You just received an email from your rich uncle who normally invests in real estate. He is excited about your company and wants to put in $25k for 0.1% of your company, your first outside capital. That gives you a pre-money valuation of $25M! So everything is great, right?
Cue Lee Corso – “Not so fast my friend.”
Wait, what’s wrong? I am being lawyered?
I don’t take pleasure in bursting bubbles but I do enjoy giving companies proper counsel even when the medicine is tough to take. The issues with the scenario above are 1) the potential impact it can have to your company’s future hiring plans through overpriced equity and 2) the great likelihood that the early investor overvalued your company and may have resentment when future investors buy at a lower valuation. The rest of this post will focus on #1.
How equity prices affect hiring.
Early stage companies, especially those who have not raised a financing round, typically don’t have the cash needed to pay team members market rates. Therefore, they must use equity as the tool to raise total compensation and attract employees and consultants. A company that can’t pay Linda, a developer $180K might be able to pay her $100k and issue equity to make up the difference. Because of this keeping equity prices low during the early stages of your start up is essential. Let’s walk through an example of how this looks.
Linda has negotiated for $100K in salary and wants 2.5% of the company (on a pre-funding basis) as an early employee. The Company has 5,555,556 shares on a fully diluted basis including unused shares set aside in its option pool where Linda’s shares will come from. That 2.5% equals 138,889 shares.
Assuming the company is early stage and has little or minimal revenue, the board of the company, who sets the company’s valuation, could say that their stock is worth par value. The company set par at $0.00001 per share.
If Linda is issued options the strike price will be $0.00001 so she can purchase her options for $1.39. If Linda is issued shares she can purchase them for $1.39 or the company can issue them to her for free and Linda will likely owe tax on that $1.39.
Building on our initial scenario above:
- Pre-money valuation – $25,000,000
- New money – $25,000
- Fully diluted capitalization – 5,555,556 shares
The factors above give us a price per share of $4.50!
If Linda is issued options the strike price will be $4.50 so she can purchase her options for $625,000.50. If Linda is issued shares she can purchase them for $625,000.50 or the company can issue them to her for free and Linda will likely owe tax on that $625,000.50.
Assuming a 20% tax rate that bill would be ~$125k.
Ouch. Linda is not happy.
The company decides to hire a third-party valuation firm and convinces that firm that the common stock should be priced at $0.50 per share since the $25K was a small investment and shouldn’t be entirely reflective of the value of the company.
This reduction causes the equity grant to be worth a little less than $70K and a prospective tax bill set to $14k. Still not ideal, especially if your uncle finds out that you argued that the stock he paid $4.50 per share for was really worth $0.50. Thanksgiving dinner is going to be rough this year…
Taking a Step Back
It’s natural to want to feel that your company is worth a lot, especially early on when you are grinding alone or with a small team. You quit your $200k job at Google so you NEED to believe your company is worth millions.
However, it is incumbent upon founders to have the long-term view of what is best for their company in mind and consider issues like what is mentioned above before taking outside capital from friends and family.
My next post will discuss how to properly raise from friends and family.