How Startup Stock Works

Feb 2014

(Based on an Explanation to an IHer)

 

“This planet has – or rather had – a problem, which was this: most of the people living on it were unhappy for pretty much of the time. Many solutions were suggested for this problem, but most of these were largely concerned with the movement of small green pieces of paper, which was odd because on the whole it wasn’t the small green pieces of paper that were unhappy.”

– Douglas Adams, The Hitchhiker’s Guide to the Galaxy

 

“Either the product takes twice as long to build and costs three times as much, or takes three times as long to build and costs twice as much – you just don’t know which one.”

– Jeff Stewart, Angel

 

For most of the growth of a startup the wealth is unrealised. What that means is most of the wealth created by a startup is intangible and non-transactional so it can’t be used to buy things the way money can. That’s not to say the wealth isn’t real but it only exists in the context of the startup. The short hand for this wealth is the stock of the company, which is what founders own and what investors buy when they invest in a company.

Stock and shares are basically the same thing but in vernacular refer to denominations. One is the multiple of the other the same way leaves refers to a quantity of many leafs. So stock tends to be a large chunk of shares, whereas shares tends to refer to an individual or small amount of shares. It helps figure out what people are talking about. When they say stock, they are usually referring to a large ownership but when they say shares it’s typically smaller.

When you own a piece of something, and that thing has value, you have equity in that thing. When you own stock in a company, you have equity in that company. So when people talk about equity, they are also talking about how much stock they own.

When you sell stock for money, this is referred to as liquidity. Like water, in the sense that it is free flowing. When you have money which can be used to buy things, you have liquid money. Whereas stock is illiquid because you can’t use stock to buy anything. Like a dam, in the sense there is a huge amount of water held behind it but is jammed. Your local supermarket will have a hard time accepting a stock certificate in exchange for groceries so it would be considered an illiquid asset. Illiquid assets can’t be used to buy stuff.

A company can basically issue as much or as little stock as it wants to. The people who decide how much are the ones on the board of the company. If too much stock is issued, it means each individual share is worth less and vice versa so if only a small amount is issued, then each share is worth more. You’ll notice that part of the worth of shares depends on how many are issued.

Where this is written down is called a capitalisation table. It’s a table or a document that contains a big list of who has invested, how many shares they own, what percentage of the company it is worth and what is the price of each share. Every company which can issue shares has one and is located in the company ledger. This is a very important document.

When you issue shares to someone, they give you money, then you add their information to the capitalisation table, and create and give them a share document. A share document is like a receipt you give to someone after they’ve invested in the company. It’s a document that indicates a person owns X many shares at Y price per share and has paid Z for purchasing them. They are now a shareholder. Another important document is called a shareholders agreement. It is a document that illustrates the rules all of the shareholders must operate under.

In the olden days, this would have been sufficient but today with regulatory bodies, frequently this information will need to be submitted for approval whenever a change is made to the capitalisation table. Or at the least they need to be given notice of the change. Every country has a different protocol for how this works.

If you own a hundred shares but the company has a million shares issued you don’t really own that much. But if you own a hundred and there are only a thousand, then you own quite a lot. Every time more shares are issued, it makes the shares of everyone who previously owned stock worth a little bit less. How much less? Proportionally so. So however many shares are issued as a percentage of the total number of shares, is how much each share is worth less by.

A mistake a lot of people make when visualising stock in a company is that they assume it is a finite amount but in reality a company can basically procure shares out of thin air. The company is like a share creating machine, it can create shares whenever it wants to and give it to people in exchange for things. So long as it keeps track of how many are issued and when.

Theoretically you can take anything with fluctuating value; which is most things that can be bought and sold, break it apart into an abstraction, commodotize it and then sell ownership of a part of the whole as a share. To invest in something you really just need the price of it to go up and down and have something real move around when you trade the abstraction of it.

A good way to make stock worthless is by issuing a lot of it so that each individual share is worth much less. This is largely just corporate manipulation and is sometimes how founders can get burned. The real indication of the value of shares is the company the shares belong to and how good it is. Shares in a good company will always be worth something but shares in a bad one are often worth nothing.

To figure out what stock is worth you have to know what the company is worth that issued the stock. There are a lot of formulas for working this out but a common one is using a price to earnings ratio. It means the company is worth some multiple of the revenue it makes. The multiple usually depends on what the company does and what industry it is in.

But this also works in reverse, where you can figure out what a company is worth by its shares. To do that you multiply the price of each share by the total number of shares issued. This is the market capitalisation and is the total value of the company at this moment in time. The word for this is valuation. The key point is time.

