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Corporate Finance Primer

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Survey of corporate finance knowledge.

Top-of-mind for the CEO / founder:
- Company creation, and initial share pool
- Raising capital the usual way
- Raising capital via debt
- Raising capital via bridge loans
- Common Shares vs Preferred Shares
- Section 409A, and valuation
- Employee pool growth (and equity plan, e.g. http://www.slideshare.net/wealthfront/wealthfront-equity-plan)

Top-of-mind for employees:
- Shares, Options and valuing a grant
- Exercise
- Tax Scenarios

Published in: Economy & Finance, Business
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Corporate Finance Primer

  1. 1. Corporate Finance Primer
  2. 2. 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.
  3. 3. All About Acme LLC • Initial valuation $1M (we’ll get back to this.) • 10M shares, ie $0.10/share
  4. 4. 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
  5. 5. Funding Round • Acme grew to $4M, pre-money • Raising $1M
  6. 6. Funding Round • Pre: $4M/10M, so $0.40/share • Post: $5M/X = $0.40/share (value preserving) • Need to issue 2M shares
  7. 7. Funding Round $1M $2M $3M $4M $5M pre $4M post $5M Equity Cash 100% 80% 20%
  8. 8. Funding Round • Dilution in percentage ownership • No value dilution • Bet that cash can be converted in at least same equity value
  9. 9. 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
  10. 10. Acme Promissory Note • $500K • 12% interest, yearly installments • Capital repaid in full at year 3
  11. 11. 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)
  12. 12. Acme Bridge Loan • $500K • 6% compounded monthly • Right of first refusal in next round
  13. 13. Valuation • Initial & Seed • Series A “getting to product/market fit” • Series B “operationalizing” • Liquidity
  14. 14. 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.)
  15. 15. 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.
  16. 16. Timeline of 409A 0% 25% 50% 75% 100% Common Preferred
  17. 17. 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.)
  18. 18. 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
  19. 19. 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
  20. 20. Acme Employee Pool • 10M shares outstanding, $4M valuation total • Want to have ~10% for new employees • Create 1M shares earmarked for distribution
  21. 21. Employee Pool • New Hires • Evergreens • Promotions & Performance
  22. 22. Expanding Employee Pool • Issue new shares earmarked for distribution to employees
  23. 23. Acme Employee Pool • Pre: $4M/10M, so $0.40/share • Post: $4M/11M, so $0.37/share?
  24. 24. 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!
  25. 25. 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.)
  26. 26. 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.
  27. 27. Exercising • Tax benefit, at the cost of liquidity • Golden handcuffs, not • Early exercise even better!
  28. 28. Tax Implications Timeline for scenarios • 2010: Option’s strike at $10 • 2012: In one scenario, exercised at $50 • 2013: Sold shares at $100
  29. 29. Tax Implications $0 $25 $50 $75 $100 Early Exercise* Same Day Sale Exercise Acme Income Capital Gains
  30. 30. 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% !

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