There are a ton of ways to structure stock options for investors, and figuring out which combination makes sense can be pretty overwhelming. This is particularly true for startups when the future is completely uncertain and there is no way of really knowing the number of funding rounds that may be needed down the line. Ideally, a startup’s strategic plan, business model, and anticipated trajectory should be outlined well enough to allow for the calculation of at least rudimentary financial forecasts and projections.
Then, those forecasts can serve as a starting point for determining the number of successive fundraising rounds that will be needed to achieve the predetermined goals, as outlined in the plan and model. This, in turn, will help a company to decide on the types of stock options that it may be interested in offering. However, regardless of how detailed the initial structure is, there are several types of options that tend to predominate.
A fully participating preferred stock option is usually the standard favorite, as it entitles investors to receive their full investment before any other investors, along with a portion of the common stock, which is generally based on a percentage and/or established ratio. The fact that these investors are “fully” participating and designated as “preferred” makes it pretty clear that they have a lot at stake but also a lot to gain. However, because this option gives these stockholders so much of the pot and thus can erode the founders’ share, a lot of companies choose to limit this to a certain percentage and/or offer the other common options discussed below.
A capped participating stock option still allows investors to recoup their capital along with a percentage of the converted amount for the remaining portion, but the latter part is usually capped at a certain agreed upon percentage. Although this is still a fairly safe and generous option, it prevents all of the liquidation proceeds from going to one segment of the investors, as may happen if there is not going to be enough leftover after the preferred holders receive their share. Thus, it is simply a limited form of fully-participating stock that protects more of the players. Obviously, the fully participating route is going to be the investor preference, but the capped version should both entice investors and keep the founders and any future investors comfortable as well.
Another option is the non-participating stock in which investors receive their share of the preferred stock proceeds and then do not share in the remaining distribution. However, in some cases, the non-participating stockholders receive either their preferential portion or the portion equivalent to the common stock had they converted, with the amount paid out usually being whichever one is greater of the two. This one is generally favored by founders, especially in the early days of a startup’s existence, but is obviously not as attractive to investors.
It is important for leaders to think about what makes the most sense over the long term, will not result in excessive dilution, and whether it is the type of structure that will allow the business to take the company public down the road, if that is the end goal.