How and When Founders Should Capitalize
Founders can structure cash infusions early in a startup’s lifecycle in a variety of ways. And on the face of it, money is money. Most of the startups we work with don’t intuitively sense the importance of forecasting and and planning when it comes to the valuation of their “baby.” But it can make the difference between the life and death of a startup.
There is no “one-size-fits-all” solution to the question of getting your startup up and running — or keeping it that way, for that matter — but making informed choices is what we advocate at Bax. Read on for a breakdown of some of the most common elections.
Common Stock Value
Infusing cash is essential to getting most startups off the ground. To this end, founders are sometimes tempted to ramp up the purchase price of common stock, so that they can basically make the startup a loan through the purchase of common stock.
However, most startup attorneys recommend against this.
It can eat away at the value offered to employees and consultants through common stock offerings, as the core attractant for these folks to equity offerings is the potential increase in full market value of the stock from the time it was issued to the time of sale.
If the value is prematurely inflated as a means of infusing cash into the business, the potential return on common stock holdings is diluted significantly.
However, it is highly advised that a startup issue stock to its founders immediately upon incorporation. Shares are generally sold for a fraction of a penny to founders, which keeps the startup attractive to potential investors and employees while also avoiding potential tax law pitfalls.
When a startup is in need of immediate capital, founders generally deliver it by way of a simple loan. With this approach, the company is obligated to repay the founder at a later date with nominal interest, and the startup’s equity offerings are still intact.
As an alternative, certain founders choose to make a seed investment either as a convertible note or safe. This route may carry unintended consequences with future investors, and they may seek to dismantle founder-driven seed investments if it appears too economically favorable for the founders.