Startup Acquisition: what happens to employees?

A younger version of me and a younger version of this Youtube channel started this series called Startup Funding Explained.

We went through a theoretical company's story while analyzing how the cap table evolved through various rounds of funding. Make sure to watch Parts 1 through 3 if you want to get a grip on that.

But if you are only in for the good stuff, that's OK. This video will analyze a few exit scenarios for that theoretical company and how much money everyone does, or does not make.

BTW, a lot of the topics covered here were way beyond my expertise, so Steve Barsh from DreamIt will be joining us to elaborate further on some key aspects of how this transaction works.

BTW, a lot of the topics covered here were way beyond my expertise, Steve Barsh  helped us put these estimations together. Make sure to check out his video on Startup Exits.

Let's look at the last version of the cap table:

Founder 1 4,000,000 33.96%

Founder 2 1,500,000 12.74%

Friends & Family Investor 2,000,000 16.98%

Employee 1 (OP1) 250,000 2.12%

Employee 2 (OP2) 250,000 2.12%

Convertible Note Investor 500,000 4.25%

Option Pool #2 500,000 4.25%

Series A Investors 2,777,778 23.58%

In a nutshell, here's where the company is at,  

• Raised a Seed Round of funding through a Convertible Note.
• Raised a Series A Round of Funding, which valued the company at $10MM.
• The investors on the Series A negotiated a liquidation preference that guarantees them 2x the capital invested.
• A Series A round probably had additional terms, but we are trying to keep it simple for Youtube purposes.
• We also had two option pools, the first one with a Strike price per share of $0.0312500 and the second one with a Strike price per share of $1.

If some of this stuff doesn't make sense, again, make sure you watch the third episode in this series.

Now we will go over two scenarios: a rescue acquisition or acqui-hire and a strategic exit for the company.

In a video a couple of weeks ago, Steve Barsh, one of the partners at DreamIt went over what each one of these acquisitions means. Make sure to watch that video for more context.

Let's get to it.

Scenario 1: an acqui-hire

Let's say this company started struggling soon after the round. It has managed to stay afloat, but it's not growing very much.

The company might seek out a buyer that has an interest in taking profits out of the business.

There are some holding companies or funds that purchase SaaS companies and are very good at monetizing them. A SaaS company usually operates on a 75-85% gross margin (revenue vs. costs, meaning server costs).

The remaining costs are support staff, technical/product team for new features and maintenance, and the operational costs: office, accounting, etc.

These holding companies acquire multiple SaaS companies and have centralized, shared operations, accounting, legal, developers, and support. These resources are shared across all the SaaS companies in the holding company to squeeze a lot more profit than the company can do independently.

They are not buying the business for strategic reasons. They are buying it to earn profits from it, so the acquisition price will probably be a 1x to 2x multiple of their revenue.

Another common scenario is for a company to absorb the team and perhaps a patent or a brand name. In those cases, some price references are $1MM per engineer, or merely enough to give investors a 1x return on their investment so that they can greenlight the deal.

If you think the $1mm per engineer sounds like a lot, it may not be. If the average base salary in NYC or Silicon Valley is $130,000 per engineer, and you could hire a team of 5 or 6 engineers who have worked together for years and are a highly efficient team, the price may not be crazy. In particular, if this is an acqui-hire at a very low purchase price, the engineers' employee stock options may be worthless if they are “underwater”. “Underwater” means the startup’s price per share at acquisition is BELOW the stock option strike price for the options the engineers have. So the stock options are worthless and the acquirer is giving an incentive for the engineers to stay on. Note that the $1mm per engineer may involve a retention component to make sure the engineers don’t just get the $1mm at closing and then walk out the door.

Again, none of these acquisitions are very exciting, but they can provide a soft-landing for the team and some liquidity for investors. There can be an inherent tension here as sometimes the founders are more interested in retention bonuses for the team (including themselves) while, on the other hand, investors are more interested in cash for the stock. Often there is a lot of negotiation that takes place around these points.

Long-story-short, let's say our theoretical business with a $12.5 MM post-money valuation after the last round gets an offer for $12MM.

So the first thing we will get with that is a price per share. Remember we had 11,777,778- so a $12MM offer means $1.019 per share.

However, we have to start with that liquidation preference. Series A investors need to get a 2x multiplier on their original investment, and Convertible Note investors too (remember they piggybacked on the same terms).

So out of that $12MM, we will take $5MM for the Series A investors (2x their $2.5MM investment) and $1MM for the Convertible Note investors (2x their original $500K investment).

That's $6MM that effectively 'bought out' the Preferred Shares, which leaves us with $6MM for the rest of the shares (Common Shares).

