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Jun262011

Founders: ff, super f and plain old f'd


Prior to 2005, deciding on the capital structure of a startup was a very simple affair.  Most capital structure included 80% common stock for founders, 20% for the employee stock options pool (ESOP) and then investors got preferred stock which diluted common and ESOP equivalently.  But today, founders have more options including having Series FF Class Preferred, which allows you to sell a portion of your founder shares at an institutional round without causing a tax effect on common and Super F shares which gives founder shares expanded voting power.  

So what are these new semi-exotic shares and how do you decide when to use them and when not to?  Could choosing the wrong structure accidentally just get you F'd?

Some History.  In 2005-2006, my company, Powerset, helped create the Series FF class preferred share structure along with Orrick, the law firm and Peter Thiel, Luke Nosek and Sean Parker.  I was, for better or for worse, the first person in the United States to ever have Series FF class preferred and to sell it.  So with those bonafides, here's the justification behind FF from my perspective (although I urge you to talk with others because there are widely varying opinions when it comes to of FF).

The Need.  Although it seems antithetical for investors to support a founder ever cashing out prior to making the company a success, there are legitimate circumstances where investors would and should support such a move.  These cases almost always involve a circumstance where personal financial pressures are either distracting a founder or potentially causing them to make irrational or unwise decisions.  Sometimes it may be an older founder who is feeling financial pressure because they have a mortgage eating away their savings and thus they decide to position the startup to sell earlier than they should.  Sometimes it may be a younger founder whose loses their sanity after prolonged periods of too much angst associated with overly complex and retarded strategies to simultaneously change the world, get rich and somehow get laid all while juggling credit cards just to maintain a lifestyle of sleeping on a futon, eating pho and drinking Rock Star energy drinks.  However it happens, the logic of why an investor would support a founder cashing out a small equity stake is the same... if doing so eliminates all distractions from a founder's personal life so that they can be 100% focused on the startup while maintaining enough of an equity stake to be hungry, then it's simply a good investment strategy.  

The Problem.  The ginormous problem that existed prior to Series FF was that if a founder always got common and if they ever sold common, say at Series A, at a price higher than their strike price of common when they got it, then all sort of tax implications rain down on other common stock holders, typically employees, causing a shit-storm to fall on the founder's head - and rightfully so.  Basically the end of the story here is that there really wasn't any real option for founders to eliminate their personal burdens while operating their startup.

The Solution.  Enter Peter Theil, Sean Parker and Luke Nosek from FoundersFund (that's the FF in Series FF class stock) and three wide eyed idiots crazy enough to be willing test subjects, i.e. me, Barney and Lorenzo - the founders of Powerset.  While we were developing the idea of this stock, we jokingly referred to it as Purgatory stock because it was neither preferred stock (heaven) or common stock (hell), but rather sat in a gray area between (purgatory).  The idea was that this special stock could only be given to Founders at the founding of the company.  It it had the magical property where if it was sold at Series A, it went to heaven and became Preferred Stock at the preferred strike price of that round and if it was not sold as Series A, the idea was that it would fall to hell and it would become common stock and was valued the same as other common, thus it would therefore not cause any nasty tax effects for common stock holders.  

The Weirdness and the Benefit.  I still remember the day we told Charles Moldow at Foundation Capital that we had invented a new class of shares that we called Series FF shares and that we intended to use them at Powerset - the look on his face was worth the $7M we were asking him to give us for our Series A.   Looking back on it now, it seemed a bit crazy to introduce such an obvious flag in the middle of our fund raising process.  But I guess inventing a new type of stock really didn't add any more craziness than the already ridiculous notion that we were asking for a $40 million+ valuation and we were taking on Google head to head... so why not?  My top secret strategy was to take Charles out for milk shakes at the Creamery in PA every Tuesday for what seemed like the entire summer of 2006 to get him used to the idea (and of course I made him pay for my shake too).  Eventually, Charles finally agreed to do the round with FF intact.  I must say I'm still a little shocked that we got our round done with FF, but once the word about this magical new type of stock got out, it immediately launched a wave of companies who wanted to copy what we had done.  

The numbers.  At Series A, I was the first person to sell Series FF preferred and I sold $xxxK to xxxxx xxxxx, which, I think, represented something less than 5% of my stock (I can't quite remember).  I used the money to reduce the loan on my house, which reduced my money salary requirements to startup levels.  For me, it truly did have the intended affect... it made me more settled, more confident and more patient.  In essence, Peter had created a "safe zone" for me to operate so that I could make his investment more valuable.  It was a valuable lesson for me that I experienced first hand.