Over time progress is made and the value of the company increases. As the value increases, the stock price increases to represent this. The trick is that the stock may not be what the company is worth now but whatever the company may end up being worth later.

Sometimes the stock price can go down but this is usually a bad sign and when the company has made mistakes or didn’t grow as much as it thought it would. Or in really bad cases, the company actually goes backwards. This typically happens when the founders do the wrong thing or don’t put enough time into the company. When founders are not putting all their time into a company, they are indirectly reducing the value of their own stock.

The true value of stock is usually not reflected in the stock price but is amplified by the market. Everyone wants the stock to grow and via speculation can actually change the perceived value of it. And if the stock is perceived to be more valuable, then it is because stock is one of those things where it is worth as much as someone is willing to pay for it.

This is done by factoring the growth potential or how much everyone thinks it might grow in the future. If a company seems like it will grow a lot then it will be more valuable than a company that doesn’t seem like it will grow much. How do you measure that? By past performance. If a company grows a lot in a short span of time, it’s assumed it will grow a lot more and that future potential will be reflected in the inflated stock price.

It often stuns people how companies that haven’t made a huge amount of progress can have big valuations. But it all depends how fast they made that progress. If you make lots of progress quickly, when extrapolated out is assumed you will continue to follow that trajectory, so will grow a lot in a short period of time. It also stuns people how a valuation can be much much larger than the company at present. This is because they forget to take into account the future.

It always struck me as very silly. I buy something now based on how well it will do in the future? The nuance that’s missing is in a startup, my actions directly influence how well it does in the future. So for the most part it is like making a bet where you can make it easier for you to win, which isn’t really a bet at all. It’s just a risky decision.

In sport, there are many gifted athletes but you would not otherwise be able to put a price on one’s potential for becoming a superstar. But in startups you do and it’s baked into how the stock is priced. It’s one of the only fields where there is a very direct value on potential. It’s trying to put a price on something that hasn’t been done yet.

 

So as a founder you start a company and trade in your time and money for stock in that company. In exchange you get a very large stake, as much as you want really. One day you sell this stock for money and then you become rich and have real money to spend on real things.

Until this moment, you are an illiquid founder. You have a net worth because it is the value of the stock that you own. But you don’t have a lot of real money which you can use to buy things with. It is best in this phase to pretend you don’t even own the stock because otherwise it goes to your head.

Many people’s egos expand and they start to spend like their paper wealth is real wealth only to have it disappear overnight and they end up embarrassed and ruined. It is a highly volatile asset because at any moment the company could start to die and the value would disappear.

The problem is the outside world doesn’t fully appreciate this distinction. So when your friends and family hears about net worth, they actually believe you have this much money which is not true. It is because most people don’t really understand how this process works. You might one day but at the moment you don’t .

When you hear on the news about founders with huge net worths, what they are usually talking about is how much stock they own and the value of those shares. Not how much money they actually have. The assumption is one day the stock will become real money but at the moment it isn’t. At the moment they are probably just earning a salary.

Value in a business is usually in the shares, often not in the salary the business pays you. And the shares don’t turn into money until there is an exit or liquidity event such as an IPO. Let’s put some numbers on this:

Imagine a hypothetical business has been running for 10 years and has gross revenue of $30 million dollars per year. With 20% profit margins they make $6 million dollars per year in gross profit. This business might be valued at $150 million dollars since it is 5x their annual revenue. You as the founder own 10% of this business. That means you are worth $15 million dollars on paper.

But this is gross profit, to convert this to net profit we reduce expenses. The primary expense is people. The business has 50 staff each earning salaries of $80,000 per year. The employee salaries are $4 million in total. And the business decides to put $1 million dollars in savings which can be used for growth. So there is $1 million left for executive compensation. If there are 8 executives and founders, they each earn $125,000 per year. So your income is $125,000 per year, about as much as a doctor.

So you as a founder who owns 10% of this business would be worth $15 million dollars on paper but earn an annual salary of $125,000. You would only get to cash out and have $15 million in cash if the business gets sold. The point is important. You can be very wealthy on paper but only earn a modest income.

 

A lot of the time what a founder does is take a small salary to maximise the value of their shares and tries to keep their money in stock for as long as possible because the value of the company is increasing faster than it would if it was just plain money. Since the value of money typically decreases with inflation so you can buy less with it each year.

Why would anyone do this? The benefits are mostly tax. You hold onto stock as an asset instead of earning an income. So you get taxed once at the end when you sell your stock instead of every year when you earn an income. And you just have to survive until you get to that point.