That is $6MM divided by 8,500,000 shares for an effective $0.7058 per share. But we're not done yet. We have to do a small parenthesis about Stock Options.

Stock Options

Stock Options are options to buy shares at a specific strike price. They are designed that way for two reasons,

1- so that when they are issued, the person who receives them doesn't have any tax implications. Since they are not receiving the actual shares, they don't have to pay tax on them.

2- so that the employee receiving them is motivated to increase the value of the company. If the company's price per share doesn't grow, the Stock options are not worth anything.

Let's say an employee has 1,000 stock options at a strike price of $1.

If the company gets acquired for $2 per share, they can effectively execute their stock options (technically buy the shares at their unique, discounted strike price) and then sell them for double the price, which the acquirer is paying.

So 1,000 stock options bought for $1 each, sold for $2 each, there's a net earning of $1,000. Great!

Employee stock options have a lot of moving parts. When structuring stock option plans make sure to have accountants and lawyers working with you who have a ton of experience with this. If your aunt or uncle is an attorney and largely handles divorces or personal injury cases and says “I’m happy to help you,” say “no thanks.” If this is not done correctly, a poorly structured stock option plan can have devastating consequences. From vesting schedules to cliffs, to how long to exercise after separation and how long until options expire. Expiring options can be a big issue at companies that stay private longer, like Uber and Airbnb, where employee stock options MAY expire if it takes too long for the company to get acquired or go public. If the stock options are going to expire employees may have to come “out of pocket” and put money down (money they have or even worse, have to borrow) to actually exercise and “buy out” the stock options so they can get the actual stock before the option expires. Again, like Steve said in his video on acquisitions, “bring your A team.”  

Now looking at our scenario, you'll see the problem.

The second Stock Option pool this company offered has a strike price of $1. The price per share for this acquisition after paying the liquidation preference is $0.70. It's not worth buying shares to resell them for less.

So we can assume that the second stock option pool doesn't get executed. That means the company only has 8,000,000 shares to sell.

At 8,000,000 shares, we have a slightly higher price of $0.75 per share. And that is the price we'll be using.

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Cap Table

Founder 1 4,000,000

Founder 2 1,500,000

Friends & Family Investor 2,000,000

Employee 1 (OP1) 250,000

Employee 2 (OP2) 250,000

Founder 1 sells 4,000,000 shares at 0.75 effectively getting $3M.

Founder 2 gets $1.125M for the shares they vested. Friends and Family investor gets $1.5M, a significant 30x multiplier on their investment. Not bad at all!

The employees that hold stock option pools have to buy their shares. They have 500,000 shares total, which they purchase at the strike price of $0.023, so they have to 'pay' $11,500 for them.

Simultaneously, however, they sell them for $0.75 each, which gives them earnings of $0.727 per share. Since each of the two imaginary employees had 250,000 shares, they get profits of $181,750. Not bad. Or is it?

If they had been working at the startup for several years and had taken a below market salary in hopes of getting rich from the stock options and over 3 years got another $180k in taxable cash... maybe the $60k per year was a small win but not totally life changing.
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All that money is, of course, subject to taxes. So be prepared to take a chunk out of it. If you are a foreign founder, not registered as a US taxpayer, it's going to be a flat 30%.
And that's that.

Scenario 2

Let's look at the second scenario, a sexy acquisition.

Let's say the company gets bought for $35MM.

In this case, the price per share would be a very sweet $2.972.

The liquidation preference clause doesn't apply in this case since the price per share guarantees these investors a 2x return.

The math here is a lot easier. The number of shares owned by each shareholder, multiplied by $2.972.

Here’s how that would look,

Now interestingly enough, a $35M acquisition sounds like an amazing deal for the founders. The founder who stuck around is getting an $11M exit, which certainly changes anyone’s life.
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Even the second Option Pool of employees is getting gains of $1.972 per share. They will need to ‘virtually’ pay $500,000 to buy those shares but get $1.485M in exchange for them. Remember, this is a cashless transaction, so the option pool holders don’t actually have to buy the stock options, they just get the difference on the price.
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But the investors, not so much. They are getting a 3x return on their investment, which is good, but certainly not what venture capital investors are in for.
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The success rate of tech companies is low, so investors are looking for the big whale, the big 10x return that makes up for all the companies that didn’t work out. This company is making up for 3.

This directly connects to a common question I get from founders, around business valuation, and even around the type of company that can raise venture capital.
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Even this pretty successful company, getting acquired for $35M, is a meh story for its investors. If you intend to raise venture capital you need to have a clear path to that $100MM or more valuation. Now you understand why, hopefully.
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Now we can’t turn a $1M into a $100MM company, but we can make sure your pitch deck tells the best possible story about your business: either by having our team help you write it or design it, or by using our AI design tool.