3

Consider this scenario:

While incorporating BigCo, Jack specifies that the number of founding shares is one million. Jack releases a product and sells it under BigCo. The product doesn't bring enough income. Still, Jack wants to hire two people to improve the product. He does not have the resources to hire them, and so he seeks financing. A representative from Venturo expresses interest. The rep and Jack sit down and agree on a valuation of $1m for BigCo. They further agree on transferring ownership of 25% of BigCo. There is now a question: is the check written as a personal check to Jack or as a check to BigCo.

If the check is written as a personal check to Jack for $250,000, then Jack has just sold 250,000 shares. He needs to pay capital gains taxes on the $250,000. Let's say the sum is $50,000. Jack then proceeds to deposit the remainder ($200,000) in BigCo's account and pursues his effort to hire two people. The amount transferred to BigCo is a shareholder loan. At some point in the future when BigCo's position permits, Jack can reimburse himself sums that add up to that amount without having to pay additional taxes on them.

If the check is written as a check to BigCo, it is less clear how Jack can compensate himself for the equity sale. It is as if the equity was owned by the corporation, not by Jack.

What am I misunderstanding?

4

BigCo is selling new shares and receives the money from Venturo.

If Venturo is offering $250k for 25% of the company, then the valuation that they are agreeing on is a value of $1m for the company after the new investment is made. If Jack is the sole owner of one million shares before the new investment, then BigCo sells 333,333 shares to Venturo for $250k. The new total number of shares of BigCo is 1,333,333; Venturo holds 25%, and Jack holds 75%.

The amount that Jack originally invested in the company is irrelevant. At the moment of the sale, the Venturo and Jack agree that Jack's stake is worth $750k. The value of Jack's stake may have gone up, but he owes no capital gains tax, because he hasn't realized any of his gains yet. Jack hasn't sold any of his stake. You might think that he has, because he used to hold 100% and now he holds 75%. However, the difference is that the company is worth more than was before the sale. So the value of his stake was unchanged immediately before and after the sale.

Jack agrees to this because the company needs this additional capital in order to meet its potential. (See "Why is stock dilution legal?")

For further explanation and another example of this, see the question "If a startup receives investment money, does the startup founder/owner actually gain anything?"

Your other scenario, where Venturo purchases existing shares directly from Jack, is not practical in this situation. If Jack sells his existing shares, you are correct that the company does not gain any additional capital. An investor would not want to invest in the company this way, because the company is struggling and needs new capital.

  • This is not necessarily correct - the OP appears unclear as to whether the money in the company will be bought as new shares, or as existing shares. If the company is buying new shares, I agree with your analysis. If the company is buying some of Jack's shares, then I agree with @littleadv's answer. – Grade 'Eh' Bacon Jun 17 '16 at 14:38
  • Also - I think the OP implicitly believes that the new venture company would be buying Jack's shares, but that does not align with wanting to use the money within the company, which means the company would need to be issuing new shares to the venture co. – Grade 'Eh' Bacon Jun 17 '16 at 14:40
  • @Grade'Eh'Bacon The OP stated that the company is looking for more capital to hire more employees. If Venturo purchased existing shares, that goal would not be accomplished. The OP is misunderstanding the process, which is why the numbers in the question aren't right. littleadv's answer also has Venturo purchasing new shares; we just chose different numbers for our assumptions. – Ben Miller Jun 17 '16 at 14:44
  • I guess I should clarify that I agree your answer is correct, but that clarification of the fact that an investor could buy new shares from the company [which allows the new money to be invested in additional staff] or old shares from the current owner [which may require the current owner to record a taxable gain or loss, and would also require that owner to put the money back into the company to be used for operations] might increase the value of the answer to the OP, who appears confused on this point. – Grade 'Eh' Bacon Jun 17 '16 at 14:47
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    @Grade'Eh'Bacon Fair enough. I've added a paragraph to address the alternate scenario. – Ben Miller Jun 17 '16 at 14:58
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The check is written to BigCo. Jack is being diluted, corporation issues more shares. There's no gain, no change in Jack's equity value. Jack didn't lose or win anything. BigCo was worth $1M before the additional money, it is worth $1.25M after the additional money, with Jack owning the same $1M, but the cake is now bigger (obviously the numbers are wrong in your example, but you get the point).

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If Jack owns all of the one million founding shares (which I assume you meant), and wants to transfer 250,000 shares to Venturo, then he is just personally selling shares to Venturo and the corporation gains nothing.

If Jack does not own all of the founding shares, and the corporation had retained some, then the corporate shares could be sold to raise cash for the corporation.

Usually in situations like this, the corporation will create more shares, diluting existing shareholders, and then sell the new shares on the open market to raise cash.

  • "...the corporation will create more shares, diluting existing shareholders" Even though there are more shareholders when new shares get issued, the value of the company increases because of the new cash raised from those shares. If the new shares are issued at the correct price, then there is theoretically no net dilution to the old shareholders. ie: if a company with 100 shares is worth $1M, and 30 new shares are issued for $300k, then each share owned by the original shareholder is still worth $10,000. – Grade 'Eh' Bacon Jun 17 '16 at 15:08
  • You are absolutely correct in that net share value would still be the same after new shares are issued if they are priced correctly. However, dilution in the sense of percentage ownership of the corporation would still occur. In your example, one share would own 1% of the corp before new shares are issued, but afterwards one share would be roughly 0.76% of the company. I should have specified dilution of ownership. – RaskaRuby Jun 17 '16 at 16:36
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If the check is written as a check to BigCo, it is less clear how Jack can compensate himself for the equity sale. It is as if the equity was owned by the corporation, not by Jack.

This is correct. If the check is written to BigCo, then it is BigCo issuing new shares. Jack doesn't compensate himself for the equity sale, as he didn't sell anything. The company traded shares for money which it uses for expansion. In the long term, the capital gain from expansion may exceed the value of a $200,000 no-interest loan to the company.

If the value of the company before investing $250,000 is $1 million, then the value after investing is $1.25 million. So $250,000 is 20% of the value of the company. BigCo should not give the buyer 25% of BigCo but only 20% in that example. If it does give 25%, the buyer is getting a $312,500 stake for only $250,000.

With the other example, Jack sells 25% of the company for $250,000 from his personal shares. This doesn't change the assessed value of the company, just Jack's stake. Jack then loans the company $200,000. This also doesn't change the assessed value of the company (at least in theory). It gains $200,000 but has an offsetting debt of $200,000. In net, that's no change. Assets and liabilities balance the same.

So if you know that the assessed value of the company is $1 million and that the buyer is paying $250,000 for a 25% stake at that same valuation, then you know that the check is being written to Jack. If the check is written to BigCo, then one or more of those numbers is incorrect.

The buyer could be getting a 20% stake. The new value of the company after the investment is $1.25 million.

Or paying $333,333.33. The new value of the company after the investment is $1,333,333.33.

Or BigCo could only be worth $750,000 before the investment. The new value of the company after the investment is $1 million.

Or Jack is getting screwed, selling $312,500 in stock (25%) for only $250,000. Jack's shares drop from being worth $1 million to only $937,500. The value of the company is $1.25 million.

Or some combination of smaller changes that balances.

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