Venture capital is drying up. So sayeth every oracle of Silicon Valley and the rest of the startup ecosystem. I don’t know that I agree with them (a good question – for another time), but I do know that belt-tightening times like this often lead entrepreneurs to look beyond the preferred equity-style investment structure which VCs spoon (force) feed their targets, searching for sources of cheaper capital.

There are exciting new possibilities out there, particularly seeking capital from previously unavailable markets via Reg A+ and Reg CF. However, a good dig into these options reveals that they are actually quite expensive and time consuming (again, a topic for a future post), and oh my goodness we’ve got all this common stock lying around and why don’t we just sell it??! Well, I’ll tell you.

Let’s start with the purpose of common vs. preferred stock.

  • Common stock usually ends up in the hands of you (the founders), employees (via an equity incentive plan or something similar), and maybe a few other people. It’s a cheap way for the company to manage limited cash flow and align interests. A low common stock price is valuable, particularly with respect to your employees (who are your main audience here), because a lower price means, among other things, that a) employees who aren’t millionaires can afford to exercise stock options if they want to, for example, take advantage of long-term capital gains tax treatment, and b) the profit they will enjoy at a given exit price will be greater.
  • Preferred stock, on the other hand, really exists for the sole purpose of raising operating capital from outsiders. The fewer shares sold in exchange for the money the company receives, the less the voting power of the existing shareholders is diluted. The upshot of all of this is that in order to maximize the benefit to the company, preferred stock should be worth as much as you can convince investors to pay for it.

In addition to these basic underlying principles, and to a significant extent as a consequence of them, there are a number of unfortunate consequences of upsetting your capital structure by selling common stock to raise capital:

  • Option Pricing: As a general rule, options must be issued with a strike price equal to the fair market value of the underlying security at the time of issuance. Having sold common stock to investors at a given price, it becomes very challenging to justify issuing options to employees at a lower price. This puts your employees on an equal economic footing as your investors, and it doesn’t take creativity to imagine how employees (particularly prospective employees) will react to being told that their “equity incentive” will require them to buy shares at the same price as the millionaires sitting in on the Board meeting. It’s difficult to overstate how effectively this can undermine a company which depends on equity incentives to attract and retain talent.
  • ISO Limitations: Incentive Stock Options (or ISOs) are a highly effective method of attracting and retaining team members because of their advantageous tax treatment in contrast with Non-qualified Stock Options (NSOs). However, the total aggregate value of ISOs that become exercisable for an individual for the first time within a calendar year may not exceed $100,000 (valued at the time of grant). For example, an option for 200,000 shares (a very modest grant, percentage-wise) vesting over four years becomes exercisable for 50,000 shares per year. Using an actual valuation (though not one of my clients), if these shares are valued at $9.51 (because the company sold common stock to investors at a high valuation), the advantageous ISO treatment is only available for about 20% ($100,000 limit / $475,500 total exercisable) of the value of the option for that year. So in addition to being required to pay significant amounts to exercise the option, the optionee will be forced to pay tax in the current tax year on about 80% of any spread between the strike price and the fair market value at the time of exercise, rather than having that tax deferred until the shares are sold. TL;DR: Employees generally can’t afford the taxes they will incur on high-priced options.
  • Rule 701 Limitations: Rule 701 is an exemption to the federal securities laws requiring that all transactions in securities be registered with the SEC. It applies generally to employees or consultants, and is the rule that makes equity incentive plans work. However, it has limitations, and a skyrocketing common stock price is a great way to violate them. Specifically, the 701 exemption runs out after you have issued $1 million worth of shares, or 15% of the value of your assets, or 15% of the outstanding amount of the class of securities being offered and sold in reliance on the rule, whichever is greater. If you go out and raise money by selling common stock at a high price, you’ll be amazed how quickly you lose the 701 exemption which protects your entire equity incentive structure. And if you think the SEC doesn’t care, go check out what they did to Google.

This is necessarily a limited review of the issue. Other perspectives should be considered as well, such as the opinion a new investor will have if they arrive on the scene, interested in putting money into what they view as a great business opportunity. How interested will they be if they see a capital structure in need of serious attention? Will they want to invest when their money will be going to fix past mistakes rather than growing the company? How will it reflect on the management team, not just for this investment opportunity, but into the future?

Choosing to raise capital for your company, and determining the best way to do it, is complex and challenging from both a legal and a business perspective. In very, very limited circumstances (or in a downright emergency) selling common stock for capital might be the right choice, but in the vast majority of cases it will cause significant problems with your capital structure which are difficult and time consuming (read: expensive) to undo.

Before you choose the quick and easy path, be sure to have a talk with your lawyer and your other professional advisors, and work with them to formulate an investment strategy which will serve your company’s needs now and into the future.

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