Convertible Debt & 83(b) Elections
October 30, 2014 | By Kevin Vela
The panel was moderated by Michael Sitarzewski, and he asked three legal-ish questions relevant to startups and raising money. I thought it would be worthwhile to restate them here, and provide a little more detail.
What is convertible debt?
Convertible debt is an alternative to equity fundraising. Traditionally, startups raise capital by selling ownership, or equity, in their company. This is also known as a “priced round.” Some time ago (not forever, but not yesterday either), the concept of “convertible debt” was introduced. In this scenario, the investor “lends” the startup money, let’s say $100,000, at a reasonable interest rate (assume 5%) and with a maturity date in the 12-24 month range (usually). The understanding and intent of the investor and company is not for the startup to repay the debt, but rather for that debt to convert into equity at a discount to the next round. A common discount is 20%.
So in the example above, if the startup completes a Series A round at a $1M valuation a year after the investor lent the $100,000, the investor’s $100,000 would have grown to $105,000, and would convert into equity at a valuation of $800,000 (or 20% off of the $1M Series A valuation). Again, the investor’s loan converts into equity at a 20% discount to the Series A round.
These days, most convertible notes have a conversion cap on them, so that if the Series A round is extraordinarily high, the investor is protected. The language usually says something like “the principal and accrued interest shall convert to the lesser of (a) 80% of the per share price of the Series A round and (b) the price per share calculated using a $3,000,000 valuation.” The language is generally fancier and more lawyerly than that, but I don’t want to bore you any further.
Convertible notes are almost always significantly less expensive to prepare than are the docs associated with a priced round, and every VC I’ve dealt with is very comfortable investing into a company with convertible notes on its books.
This is not a comprehensive overview of convertible notes, so check with your attorney before issuing them, but I hope that this can serve as a good introduction.
What is an 83(b) election?
83(b) elections deal with restricted stock (or units, I’ll refer to them together as “securities”), which are generally granted or sold to founders and early employees. The securities are “restricted” because the issuing company (the startup) has the right to buy back the shares if the founder/employee leaves. This is similar to a vesting schedule, but is known as a “repurchase right.” If the founder leaves after 6 months, the startup can’t afford to have that founder walk with all that equity. So generally there is a 3-4 year repurchase schedule, whereby the founder would keep a fraction of the securities, and the company would buy the remainder back at the issuing price (usually nominal).
Under the Internal Revenue Code (my 2nd least favorite code), the founder/employee does not recognize income until the securities are released from the repurchase schedule (basically “vest”). Because the value of the company is likely increasing over time, the securities could be worth significantly more at the release date, and therefore force the founder/employee to recognize that income (which would be more and more every time if the company’s value continued to increase). By using an 83(b) election, the founder/employee can recognize ALL of the securities at the time of purchase, at the price as of that date (usually very very small), rather than some later point in time.
Let’s assume that the founder is getting 5,000,000 shares at a value of $.0001 (typical value for shares of a Day 1 startup). The founder should buy those shares for $500 and make an 83(b) election. Because the purchase price equals fair market value, there is no income. Moreover, this will get the clock ticking on the capital gains holding period.
Note that 83(b) elections must be made within 30 days of the purchase. There are no exceptions to this rule. Send in your 83(b) form as soon as you can.
Check out this Founders Workbench article with more info on the subject.
Do I have to organize my company in Delaware?
I say no, and have written about it at length here. Some VCs still prefer a Delaware C (Jeff Williams mentioned that Covera has preferred C-Corps in the past, but Texas or DE C is fine), so have this conversation with your advisors to determine what is best for you.
Update: With the passing of the Tax Jobs and Cuts Act of 2017, a C-Corp makes sense for more startups than ever before. Because of the decreased corporate tax rates, the tax consequences of a C-Corp are no longer as consequential in comparison to an LLC, and a C-Corp’s ability to scale, as well as the widespread preference by venture investors now trump the much smaller tax burden. Thus, I’ve fallen in line with the vast majority of venture attorneys and am actively recommending C-Corps for startups.