In an effort to modernize, the industrious munchkins of OZ are researching a yellow brick information superhighway to connect everyone across the land. As a visionary, the Wizard recognizes that soon the citizens of OZ will have virtual access to information 24/7. While profitable, the EPIC business model is about to become obsolete. The Wizard decides to be a first mover and cannibalize EPIC’s current emeralds and mortar business model. The Wizard registers the domain name oz.com and sets out to find a new business model and team to capitalize on the pending yellow brick revolution.
Wizard knows he needs founding partners with complimentary skill sets. The Wizard approaches server hardware expert Mindy the munchkin and data analytics savant Sam the scarecrow. He offers to let them in at the ground level of oz.com. The three agree on a dynamic allocation of the founder stakes for the first three months. The team selects the Grunt Fund Calculator from Slicing Pie by Mike Moyer as their founder stake equity allocation tool. The founders agree on a set of Slicing Pie parameters heavily weighted on human capital and intellectual property; 3.7 times cash, 2.1 times equipment, 2.9 times salary, and 5 times IP. The team will divide 40,000 founder shares at the end of the three month grunt fund period. The team agrees to convert their current annual salaries into an hourly wage (divide their annual salary by 2,000 hours per year). They will track the number of hours contributed per week and accrue the appropriate dollar amount in the Grunt Fund.
During their discussions the Wizard, Mindy, and Sam agree the oz.com domain name, the search engine concept, and both pending and issued intellectual property are valuable and should be included in the Grunt Fund calculations. Everyone agrees to transfer rights to their intellectual property in exchange for compensation in the Grunt Fund calculations.
• Mindy. Mindy can work magic with hardware. She is willing to personally procure and sign over a new server stack to oz.com. The hardware is valued at $123,456. She has a market salary of $198,765, but is willing to work for only $2,750 per month during the Grunt Fund period of oz.com. Mindy has been tinkering in her basement on a concept for boosting hardware communication rates by 71%. The team agrees her communication related IP is worth $420,000. Mindy is responsible for building the hardware necessary to support the launch of oz.com.
• Sam. Sam is a software savant. He will assign the rights to his needle in a haystack algorithm over to oz.com. The team agrees it is IP worth $333,333. His market salary is $192,168 and he is willing to work for $5,000 per month for the first three months. Sam will be responsible for search software development, iterative improvements, and support.
Over the next three months, the team works hard to build an oz.com alpha prototype with basic search functionality. During the three month Grunt Fund period, the team recognizes the need to establish a pool of options for the retention and recruitment of partners and employees. Upon completion of the Grunt Fund period, the team will incorporate and distribute the originally agreed upon 40,000 shares to the three founders. They also agree to establish an option pool with 12,000 additional shares (52,000 total shares). The options will vest with a one year 25% cliff and 25% annual vesting on the employee’s hiring date. The par value for each of the newly issued 52,000 shares and options is $0.01. The founders also agree that their founder shares and the option pool should both include a buy back clause if someone voluntarily or involuntarily leaves the company.
Throughout the three month Grunt Fund period, Wizard, Sam, and Mindy have been demonstrating their alpha prototype to potential Angel investors at every opportunity. They generate significant interest. The team selects the Scarecrow, a scatter brained but well-meaning angel investor with an impressively large network of potential key partners. The same day oz.com is incorporated at Emerald City, the team accepts a convertible note for $550,000 at 19.3% interest and 42% discount upon conversion during the first priced round. The Scarecrow angel investor wants to protect his downside and demands a $1,650,000 cap. The Wizardaccepts on behalf of oz.com.
The same day they incorporate and close on the Scarecrow’s Investment, the team uses thefresh capital to hire three engineers. Because of their deep knowledge of the yellow brickinformation superhighway, the oz.com team awards 2,000 options each to the three engineers (6,000 total granted options). Because there is no established independent valuation of oz.com, the strike price for the three engineers is set to the initial par value per share.
The team starts arm in arm down the road towards a minimum viable product. The three new engineering hires help Sam and Mindy build out a basic product offering. The Wizard develops their first revenue model based on subscription service fees. They sell subscriptions to less than 0.1% of the population of Oz. The cost of customer acquisition is high. Hiring three engineers at 2,000 options per engineer has cost the founders half of their option pool. Time goes by and the original Scarecrow angel investment cash is almost depleted. The team has not yet demonstrated a sustainable and scalable business model.
Shortly before their angel funded runway runs out, oz.com has its eureka moment – one of their customers asks if they can pay to advertise to people searching on the oz.com search site.
The team realizes this could be their killer app! They could sell online advertising instead of search subscriptions. The founders dub their concept ‘oz-words’. Mindy and Sam franticallybegin revising their search engine code to allow for targeted advertising. The Wizard knows reconfiguring oz.com to take advantage of their epiphany will cost time and money. He begins meeting with venture capitalists to pitch their new advertising concept and explain the need fo a Series A venture investment.
The Venture Capitalist community is wary. Alphaba Venture Capital is the only firm willing to make an investment offer. The term sheet oz.com can obtain given their weak financial position and unproven minimum viable product is a $2.2M investment against a $4.4M pre-money valuation including a 18% dividend and 2:1 voting rights of preferred over common. Upon exit the Alphaba Series A preferred shareholders will hold an 8X liquidation preference and full participation. Preferred shares will convert to common shares at a 1:1 ratio during a liquidation event. The Alphaba VC firm also demands that oz.com add an 14,000 additional options to the option pool prior to making her investment. The additional options will be governed by the existing stock option holder agreement terms. The deal is grudgingly accepted and Alphaba’s VC Fund becomes an investor-owner of oz.com. The Scarecrow angel investor converts into preferred shares of oz.com with equivalent rights as the Series A VC investor Alphaba. The
Scarecrow is ecstatic to begin accruing dividends the day she receives preferred shares. The agreement stipulates her preferred dividends will be calculated on her original investment (ignore interest). The Series A deal is done exactly two years from the date of incorporation.
