I hear it all the time: “We raised $10,000 from an angel investor in exchange for 10% of our company,” or some other variation of [person] gets X% for [small investment].
As innocent as this sounds, it means that the company has essentially sold equity in the company. Selling a fixed chunk of equity for a fixed sum is equity financing and it means that a meaningful company valuation can be determined, or at least implied, during the investment round. For example, selling 10% of the company implies that the company had a pre-money valuation of $90,000 and, therefore, a post-money valuation of $100,000. This is called a “priced” round.
Extreme caution should be taken when selling equity for cash to avoid legal, ethical and tax consequences.
You may very well be in violation of securities law if you sell equity to unaccredited investors or without proper documentation and disclosures. Even crowdfunding requires extensive and expensive documentation, known as placement memorandums (PPM), to secure investment in exchange for priced equity. PPMs are usually created by lawyers and provide detail with regard to a businesses operating history, business plans, financial performance & forecasts, and full disclosure of the plethora of reasons why the company might fail.
In my opinion, most founders are not qualified to properly value their own company. Neither are their moms, dads, buddies, rich uncles or aunts, lawyers or anyone else in their personal networks. Likewise, angel investors, who are investing their own money, aren’t qualified either. Valuation discussions are highly-biased, emotional, personal. Even those with the best intentions can be led astray by desperation, ignorance or an overly-optimistic view of the future.
Another problem with setting a premature valuation for your company is that the IRS (or other taxing agency) may deem subsequent equity allocations as taxable income which means the recipient will pay tax (in cash) even if the stock turns out to be worthless (the most common scenario).
Slicing Pie allows a company to divide equity in a company before a valuation can be set. Until a value can be set, the value is $0. If nobody is willing to buy it (your equity) it has no value. Think about it, what the value of a product that nobody wants? So, unless the company is raising a serious amount of money with professional investors you should probably be slicing Pie instead of pricing Pie.
When to Price Instead of Slice
A company that has created a repeatable, sustainable business model, produced hard assets, intellectual property or cash flow, on the other hand, is worth something. These are things you produce while you’re using Slicing Pie. When you have these things, it’s time to price and “bake the Pie.”
A professional investor who invests other people’s money (like a VC) is much better qualified to make a financial offer for equity, especially if he or she has the proper documentation including a business plan, due diligence reports and a Private Placement Memorandum (PPM).
This doesn’t mean there aren’t unscrupulous professionals, but a few things are usually true about professional investors:
Of course, you can, and should, shop your deal around to negotiate the best terms, but you aren’t going to trick a professional investor. Different VCs will value your company based on different criteria, to some you will be more valuable than to others. Of course, they could trick you, so be sure to surround yourself with advisers or attorneys who can spot red flags.
I’m not very experienced with equity crowdfunding, but it appears that they are usually lead by a professional investment group and require similar documentation.
A professional or crowdfunding round should raise enough money to cover all the corporate expenses (including salaries) until breakeven or the next funding round. This means that the Pie will stop accumulating slices and can be “baked”. Baking the Pie means that share vest or are otherwise fixed and are now subject to the terms of the investment.
Pricing Without Professional Investors
Some companies have no intention of raising money or, they intended to, but decided against it because they reached cash flow breakeven and don’t need or want money for growth. As in a professional round, a breakeven company is meeting all its financial obligations and slices are no longer accumulating so the Pie bakes.
If your company has outstanding convertible notes, KISS or SAFEs, you will need a valuation to convert the equity. For this you will need to find a professional accountant who is certified for 409A valuations. A 409A valuation is common when setting the strike price for option pools, but can also be used to convert a convertible loan, KISS or SAFE (see below) in the absence of a Series A round. Check out Capshare for a free, DIY 409A tool (with limitations).
Pricing a Pie is much trickier than slicing a Pie. During the bootstrapping stage, stick to Slicing Pie. The contributions made in Slicing Pie are the bets placed on the future price of the Pie.
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