Prework Module 5: Startup Survival Guide

June 13, 2022

Overview

In previous modules, we explored how various markets work and the basic definitions of equity and stock. In this module we will explore some of the financing stages of startups, as well as different ways in which they compensate their employees.

Module Objectives

By the end of this module, you will be able to:

Identify the major funding rounds for startup companies
Identify differences between common and preferred stock
Identify some of the most common ways in which startup employees can be paid for their work.

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Do you like to create new things? Push the boundaries of what people thought was possible? Create value for others with your ideas? If so, you may want to consider working for a startup!

Startups are nascent entrepreneurial companies looking to bring a new product or service to market, and differ from “lifestyle businesses” in their goal to rapidly scale and disrupt an existing market. If things go well, they are often purchased by a larger company, or undergo an Initial Public Offering (IPO) to become a public company.

Startups also raise capital differently than other businesses. In this module, we will explore some of the most common funding methods, as well as the types of stock and remuneration offered by these companies.

Reading: Funding Series

Startups are inherently a risky investment that few have the capital to take on. For this reason, there are relatively strict definitions on who can be an accredited investor in the US. However, in 2016 some of these rules were relaxed, enabling even more people to invest in early-phase companies.

There are five major funding rounds that startups go through on their path to becoming a public company. Each of these rounds is progressively larger in terms of funding received, and considered to be less risky for the investors.

Pre-Seed/Seed Funding: Also sometimes referred to as the “Founder’s” or “Friends, Family, and Fools” (3F) round. These are the earliest and riskiest investments to make, and often come with short (1-2 year) timeboxes on delivering the next phase of product. Seed-stage companies should have a developed Minimum Viable Product (MVP) or prototype before seeking funds for this round. It is common for software or Software-as-a-Service (SaaS) products to have minuscule funding at this stage.
Angel/Early-Stage Funding: This stage begins the process of the rapid development of both business operations and product iteration. Companies in this stage are building out core teams, setting up manufacturing systems, and perfecting their flagship products.
Series A, B, C Rounds: Each of these stages are (ideally) receiving progressively larger funding amounts from investors. As startups continue to grow through these rounds, they further optimize their business operations and expand into a mid- to large-size corporation.

While we have only discussed up until Series C, some businesses continue into Series D or more rounds, depending upon the types of projects they are undertaking. After a company has reached longer-term stability and continues to grow, they may decide to transition to a pubic company, in the process known as an Initial Public Offering (IPO). Other companies may opt to remain private, in order to maintain equity in their company or avoid the regulatory requirements of being a public company.

Earlier investors are typically rewarded with a larger number of shares in the company, as they take on more risk relative to investors that join later when the company becomes more stable. In some regions, early investors aggressively lock out later investors that may potentially dilute shares, which motivates investors to invest earlier rather than later.

Student Activity: Crunch Numbers on Crunchbase

See instructions in activity file.

Reading: More Than Just Stock

Recall that stocks represent a share in the equity, and thus ownership, of a company. This partial ownership often comes with voting rights for an event such as corporate policies, approval of new board members, and other events that impact the company at scale. The amount of voting power associated with each stock varies depending upon on the companies and its policies. For example, some companies scale the number of votes a stock is worth by the position of the person casting the vote. Stocks come in two major forms with regards to this voting power, which we will explore here: common and preferred stock.

The vast majority of the time anyone is discussing the price or action on a stock, they are referring to common stock. This form of stock confers ownership of the company, as well as rights to dividends if the company distributes them. However, while preferred stock still represents ownership of the company, it differs in two key ways. First, preferred stock doesn’t come with voting rights! Preferred stockholders are generally beholden to the decisions of the company as a whole. Second, preferred stockholders are given priority in the payment of dividends, a merger, or a liquidation. The dividends are also often pre-specified, so that there is a consistent return associated with holding the security. Essentially, holding a preferred stock trades voting powers in favor of financial priority. Preferred stock can be converted into common stock under certain conditions as well.

In private companies, the descriptions of voting rights and compensation are largely dictated by company policies. Preferred stock within the same comapny may have different subtypes with different voting, liquidation, and dividend rights, among other factors. However, when a company transitions to public, there tends to be a flattening of the different types, such that there are only the preferred and common stock types.

Reading: Relevant Remuneration

The end of many interview processes involves some negotiation of payment. When working at a startup, you may be offered the opportunity to exchange some of your potential income for equity in the company you are helping to build. This section will explore some of the possible ways in which you may be compensated for your work.

Regular income: Income typically associated with working at a job. In some startups, there may not be enough cash on hand to pay competitive salaries, and thus other methods of compensation may be used.
Up-front equity: This is typically restricted to founders or extremely early employees in the company. Often in the pre-seed and seed stages of a company, there may not be enough cash to pay a salary, and thus a major share/ownership of the company must be portioned among those working on a project.
Options: Companies that are beginning to grow may offer options in the company in addition to a regular income. These options are often not able to be exercised until the company is acquired or reaches an IPO. Ultimately, however, the employee has the opportunity to possibly purchase shares at a significantly lower price than what the equity is currently worth, meaning that the stock could be sold immediately for a profit, or kept as it continues to grow.
Restricted Stock Units (RSUs): an RSU is another stock-like compensation method that essentially assigns a certain number of shares to be given to the employee after a given amount of time, known as the vesting period.

Owning equity in a company that is in the process of growing is intrinsically a long-term and illiquid risk. Most people will work for three to five years as their equity in a company fluctuates in value, and wait even longer before the asset can be liquidated for cash. However, this risk also comes with the opportunity for outsized returns–if a company becomes highly valued (a “unicorn”!) then the equity could be worth millions overnight.