Creative Common Stock

I am a huge fan of simple cap tables.  A cap table is a written record (in Excel, for example) of who owns stock in your company.  It lists every owner out by amount owned, type of stock (common or preferred), and date purchased.  It also lists out option holders and warrant holders.  It should also provide a combined summary so that it is easy to see who owns what % of the company on a fully diluted and converted basis.

One rule of simple cap tables is to issue “normal” stock to founders (common stock only) and investors (typically preferred stock, but sometimes common stock to early friends and family).  Additionally, at the seed stage, investors and the company might want to issue the investors convertible debt to avoid the question of valuation.  For clarity, it is impossible to issue stock without putting a value on the company.  There are no exceptions to this rule.  With convertible debt, however, you can raise money via a debt instrument that later converts to equity typically at a discount to the next qualifying equity round price.  So, again, with convertible debt, you delay the valuation decision altogether until the next equity round is raised (and hopefully by then the company is more mature leading to better metrics for valuation).

Yesterday I spoke with a faculty member at Cornell about structuring an investment.  A real institutional investor wants to invest $XX,000 in his company.  I stress that the offer is from a real investor with a good reputation.  The company is at the pre-seed stage, and the outside investment would qualify the company for an additional grant from a government source (matching funds).  Seems like a win-win.  The investment is a small one and, to me, the investor is basically buying a ticket to watch the company and participate in future financings if desirable.

The investor suggested to the faculty member that the investment be convertible debt.  This suggestion was completely appropriate as doing a Series A round for only $XX,000 would gum up the company’s cap table (thereby violating the simple cap table rule).  When the company raises its first meaningful equity round (in terms of dollar amount), it will not want to have any existing preferred stock on its cap table.

The wrinkle is that, in this case, a convertible debt investment will not qualify for the government match because it is not equity.  So, we needed a solution.  The investor deserves to get preferred stock ultimately (remember, that was the goal of the convertible debt).  Understanding that convertible debt would not work for the company, the investor proposed a fair valuation for the investment (in other words, the investor proposed that the $XX,000 would purchase Y% of the company).  The only concern is how to issue common stock to the investor and still make it feel like an institutional investor.

After discussion, the faculty member and I concluded that issuing common stock with the contractual right (by written agreement) to convert the common stock to preferred stock in the next equity round would work.  I hope the investor agrees.  The conversion ratio would have to be worked out (it could be one for one or, more likley, will be based on simple formula comparing the share prices of each round), but it seems like a good solution.  Critically, it keeps the company’s cap table simple and positions the company well, from a cap table perspective, to eventually raise a “first” preferred stock round when it is ready.

I am curious to see how it works out.

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4 thoughts on “Creative Common Stock

  1. Facebook has managed to stay within the SEC’s rules that require a company with over 500 shareholders to register on a national securities exchange. Facebook has also sold common stock directly to some investors. And there is an incredibly active market for its stock on Second Market, which is purely a private exchange. Facebook is not involved in the Second Market transactions other than to approve the actual transfer (which gives it the ability to stay under the 500 shareholder rule).

  2. Am I correct In assuming that a cap table would be very simple when raising convertible debt?

    For instance, take the following example:
    – 2 founders start a company and agree to equal equity.
    – They raise $xxx,000 in convertible debt from 5 investors in a seed round.

    In that case, would the cap table simply show 50% equity for each partner, since a valuation hasn’t been set yet?

    Should you still show the debt raised from each investor– along with any warrants given (if applicable)?

    • Mike, you are correct, but you should definitely keep track of the convertible debt on a separate tab of the cap table. It should show debt for each investor and accrued interest for each. Warrants should be on a separate tab as well listed by investor, number of shares covered by the warrant, and exercise price. Thx.

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