Rule 409A – Again

I first wrote about Rule 409A back in September 2011.  Here is the post, which focused mostly on how 409A valuations are used for stock option purposes.  BTW, I continue to think that as applied to private companies 409A is a terrible rule.  And I think that early stage companies should take the risk and not use 409A valuations.  As companies move to later stages and have meaningful revenues and profits then 409A valuations begin to make more sense.

I would like to add another Rule 409A thought.  Here goes:  please do NOT think that the 409A valuation has any bearing or meaningful relationship to how a VC will value your company.   Said another way, a 409A valuation is meaningless to how VCs negotiate pre-money valuations for their investments.  The 409A valuation is not based in VC reality.  Sure, you might say that VCs have warped senses of reality.  I can understand that!  Regardless, don’t dig yourself any credibility holes by trying to use the 409A valuation as a negotiating tactic.

To repeat what I wrote in my earlier post, I think that 409A valuations routinely work to the detriment of employees.  Stock options prices for startups should be as low as possible.  The government would end up collecting more tax on successful exits and the employees should be delighted to pay more tax on their larger gains!

Thanks, and enjoy the weekend.

Convertible Debt – Qualified Financing Triggers

I recently dealt with a tense situation regarding the “Qualified Financing” trigger in a standard convertible note financing.  For background, convertible debt documents typically provide that the debt will automatically convert into a future0 Qualified Financing equity round.  And that conversion is typically at a discount to the Qualified Financing equity round price.  Here is an example of actual language from a promissory note:

“Upon the closing of a Qualified Financing, the principal and accrued interest of this Note shall be converted automatically without the consent of the Holder into securities of the same class or series as are issued in the Qualified Financing. The number of securities to be issued in such conversion shall be determined by dividing the sum of the then outstanding principal amount of this Note and all accrued but unpaid interest thereon by the Conversion Price.  The “Conversion Price” means an amount equal to eighty five percent (85%) of the price per share paid by the investors in the Qualified Financing.”

It is extremely straightforward – here the discount was 15% to the Qualified Financing price.  (Sometimes, though not in this example, you will see a valuation cap built in too so that the debt holder gets the better of the discounted price of the valuation cap price. I suppose I should do a post on valuation caps too at some point.)

Here is the definition of Qualified Financing from the same promissory note:

”    “Qualified Financing” means the issuance of equity interests (or debt securities convertible into equity interests) in the Company to investors prior to the Maturity Date (as the same may be extended) in one or a series of related transactions, the principal purpose of which is to raise capital, which transaction or series of related transactions result in the Company receiving gross proceeds of not less than $700,000 (inclusive of the principal amount of the Notes that will convert into equity in connection with the consummation of the Qualified Financing).”

Typically you set the Qualified Financing trigger to be a meaningful amount of NEW equity financing so that the convertible debt is converting in a financing that will give the company some meaningful cash burn runway.  That is the whole premise behind having the conversion be automatic.  If the company is successful in raising the equity round that gives it some breathing room and runway, then the debt automatically converts and everyone is happy.  Goal accomplished.

I have used the word “typically” a few times in this post.  I am now going to use it again.  Typically, in the definition of Qualified Financing the amount of the outstanding convertible debt notes do NOT count towards achieving the Qualified Financing threshold as it is NEW cash that gives the company the breathing room and runway.  In the definition above the threshold is $700,000, which would give the company meaningful time to achieve its next set of milestones and set it up for additional capital raising if required.   Now, I hope some of you see the problem in the definition above.   It uses the word “inclusive” as opposed to “exclusive”.  I underlined “inclusive” in the definition.  In all the convertible debt deals that I have done (probably 50 or more), I have only used the word “inclusive” once.  And I honestly do not know why on that one occasion I agreed to it.  Mental lapse?  Maybe!  I actually think what happened is that when we advanced the first promissory note we were highly confident that the Qualified Financing was not far off so that including the note amount was okay because the note amount was small (like $100,000).   Well, the Qualified Financing got delayed and delayed and delayed…..and the amount of convertible debt grew and grew and grew as more debt was advanced to support the company prior to a Qualified Financing.

Ultimately, the amount of the debt approached the $700,000 Qualified Financing trigger amount.  We could not advance more than the trigger amount – that would be nonsensical and put the noteholders in a very bad spot.  The resulting conversations were awkward, but the solution was easy.   Just amend the notes to change “inclusive” to “exclusive”, which is incredibly normal anyway.

Lesson learned.

State of Startups from First Round Capital

I just read a fabulous post from First Round Capital.  Two Cornellians are partners there (Howard Morgan, one of the founders of the firm, and Bill Trenchard, who I once represented as his company’s lawyer when he was a Cornell student in like 1997! – how time flies by…..).   The post is titled State of Startups 2015.

Not only does it have some great insights, but it is really fun to read and view.  The graphics are easy on the eye and the data analysis is clever.  It seems as though the First Round Folks pulled together a great supporting cast too (see the thank you note).  First Round also does a crazy holiday video every year so be on the look out.

More to come soon….