It’s because for most tax officials, startup stock is worthless. It’s not like owning stock in a public company. The value is not guaranteed and can be lost quite easily. In fact the vast majority of startups fail and their stock ends up being worthless. It would be unfair of the government to treat startup stock like real stock and would kill innovation instantly.

So why doesn’t a founder trade their stock in for money sooner? The short answer is because they can’t. They can’t sell their stock because no-one wants to buy it. Because the startup has not created enough value to create demand for their stock. You wouldn’t want to buy a car if it doesn’t even drive properly, right? By the same token most new companies don’t end up working out, so their stock is then worthless. Buying it is the same as wasting your money from an investment perspective.

There are also no outlets to sell stock quickly and painlessly. While a company is private there are even certain rules restricting who can even buy stock. So the process of cashing out is long winded and hard and makes selling stock a non-trivial process. It typically takes a really long time and there are a lot of forms and declarations to be made. Not to mention arguing about how much to sell.

All of this is what makes owning startup stock a risky proposition. You trade in time, money and security for a small, risk prone shot at being in control of your company and becoming rich. If you are right and your company wins, it is glorious. If you are wrong and the company loses, it is devastating. It’s why this process isn’t one to be jumped into lightly.

That’s the tradeoff employees make too. You sacrifice having money in the short term in favour of having a much higher payout when the company is successful because the value of the shares you receive will be much higher. The way lots of people get burned is if they make this tradeoff and the company ends up failing or if the value all goes to investors due to bad terms (like lots of liquidation preferences, participating preferences, full ratchet anti-dilution etc).

You take on this risk in search of the higher payout. If it works and you ended up working at Google or Facebook, this was an unbelievably prudent decision. If it turned out to be a dud, and most companies are, then you will possibly have wasted years of your life and will be all the wiser. It’s why people who have been through this recommend taking some form of cash salary. To cushion the fall, if there is one.

Sometimes when you here people be really cynical about startups, this is what has happened to them. It’s how it became popular to say getting startup stock is like buying a lottery ticket. But a lottery ticket where you get to influence the outcome. That’s probably the best kind of lottery ticket you can get.

Because people who have a history of influencing outcomes in their favour are disproportionately positioned to make a startup succeed. It’s why famous investors such as YCombinator openly say the kind of founder who succeeds is someone who always gets what they want.

 

The price that you sell the stock for is based on the valuation of the business which is based on how well the company is doing, and how promising the prospects of the company are in the future. So a startup with a high valuation will be able to sell less stock for more money and is where the incentive comes in to have a high valuation for the founders. Conversely there is the incentive to have a low valuation for the investor or purchaser. So they can buy more stock with less money.

That’s why an exit is really important. Because eventually you will want to sell your stock and get real money. Or for a lot of people running lifestyle businesses, to grow the company to the point it can pay a good salary.

The illiquid stage is a natural part of every new company because it takes a really long time for the value to materialise. Always longer than people appreciate. In fact most founders spend the majority of the lifetime of their startup in the illiquid stage. It’s a bizarre feeling.

There’s something very comical about looking at a stock certificate and knowing what this represents is measured in millions but then looking at your bank account and seeing only a few hundred dollars. That is the crux of the illiquid stage. What it’s like to be a zillionaire on paper but have no actual money and the hopelessness you feel.

It’s also the part that’s the most desperate. Because you can’t afford to buy things. You have this mental cache that you are wealthy so experience the comfort associated with that knowledge, but none of the very real security of having large amounts of money.

In many ways it’s an exercise in being humble. Because it makes you acutely aware of how fragile the wealth is. So you develop an inner scrutiny of your actions that you wouldn’t have if you made cash. It’s why people who get rich in an incremental way tend to be assholes. Because their wealth is immediate. It comes to them instantly. And that goes to their head.

Whereas in a startup it’s all deferred. You may in the aggregate make just as much, if not more, but it’s all of a sudden and happens all at once. Usually the most surprised person when they actually get rich is the entrepreneur because till that moment they are living in the mindset that they’re not. That in any instance, something bad might happen to the company and their wealth will disappear as if it never existed. Because it was tied to a highly volatile entity, a startup.

It’s kind of like flying a giant plane in the middle of a war zone, while you’re being shot at, in the middle of a storm and occasionally parts of the plane break inexplicably and you fix it mid-flight, while people randomly jump out of the plane as it’s flying and you don’t really know where you’re flying, you’re running out of fuel and nobody wants the plane to land except the people on it – in fact most people want the plane to be shot down and there are other kamikaze planes trying to crash into your plane – but if you can just safely land, you become rich.

All the hard work pays off and you have enough money to have complete freedom and to do whatever you want.

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