The team closes another round of hiring the same day the Series A deal closes. Oz.com is able to attract and hire top talent with their stock option plan. The oz.com team adds an Advertising Executive with 3,000 options and a Chief Technical Officer with 3,000 options. At the same time, an additional five software professionals are hired and granted 1,000 options each. Finally as an additional incentive to continue performing, the three founders (Wizard, Mindy, and Sam) are granted 2,000 options each. The strike price for all the options granted during this hiring phase is set at the final price per share once the Series A investment yellow brick dust settles.
The lawyers use the final post money valuation to determine the fully diluted share price including the increased option pool, newly issued angel investor shares, and venture capitalist shares.
The race to profitability is on. Eighteen months after closing their VC deal, everyone is furiously working to refine and mature the oz.com business model. Oz-words is demonstrating incredible margins. The team is optimistic, but funding from the first round of VC investment is rapidly running out. The board of oz.com is faced with a difficult decision – slow the growth curve, conserve cash, and more slowly reach profitability via a boot strap process or spend at an accelerated rate and grow faster than any competitor could possibly match and achieve first mover and network effect advantages. The Wizard and the Board agree on the value of achieving an insurmountably strong network effect. They vote to accelerate spending and focus on delivering oz.com to every advertiser and citizen of Oz.
Mindy and Sam are disgruntled by what they perceive to be massive dilution during the second round of venture capital investment. One day after the close of Series B, Mindy and Sam both tender their resignations. The Share Holder agreement provides the company with a buy back clause at the most recent valuation. The Stock Option plan has an identical provision for vested options. The board holds an emergency meeting and decides that due to heavy cash demands of growth, oz.com is unwilling to fully execute the buy back clause and purchase the total founder share and stock option holdings of Mindy and Sam. Instead, the board authorizes the company to purchase 40% of the number of founder shares and vested options held by Mindy and Sam. Mindy and Sam are compelled by the buy back clause in their shareholder agreement and stock option agreement to sell 40% of their shares and vested options back to the company. After the 40% buy back is complete, those shares involved in the buy back are returned to oz.com and held as treasury stock (issued, but not outstanding). Since oz.com did not purchase 100% of their holdings, Mindy and Sam continue to own the remaining 60% of their founder shares. During the 90 day post-employment execution time window in their stock option agreement, neither Mindy nor Sam executes their vested options that were not bought back by the company under the buy back clause. After the 90 day execution period expires, the vested options become forfeit and are returned to the stock option pool for future grant.
Time passes and oz.com becomes a household name. The Glenda and Alphaba VC Firms are approaching their 10 year fund lifetimes and they are becoming very impatient to harvest their investment in oz.com. The oz.com Board contracts with Flying Monkey Investment Banking firm to sell oz.com. The Flying Monkey IB firm negotiates a service payment upon close of a 5 transaction of 5.5% of the total deal value. Oz.com contracts with a legal firm for a $1.3M flat fee to complete the transaction. The investment bankers begin targeting companies publicly traded on the Emerald City Exchange.
After an exhausting road show and due diligence process, oz.com receives a bid for $555M from publicly traded Lion of Courage Inc. (LOCi). The deal will be paid out as $195M cash, $160M LOCi stock (trading at $11 per share), and a one year $200M earn out incentive. Lion of
The cash portion of the acquisition will be paid out to the various participants according to industry standard practices and the terms of any service provider contracts, preferred shareholders, common shareholders, and vested option holders. None of the Option Holder agreements includes an accelerated vesting clause.
The earn-out balance due will be paid out as a function of sales growth for one year post acquisition. In the year prior to acquisition, oz.com had $130M in revenue. The negotiation team agrees upon a 2:1 ratio of earn-out payment for every dollar of increased top line sales over the previous $130M revenue total. In other words, if oz.com can add $1 of additional sales above $130M, the beneficiaries of the oz.com acquisition will split $2. The earn out payments are to be distributed on a pro-rata basis to all common shareholders after executing vested options and conversion from preferred to common shares. The total payout of the earn out shall not exceed $200M.
The portion of the sale purchased via shares in LOCi includes special treatment for the preferred shareholders. While the number of shares awarded to the various shareholders is to be determined on a pro-rata basis, the preferred shareholders have the right to register and sell their LOCi shares any time after the acquisition deal closes. Every preferred shareholder decides to liquidate all of their shares on the Emerald City exchange the day after the acquisition deal closes. The founders and employees holding common shares and options on common shares of oz.com at the time of the acquisition are locked out of trading their LOCi stock for one year after the deal closes.
The boards of both companies agree to the acquisition exactly seven years from the date of incorporation of oz.com. The day after the acquisition is completed and announced, the share price of LOCi jumps from $11 to $22.39. The preferred shareholders benefit from the price increase when they liquidate all of their LOCi shares on that day.
The share price continues to fluctuate throughout the year. LOCi shares close at $19.39 exactly one year after completing the acquisition. The employees and founders of oz.com sell all of their LOCi holdings on the day the lock out expires. The oz.com subsidiary of LOCi books $203M of top line revenue during the one year earn out period. The earn out payments are made at the time the earn out period ends.
The founders of oz.com use a portion of the money they receive from the acquisition to purchase a large plot of land in Kansas…