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Background: Company A has developed a software product. Revenue is about $8K per month; margin is about 75% (after royalties). Debt owed to angel and family/friends investors is about $550K. The company has effectively no cash reserve and all gross profit goes to pay operating costs and then the original founder gets what's left as income. The software product is part of the business that Company A does; there is also a consulting business.

The founder of Company A would like to get myself and a couple other entrepreneurs to help him grow the software product. To compensate new people working on the software business, the proposal is that we create a new company (NewCo) and share ownership in NewCo based on contribution to NewCo.

NewCo would buy ($1) IP and assume the debts, obligations, and revenue related to the software product from the old company. Because profit is not currently (revenue has been flat for about 6 months) sufficient to carry the debt, can we value the new company at or near $0 dollars?

The reason we want a low initial valuation is we want to grant the members of the new team all the equity that they would earn working for the NewCo for 2 years (assuming they did not take cash compensation during this period), when NewCo is created and the new team members do not want create an unfavorable tax situation for themselves by agreeing to receive this equity.

Question: Do knowledgeable folks out there think we have reasonable grounds to set the valuation of NewCo at or near nothing, so that when people get their redeemable equity they incur no tax liability? Please let me know why and what valuation method you use to reach your answer. TY!

Other Information:

  • In the event that people who get this initial equity get paid in cash for their work or do not perform, NewCo would redeem the appropriate number of shares.
  • The original founder will keep his personal guarantee on the debts that transfer over; new owners in NewCo will not be liable for this debt personally.
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1 Answer

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The most reliable valuation method is that which is agreed to by all parties. If you agree that the value of the IP and revenue is offset by the liabilites/obligation and debt -- and everyone agrees-- then it can be worth nothing!

Is this a good deal?

Let's assume that of the 96K/year revenue could be doubled next year (OMG) to 192K. Let say you are able to increase margin from 72% to 85% (OMG) And lets say that you can put 100% (OMG) of that increase to the bottom line -- or 15%. That would be a total of 27.3K to service the debt. Seemse like a tall order-- especially if no new capital is infused -- but let's say your team is brillant and you can do it. Let's assume a slow and gradual increase after that in the amount you put to the bottomline. That means that the $550K would be paid off in over 20 years?

If that debt is on your books, no new capital will come in without some type of debt/equity swap -- why would they put new money after bad? Without new capital you will be bootstrapping without sufficient resources to grow. Without dramatic growth the projections for paying off the debt seem slim.

I am sure I am missing something -- but probably not enough to turn the balance sheet projections around. You say you want to "start-fresh" -- this scenario sounds more like starting with a huge stinky pink elephant in the room.

Based on this -- these would be my other assumptions:

  • That the software adds value to the consulting practice. Either as a service to clients or a lead generator.
  • That defaulting on the notes is not an option for the business since they are personally guaranteed.
  • Personally defaulting on the notes are not an option for the owner/founder because he has other assets that could cover and that he doesn't want to lose.
  • That the notes is with friends and family who have written it off as an "investment" but there needs to be some nominal servicing of the debt.
  • That the people involved in NewCo would like to launch a successful business to earn income and equity.

If these assumptions are true -- or largely true - then I would strongly reccomend a structure more like what I recommended like this:

  • Rather than assuming the debt/liabilities/relationships/issues/upside-down balance sheet -- Why not acquire a license on the IP, an assignment of the clients in exchange for agreed upon monthly payments which would be used to pay down the debt. Then when the debt is paid the IP would transfer. NewCo would launched clean with a license for use on the IP and payment on that IP dedicated to serving the debt.

  • Don't provide significant equity to all of the people from the get go -- let them earn it over time for performance. Perhaps that "vesting" would happen once the NewCo has proven itself to be successful at a specific benchmark of profitability. Then the "tax liability" would be incurred concurrently with the company being able to provide a financial bonus to off-set.

  • The debt would be paid off by the founder from his equity position in the NewCo if they are able to turn the current asset into something a little shinier. After the founders of NewCo have vested-- allow the founder to "sell" his equity in the NewCo at anytime to any of the current creditors.

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Joseph, thanks for sharing your thoughts. Yes, I realize that the numbers do paint a bleak picture. Some of the debt will be converted to equity so the payback scenario isn't so bad and their are some bigger deals looming that require a bigger team to manage, so there is more hope than I may have given the impression of. In particular, I liked your suggestion about licensing the IP - I missed that line of thinking completely. Thanks. – StartingFresh Nov 9 '11 at 1:56

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