Slide 1Slide 1E145 Entrepreneurship Autumn 2008Session 12Stock OptionsSlide 2Slide 2E145 Entrepreneurship Autumn 2008Agenda•Barbara Arneson Case•Stock OptionsSlide 3Slide 3E145 Entrepreneurship Autumn 2008Barbara Arneson Case•What is the number of shares outstanding at BioGene as of May 31, 2006? – What is its current PE ratio? – Why do you think it is higher than the current average of other bioinformatics companies•What is Barbara's % ownership in each firm?•Compare the firms in 4 years when the stock options will be fully vested. – Assuming Barbara remains employed which stock option offer is better? •What other factors would you suggest Barbara consider in making her decision?Slide 4Slide 4E145 Entrepreneurship Autumn 2008Barbara Arneson CaseCase AnalysisAll other factors being equal, and based on the stock option packages only, I would accept the (BioGene/InterWeb -- choose only one) offer because ...Slide 5Slide 5E145 Entrepreneurship Autumn 2008Metrics in ActionMarket CapNet Income: $10 MP/E: 30$300 MShare Price: $15 # Shares: 20 M$300 MSales: $100 MP/S: 3$300 MSource: Prof. Tom Byers: StanfordSlide 6Slide 6E145 Entrepreneurship Autumn 2008Metrics CalculationSales: $100 MNet Income: $10 MShares Outstanding: 20 MStock Price: $15Public Company Info:(must be filed with SEC)EPS:P/E:P/S:Market Cap:We can calculate:Source: Prof. Tom Byers: StanfordSlide 7Slide 7E145 Entrepreneurship Autumn 2008Metrics CalculationSales: $100 MNet Income: $10 MShares Outstanding: 20 MStock Price: $15Public Company Info:(must be filed with SEC)EPS: $0.50P/E: 30P/S: 3Market Cap: 300We can calculate:Source: Prof. Tom Byers: StanfordSlide 8Slide 8E145 Entrepreneurship Autumn 2008Stock OptionsSlide 9Slide 9E145 Entrepreneurship Autumn 2008•Worthless PaperOr •$100 MillionSlide 10Slide 10E145 Entrepreneurship Autumn 2008IdeaBusiness PlanPrototypeBetaSalesProfitabilityDecreasing Company RiskDecreasing Company Risk$ 1M$ 50M$ 100MDecreasing Investor ReturnVenture CapitalBanksAngelsF&FGov’tIPOStrategic PartnersSources of FundingSource: David M. LeeSlide 11Slide 11E145 Entrepreneurship Autumn 2008What’s this Stock Stuff?•Why does everyone want it?– Finance the company before it’s profitable– Obscene returns for “risk capital”– “Combat pay” for founders and employees•How do you get it?– Invest money– Start the company– Work at the company– Buy stock at when it is publically tradedSlide 12Slide 12E145 Entrepreneurship Autumn 2008StartupA race against time to create value and reduce risk (1) Founding:An entrepreneur begins with a vision and shares of stock in the new venture.Entrepreneur trades stock for ideas, money, and people(2) Seed Stage:•Venture capitalists provide money in return for stock•Employees join via friends & associates in return for cash salary and stock options•Ideas become intellectual property which represents the initial value in the company(3) Growth Stage:More money, ideas, and people are obtained, but for much less stock than in the earlier stage due to lower risk(4) Exit Stage:•Company files for IPO•Entrepreneur, investors, and employees can cash in stock for money •A viable public company has been created•Each party continues to build the company, retires, or starts the game againReference: Start-Up by Jerry KaplanSource: Prof. Tom Byers: StanfordSlide 13Slide 13E145 Entrepreneurship Autumn 2008VC John Doerr of KPCB Q. What is the most important part of any business plan? A. “I always turn to the bios of the team first. For me, it’s team, team, team. Others might say, people, people, people -- but I’m interested in the team as a whole.”Slide 14Slide 14E145 Entrepreneurship Autumn 2008Why Stock Options in a Startup?•Aligns Everyone’s Interest to Liquidity– ties compensation to collective success – Provide incentives to employees to work harder– Motivation for the potential big payoff– Team spirit everyone with “skin in the game”•Conserves cash– Conserve cash – cash is king for startups – Allows start-ups to be competitive with established companies•Retention– Vesting is like drugsSlide 15Slide 15E145 Entrepreneurship Autumn 2008Common vs. Preferred Stock•“Preferred” is what investors buy–has preference on liquidation–Usually has cumulative dividend rights – Converts to common at "exit“– Make aggressive promises, don't perform, and you pay» Via anti-dilution rights •“Common” for founders and employees•Why the distinction?–Outside investors demand special rights–Justifies lower price for common – avoids…» Tax problems» Accounting problemsSlide 16Slide 16E145 Entrepreneurship Autumn 2008Common: Employee Stock•Lesser Rights than preferred– Preferred gets their money back 1st(and then some)– Other rights•Acquired by:– Founders’ shares (outright ownership)– Stock grants– Stock Options» Incentive Stock Options (ISO)» Non-qualifying (NQ)– Common Price set by 409A analysisSlide 17Slide 17E145 Entrepreneurship Autumn 2008Pricing Common Stock Options•For public companies – current market value– Different specific methods, but basically a ten day trailing average•For private companies – With venture backed firms, can use =>10% of last round price– Then 409a requires independent audit » ISO’s are exemptSlide 18Slide 18E145 Entrepreneurship Autumn 2008Stock “Vesting”•“Golden Hand-Cuffs”– Forced servitude– You have to stay to receive all your stock•Reinforces the idea that company’s value is built going forward•Avoid “free riders” – e.g. co-founder leaves; you keep workingSlide 19Slide 19E145 Entrepreneurship Autumn 2008Vesting Schedule•Total vesting time– Typically 3-5 years; 4 is typical•The “cliff”– Period of time during which none of the stock (or options) vests. Typically the 1styear•Monthly vesting– % of the stock which vests at the end of each month. Depends upon total vesting time.Slide 20Slide 20E145 Entrepreneurship Autumn 2008Dividing Up the Stock Pie!YouFounding employ-eesEarly stage financingYouFounding employeesInvestorsExpansionfinancingYouFoundingemployeesKey employeesInvestorsIPO / Acquisition / Buyout financingPre-financingYouSource: Prof. Tom Byers: StanfordSlide 21Slide 21E145 Entrepreneurship