Corporate Finance Primer

Disclaimer

This talk is given in my personal capacity, not work-related, no company related information will

be discussed, and it is neither legal nor tax advice.

All About Acme LLC

• Initial valuation $1M (we’ll get back to this.)

• 10M shares, ie $0.10/share

Funding Round

• Bring in capital (cash) via sale of new shares to investors

• Similar to more guests at a pot luck: more people and more food

• Since cash is king, gets preferential treatment

Funding Round

• Acme grew to $4M, pre-money

• Raising $1M

Funding Round

• Pre: $4M/10M, so $0.40/share

• Post: $5M/X = $0.40/share (value preserving)

• Need to issue 2M shares

Funding Round

$1M

$2M

$3M

$4M

$5M

pre $4M post $5M

Equity Cash

100% 80%

20%

Funding Round

• Dilution in percentage ownership

• No value dilution

• Bet that cash can be converted in at least same equity value

Debt Issuance

• Traditional model of funding

• Deterministic returns (if all goes well), and faster liquidity

• But exposed to company failure without being exposed to its success

Acme Promissory Note

• $500K

• 12% interest, yearly installments

• Capital repaid in full at year 3

Bridge Loan

• To bridge between two milestones (eg funding rounds)

• Avoids valuation process, share issuance, generally simpler and for smaller amounts

• Incentive via discount at next round (convertible loan)

Acme Bridge Loan

• $500K

• 6% compounded monthly

• Right of first refusal in next round

Valuation

• Initial & Seed

• Series A “getting to product/market fit”

• Series B “operationalizing”

• Liquidity

409A

• Under new section, need to value to company to provide fair market value for common stock

• Strike of options is set at that fair market value to avoid tax liabilities

• (Introduced post Enron disaster, 2005.)

Valuation rules under 409A• Tangible and intangible assets of the company,

• Discounted Cash-Flows (DCF),

• Comparable companies,

• Recent transactions involving the sale or transfer of stock or equity interests,

• Control premiums,

• Discounts for lack of marketability,

• Use of valuation for other purposes having material economic effect on the company.

Timeline of 409A

0%

25%

50%

75%

100%

Common Preferred

All About Stock & Options

• Stock — subdivision of a company’s value, into a made-to-measure currency

• Option — … to purchase stock at set price i.e. the strike. Technically, called a “Call Option.” (We’ll skip put options, naked options, and other exotic options.)

Common vs Preferred

• Preferred has liquidation preference

• Common is a mean to provide in-the-money value to employees, and comply with IRS rules

• Preferred converted into common at IPO

ISO vs NQSO

• ISO has tax advantages over NQSO(Gains between strike and exercise taxed as capital gains vs income.)

• Can't qualify as ISO if aggregate fair market value of underlying stock is greater than $100,000 in a given calendar year

Acme Employee Pool

• 10M shares outstanding, $4M valuation total

• Want to have ~10% for new employees

• Create 1M shares earmarked for distribution

Employee Pool

• New Hires

• Evergreens

• Promotions & Performance

Expanding Employee Pool

• Issue new shares earmarked for distribution to employees

Acme Employee Pool

• Pre: $4M/10M, so $0.40/share

• Post: $4M/11M, so $0.37/share?

Acme Employee Pool

• Trick: 1M shares are on the books of Acme

• Ownership of 1 share, also means 0.1 of employee pool share

• Therefore, still value preserving!

Acme Employee Pool

• Dilution when issuing a grant

• Bet that new hire will translate into more equity value than size of grant

• (Similar concept as cash being converted into more equity value.)

Strike Price• Strike set when options are granted

• Most “Stock Option Plan”:

• Grant post start date

• With approval & oversight of the board

• That’s Corporate Governance, not IRS rules. Very touchy area though.

Exercising

• Tax benefit, at the cost of liquidity

• Golden handcuffs, not

• Early exercise even better!

Tax Implications

Timeline for scenarios

• 2010: Option’s strike at $10

• 2012: In one scenario, exercised at $50

• 2013: Sold shares at $100

Tax Implications

$0

$25

$50

$75

$100

Early Exercise* Same Day Sale Exercise

Acme Income Capital Gains

Tax Implications

$0

$25

$50

$75

$100

Early Exercise* Same Day Sale Exercise

Acme Income Capital Gains

!

Taxes:$90 @ ~35%"!After Tax:$58.5

Taxes:$90 @ ~50%"!After Tax:$45

Taxes:"$40 @ ~50%"$50 @ ~35%"!After Tax:$52.5

Assumption:"income taxed @ 50%, capital gains taxed @ 35%!