Since its inception, FF has gone through a roller coaster experience.  I've heard some VCs scoff at it as if it were pure evil thought up by VC haters.  I've heard lawyers refer to it as a shady way of contemplating capital structures and I've seen founders abuse it benefits to actually cash themselves out for reasons that I have thought were a bit questionable.  However, I think FF is beginning to settle out a bit.  Today, Series FF is widely understood by most law firms and it has matured in it's structure quite a bit from the Powerset days.  At the end of the day my opinion is that Series FF, if properly implemented, is a valuable tool in the tool belt of both founders and investors.  I think that Series FF is definitely NOT the norm and NEVER will be. Rather it is and will always be the exception - but a valuable one.  

Super F.  Super F is yet another semi-exotic class of shares where founders shares have more voting power.  In terms of my background with Super F, I have never had it in any of my companies, so because I believe that people should only talk about things they have experience first hand, I've decided that I 'll let someone else discuss Super F in detail.

Decisions.  So how do you decide whether or not to use Series FF in your company?  Here are the factors I would consider:

  • With Series FF: Do you need to reduce some financial pressure in your life as a founder and would reducing that pressure massively amplify you as a founder?  Are all founders in this position, or just one?  If your founding team members are all 18 and you're living in a shit house, FF may be right for you.  If you are an old fart, (meaning older than 30) and you are leaving a job that's paying you more than $200K and you've built your life on having that level of income, then FF may be right for you.  If you want FF just because you want to upgrade your honda civic to a BMW, then FF is not the right instrument and I would call you a second-hander poser want-a-be and you don't deserve to be a founder.
  • For both Series FF and Super F: they are DEFINITELY a red flags for many VCs, so beware that you are creating a flagg-able item which could make you less attractive for investors.  So consider, the current economic climate and how hot you are as a startup.  Generally VCs are more likely to be ok with Series FF in a founder friendly environment or when they are dealing with a super hot deal.  If fund raising is tight or you are a struggling startup and you really just want to make sure you close you round, don't expect Series FF to be something that is easy to get passed a VC.  I wish some website would do the homework of interviewing every VC to find out their opinion of Series FF and Super F - it would make our lives a lot easier.
  • For Series FF and Super F:  Are there other options? - lately some law firms are claiming that you can, in fact, sell common without a tax affect.  This is a phenomenon that I don't quite understand, but this is something that I would follow closely.  In terms of maintaining control, Super F is only one of many tools in the tool belt.  If I thought I could get Super F, I might just take it, but if I thought it would put my round at risk, I would focus more effort on the negotiations revolving around the "investor rights" which is in my opinion one of the most important and definitely the most under discussed part of the negotiations when it comes to raising a round of money.

Whether you decide to use these semi-exotic classes of shares, make sure you do so wisely because if you are not careful, they could F you in the end.

Disclosure.  Since Powerset I have not had Series FF in any of my companies, but I have supported their use in some of my portfolio companies from my personal fund.

/steve.

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Reader Comments (3)

I'm surprised founders aren't more frequently advised to consider implementing FF Preferred Stock upon formation of the company, since implementing it is generally a one-time opportunity that must be done before there are other holders of stock or options. I suspect the reluctance probably arises from your point about being thoughtful about creating "flagg-able" items, but I think people are probably more conservative about this than they need to be. My view has always been that if the FF Preferred were ever to be a potential red flag to an investor, you can easily eliminate the potential red flag by simply converting the FF Preferred to Common Stock and carrying on with life as if it never existed.

FYI, for founders who did not implement FF Preferred Stock at formation, there may be an opportunity for a "do-over" through a recapitalization of the company or through the issuance of FF Preferred as a stock dividend to the founders. The complexity of the "do-over" varies, but is relatively straightforward if the founders are the only stockholders and no stock options have been issued. John Bautista, Greg Heibel, Steve Venuto and others at Orrick are experts at this stuff.

Thanks for the great write-up on a couple flavors of founders preferred!

July 28, 2011 | Unregistered CommenterChris Field

I'd be interested in hearing. The TOS seems rather clear that it is not unless expressly approved by Amazon. I guess if the library got it in writing then they would be ok. abnvmp abnvmp - moncler jackets outlet.

October 15, 2011 | Unregistered Commenterwfryer wfryer

Hi - thank you for posting an informative article on this topic. A startup I am involved with is also trying to decide on whether to implement Series FF in our AOI. I was wondering if you would mind sharing an example AOI with a Series FF preferred language incorporated -- wanted to review how the rights, preferences, restrictions, and other terms differ from a "typical" AOI with only Common + Series A preferred or a Series F common. Also are there any other initial start-up related documents that need to reflect the Series FF preferred. (We'll be using an experienced lawyer when its time to do everything right, just wanted to do some independent research.) Thank you in advance!

November 2, 2011 | Unregistered CommenterN B Robinson

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