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I Just Sold 20% of My Company For $100,000.  Did I Get A Good Deal?

 

Probably not.  Maybe.  Or perhaps yes.

The truth is that valuing a startup is very difficult, if not impossible.  Assigning an arbitrary value too early in the life of a company can have unintended consequences.  Consequences that can cause big headaches down the road for the founders, employees, and current and future investors.

Take the example from the headline of this blog.  You’ve sold 20% of your company for $100,000 to Investor No. 1.  Let’s assume that Investor No. 1 bought 100,000 shares for $1.00 each.  This investment sets a per share value for your company of $1.00.

 

Setting a valuation too early can wreak havoc with the founders’ taxes.

Let’s assume that you (and your co-founders, if any) bought your founders’ shares for 1¢ per share (in reality, founders usually buy their shares for much less than a penny each, but to make the math easy, I’m using 1¢ in our example).  Then, a month or two later, Investor No. 1 comes along, signs some paperwork, and forks over $1.00 per share for 100,000 shares.  So what could be bad?

Well, under certain circumstances, you and your co-founders could owe income tax on the 99¢ price difference between the $1.00 paid by Investor No. 1 for each investor share and the 1¢ paid by the founders for each founder share.   In this example, if the founders own 400,000 shares (the other 80% of the company), the founders could owe income tax on 99¢ of “deemed income” on each share.  That’s potentially hundreds of thousands of dollars of tax.

How can this happen, you say?  It’s because the IRS might wonder why the company’s shares were only worth 1¢ apiece just a few weeks before the company sold similar shares to an investor for $1.00 each.  The IRS can recharacterize the 99¢ difference as value paid to the founders for work, rather than attributing it to an increase in the value of the company’s stock.  This is especially likely where the company’s sales or assets at the time Investor No. 1 bought his shares are pretty much the same as when the founders bought their shares.  If that 99¢ difference is deemed to be money paid in exchange for work (in other words, income), then guess what?  Income tax.

 

Setting a valuation too early can affect your employees’ stock options.

Most startups and early stage companies are cash poor but equity rich.  Fortunately, many potential employees are willing to accept stock options (equity) in addition to or instead of cash compensation.  Employees are often willing to accept stock options instead of cash for essentially two reasons:  (1) they hope that the stock will increase in value, and (2) stock options are usually offered to employees at an exercise price (usually called the “strike price”) equal to “fair market value,” which in the case of a startup is usually zero or very close to it.  This makes the stock very affordable for the employee when the employee “exercises” the option (i.e., when the employee decides to buy the options at the strike price.)

Let’s use our example again.  Assume that on March 1, Investor No. 1 buys his shares.  Then, on April 1, you hire an employee and want to offer her stock options as part of her compensation package.  But now you’ve got a dilemma.  You can’t offer the employee her stock options at 1¢ per share (or an even lower amount) because you’ve recently valued the company’s shares at $1.00 each (by selling stock to Investor No. 1 for $1.00 per share). Remember that in order to avoid a potentially big income tax hit to the employee, the strike price of stock options must be “fair market value,” which in this case is likely to be $1.00 per share or close to it.

This makes things problematic and expensive for the employee.  If the company were to offer the employee options to buy, say, 10,000 shares at a “strike price” (fair market value) of $1.00 per share, it will cost her $10,000 out of her own pocket to exercise the options (10,000 shares x $1.00 per share) .  Most employees, faced with this scenario, will think $1.00 per share is too high a price to pay.  The prospective employee won’t want to come $10,000 out of pocket to buy her shares, and she’ll hesitate at accepting employment with the company.  This can make it difficult for the company to attract talented people.

 

Setting a valuation for your company too early can affect current and future investors.

Suppose that one year after selling shares to Investor No. 1 for $1.00 per share, the company finds itself without any sales, still building out its app or product or service, and facing competition from another startup company offering a similar product.  The company decides it needs another $200,000 to carry it through to breakeven, so it starts looking around for more investors.

Investor No. 2 shows up and says that she’ll invest the full $200,000, but since the company’s value hasn’t increased since the initial investment a year earlier, and in fact has probably decreased due to competition, new market conditions, and delays in development, she wants to buy her shares at 50¢ each (which amounts to 400,000 shares).

As you can probably imagine, Investor No. 1 is going to be upset, to put it mildly.  He paid $1.00 per share at a riskier point in the company’s history, and now a later stage investor is investing at an arguably less risky point in the company’s history for half that price, and getting more shares as a result.  Not only that, but an even later stage investor or venture capital fund can use the 50¢ per share price to argue for a lower valuation when it invests down the road.  And the founders, who initially owned 80% of the company (400,000 shares), now find themselves with a much lower ownership percentage of, and therefore less control over, their own company.  This is called “dilution,” and minimizing its effects is usually one of the most important aspects of any venture capital investment.

 

So how can a startup avoid making these mistakes and falling into these potentially costly traps?

Simple:  Avoid putting a value on your company for as long as possible, especially when you’re taking your first investment money or seed capital.  Fortunately, there’s one very useful technique that startups can use to both raise seed money and avoid an early valuation.  In fact, this technique can help the company avoid giving up any equity or control at all at the time the seed investment is made.  I’ll discuss this unique tool in my next article.