Why Start-Ups Use Convertible Debt Part I: Common Stock Financing and the Problem of Setting a Valuation

Foley & Lardner LLP

Most start-up companies turn to friends, family and/or high net worth individuals as the first source of capital to fund their operations. Banks will not lend to these companies since there are no real assets to collateralize the loans, and most venture capitalists and other institutional investors need to see a further developed company with customers or at least a developed product before they will consider investing. Friends, family and/or high net worth individuals are often more willing to take this early risk.

While there are many ways for a company to structure a financing, the start-up company typically follows one of two paths: 1) the sale of common stock or 2) the sale of convertible debt.

A common stock financing is pretty straight forward. The company puts together a simple purchase agreement that contains basic representations about the company and a statement from the investor that he or she understands that this is a risky investment and has had the opportunity to evaluate the opportunity. The agreement then provides a price per share. Determining the “right” price per share is often a very challenging task for an entrepreneur founder.

Founders believe passionately that their company has tremendous unrealized value, and often try to capture that value in the early stage financing. To demonstrate this, we often ask founders of new start-up companies the following question: if an investor were to offer you $1M today, what percentage of your company would you be willing to give to that investor. The answer we receive is typically 10%. We then explain to the founders that by giving 10% of their company for $1M, they would be valuing their company at $10M.

We then discuss the issues that need to be considered with a $10M valuation. First, most high net worth investors will think the valuation is too high. Start-ups with no customers, no products, no proven management team, and just a really-good idea rarely attain at valuation even remotely close to $10M. A valuation between $500K and $1M would be more typical. However, if the founder were able to secure a $10M valuation, the Company would need to manage the consequence of such a high valuation going forward. That $10M valuation would be the new fair market value of the Company. As such, option grants to new employees and advisors would need to be made that that higher valuation – otherwise, the grant would be a taxable event to the recipient. The Company would also be cautioned against “giving away” founders equity to new key hires. For example, if the Company hired a new CEO and wanted to give him or her founder status and 10% of the Company’s equity for little or nominal cost, that issuance would result in a $1M taxable event to the new CEO. This is because the receipt of 10% of a 10M company for future services would be taxable upon receipt as ordinary income. Finally, any future raise at a valuation less than $10M would be a “down round” and would reflect poorly on the management team, even if they have made great advances in their product and overall operations.

In Part II of our convertible debt series, we’ll explore how a convertible debt financing works.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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