it work out
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6. Valuation Basics
• Valuation = what the company is “worth”
• Preferred shares drive valuation
• Common shares are what you have
• You can’t spend valuation
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7. Preferred Shares
• Shares with special rights
• Anti dilution
• Control
• Board seats
• Preferred shares usually have special economic rights too
• We’ll cover some economic preferences today
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8. Venture Capital Deal Algebra
• Pre Money?
• What the company is worth pre-investment
• = Number of shares before investment * share price (of preferred shares)
• Post Money?
• What the company is worth post-investment
• = Number of shares after the investment * share price
• = Pre + investment amount. Why?
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9. Venture Capital Deal Algebra
• Investor Ownership
• = Investment / Post money
• = Shares issued / total shares
• Option pool is part of “total shares”
• Valuation is implied
• VCs pick percentage and investment
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10. Liquidation Preferences
• Downside protection forVCs
• Their money comes out first, which is fair that they get their money back before you get
paid
• VC can pick: receive amount of liquidation preference or convert to common (i.e.
looks like debt or equity)
• All sorts of ways to adjust the preference
• Multiples (Terrible for entrepreneurs, very rare)
• Participation (next slide)
• Caps
• B round will do what you did in A – use that to keep preferences sane
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11. “Participating” Preferences (or Double Dipping)
• Get money back, then take pro rata share!
• Both debt AND equity on the same investment
• Expires in an IPO
• “Cap” (or “kick out feature”)
• After some limit, investor converts entirely to continue sharing in the upside
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12. Participating (Liquidation) Preferences
• VC Money comes out first. Then divide pro rata.
• Example: Raise $100M at $300M post. VC owns 33%
• Sale for $400M.
• VC gets $100M + 33% * $300M = $200M.
• Your company that was valued at $200M when you took the money only gets you
$200M despite doubling in value
• Much worse if you sell for $300M -> you only get $134M
• Because it’s contract, all sorts of ways to adjust these numbers
• Most common is to say thatVC only gets the preference until they get their original money
back.
• At $400M, then,VC takes 33% * $400M = $133M
• Valuation is not the only important term!
• With no participating preference, you end up with more on a $400M exit if the post is only
$250M. (VC gets 40% = $160M, you get $240M)
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13. 13
Straight VC Percentage (no liquidation preferences (rare))
$0
$100,000,000
$200,000,000
$300,000,000
$400,000,000
$500,000,000
$600,000,000
$700,000,000
$800,000,000
0 1 2 3 4 5 6 7 8 9 10 11
vc share entrepreneur share EXITVALUE ($000M)
CASHOUTTOEACHPARTY

14. $0
$100,000,000
$200,000,000
$300,000,000
$400,000,000
$500,000,000
$600,000,000
$700,000,000
$800,000,000
0 1 2 3 4 5 6 7 8 9 10 11
vc share entrepreneur share
14
Liquidation Preference
Preferred gets first $100M. Only converts to common when 33% of exit is more than $100M
EXITVALUE ($000M)
CASHOUTTOEACHPARTY

15. $0
$100,000,000
$200,000,000
$300,000,000
$400,000,000
$500,000,000
$600,000,000
$700,000,000
0 1 2 3 4 5 6 7 8 9 10 11
vc share entrepreneur share
15
Uncapped Participating Preference
Preferred gets first $100M, but also gets pro rata portion of remaining. No flat area.
EXITVALUE ($000M)
CASHOUTTOEACHPARTY

16. $0
$100,000,000
$200,000,000
$300,000,000
$400,000,000
$500,000,000
$600,000,000
$700,000,000
$800,000,000
0 1 2 3 4 5 6 7 8 9 10 11
vc share entrepreneur share
16
Participating Preference with 3x Cap
When the cap is reached, there’s a band of equal returns for investor even with rising exit
Notice: these flat bands exist where investor has a convert choice (see liquidation preference slide).
EXITVALUE ($000M)
CASHOUTTOEACHPARTY

17. 17
What is a “Convertible Note”
• Investor loans the company money
• The loan converts to equity at some price. Often at a discount to
some future financing
• May have a cap
• Sometimes there is “warrant coverage”
• Math on next slide

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Convertible Note Math
• $1M convertible note at $5M cap, 25% discount, 10%
warrant coverage
• $5M financing at $10M pre, share price at $1
• With no cap, $1M / 75 cents = 1.33M shares. Plus 10%
warrant coverage = $100K/$1 = warrants on 100,000
shares.
• But with cap, $1M / 50 cents = 2M shares

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Are convertible notes good?
• Pros
• Don’t want to set valuation
• Close small dollar amounts in several closings (“high resolution fundraising”)
• Investors think it’s safer?
• No board rights or voting
• Cons
• Gives too much in preference stack
• Accrues interest
• Can cause bankruptcy
• Just kicks the can on valuation
• Caps can be terrible – heads investor wins, tails entrepreneur loses

20. 20
SAFEs
• Simple Agreement for Future Equity
• “Evolution” of convertibles
• Not a debt instrument
• Preference adjusted to equal amount invested
• Great for company. For investor?
• Taxes?

21. 21
What drives messy terms?
• Everybody wants a headline number
• Attracts media, employees, maybe even customers
• “It will never happen to me”
• Why will your company not just go up and to the right?
• Not every entrepreneur is a repeat player, most investors are

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Option Pool Shuffle
• Options don’t get granted until board approves
• VC has at least equal voting on board
• Options don’t actually exist until granted
• Media (and often entrepreneur) care most about headline valuation
• So,VC can give higher valuation by making option pool larger

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Option Pool Shuffle Example
Scenario 1
Post Money $10,000,000
Shares outstanding (prior to financing): 200,000
Option Pool 30%
Investment amount: $5,000,000
After the financing:
Common shares outstanding 200,000
Series A shares: 500,000
Shares reserved under option plan 300,000
Total Shares outstanding 1,000,000
Share Price $10
Scenario 2
Post Money $10,000,000
Shares outstanding (prior to financing): 200,000
Option Pool 10%
Investment amount: $5,000,000
After the financing:
Common shares outstanding 200,000
Series A shares: 250,000
Shares reserved under option plan 50,000
Total Shares outstanding 500,000
Share Price $20
• Even with all other terms equal, a change in the option pool doubles share price!
• VC owns the same percentage!

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Key Takeaways
• Many terms besides headline valuation matter
• Work with a good attorney
• Pick your investors carefully