KAUFMAN, J.

DRAFT June 30, 2012

The Fate of Employee Stock Options During the Acquisition of a Privately Held Company
Jonathan Kaufman Venture Projections LLC June 30, 2012
Abstract abstract goes here.

Consider a simplied version of a typical successful nancing pathway and exit of a small, venture-backed biotech company (lets name it the Centriole Corporation). First Centrioles founders acquire 10 million shares of common stock for a nominal fee. Centriole issues $1 million of convertible debt, having 6% annual interest rate and a 20% conversion discount, to nance building a team. After one year, Centriole makes nice progress and issues $10 million (not inclusive of debt conversion) of Series A convertible preferred stock having a 1X liquidation preference and a 2X participation cap, on a $6 million pre-money valuation that includes dilution for a 20% option pool post-nancing. The total series A nancing of cash plus debt is thus $11.325 million. $10, 000, 000 + $1, 000, 000(1.06) = $11, 325, 000 1 0.2 (1)

Consider the following two equations of two unknowns for the determining the share-sizes of the Series A issuance, A, and the initial stock option pool, PA . A $11, 325, 000 = 10, 000, 000 + PA $6, 000, 000 A + 10, 000, 000 = PA ( (2)

1 1) (3) 0.2 The solution, A = 44, 674, 552shares, and PA = 13, 668, 638shares, indicates that the price-per-share paid (and thus 1X liquidation preference) for Series A was $0.2535, and the corresponding 2X Series A participation cap is thus $0.5070 per share. A typical 409A valuation would value common shares at approximately 30% of the most recent price of preferred securities, which would be $0.07605 per share of common. Centriole continues along with an approximate burn rate of $0.5 million per month, and within two years, secures its next round of venture capital 1

KAUFMAN, J.:

DRAFT June 30, 2012

nancing of $25 million on a $25 million pre-money valuation (which is $8 million above the Series A post-money valuation, a modest step up). Consider that this pre-money valuation accommodates maintenance of the relative size of the employee stock option pool at 20%. A similar set of two equations can be used to determine the resulting dilution $25, 000, 000 B = 68, 343, 190 + PB $25, 000, 000 B + 68, 343, 190 (4)

13, 668, 638 1 = PB ( 1) (5) 0.2 0.2 where B is the number of Series B shares issued and PB the resulting expansion of the employee stock option pool. The solution, B = 91, 124, 253shares and PB = 22, 781, 065shares indicates that the price-per-share paid for Series B preferred stock was $0.2744 (with a 2X participation cap of $0.5488 per share), a slight up-round. Similarly, the exercise price of the new, PB , options is $0.08232. The resulting cap table is as follows.
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The payout to shareholders will only be coincident with the cap table after all liquidity preferences and participation rights are exceeded. Typical treatment of employee stock options during an acquisition includes 100% accelerated vesting prior to acquisition and cashless exercise. ... ... , say a $180 million acquisition ($60 million of which is up-front), after rm has raised $40 million in venture capital over the past four years. Suppose that the aggregate venture capital investment of $40 million in two rounds: a $15 million series A, and a $25 million series B, and that both venture capital investments have a 1X liquidation preference and a 2X participation cap. Excluding the eects of possible options and warrants, the payout functions (often referred to as waterfall) of the rm is as follows, where s1 , s2 , and s3 are series B preferred, series A preferred, and common respectively; and p(sn , v) is the payout to security sn as a functions of aggregate payout, v. A typical earn-out for a $180 million biotech exit may include an initial payment of $60 million, followed by four contingent $30 million payments. Proceedsper-share for the initial and contingent payments, not yet taking into account the eects of options and warrants, would be as follows. The liquidation preferences and participation right cause the initial divergence in price-per-share of the three securities. These preferences have an eect up until the nal two of 2

KAUFMAN, J.:

DRAFT June 30, 2012

76 s1conv 60 s1cap s2conv s2cap 30 20 10 0 0 10 20 30 40 50 60 70 80 90 100 110 120 128

s1

p(s,v) ($ millions)

50 40

s2

s3

v ($ millions)

3 2.5

price-per-share ($)

seri
1.5

es A
B
n

series

1
com

mo

$0.45 $0.30

0.5 0 60

70

80

90

100

110

120

130

140

150

160

170

180

cumulative aggregate payout ($M)

the contingent payments. The issuance of employee stock options must comply with certain tax provisions which require the exercise price of the options to be equal to the fair market value at the time of issuance. There are many factors that can aect the determination of fair market value. Typically, fair market value for common stock is within the range of 30% of the share price of any recent issuance of preferred stock. Consider, for this example, a 20% option pool on a fully diluted basis split 50/50 between issuances with exercise prices set at $0.30 and $0.45, corresponding to periods after the issuance of series A and series B respectively.