Yes, you need to very careful about doing priced rounds at different share prices. Cheers, Scott

Thanks Bill. Let's not forget that a stockholder has a slew of rights under applicable State law (not to mention the rights granted under the financing documents). Accordingly, merely from a legal perspective, a startup is better-off with a creditor, than a stockholder. Moreover, in the event of bankruptcy, a preferred stockholder will have priority over a common stockholder (so founders will have similar complications whether the startup issues debt or preferred). Thanks again, Scott

Hey Bill - solid post. I think at the end of the day it all comes down to negotiating leverage - and right now the entrepreneurs have the leverage.

I also wanted to clarify your comment that as, "Jason Mendleson points out, a convertible debt financing technically makes a start-up insolvent from Day 1." This is incorrect under Delaware law (where most companies are incorporated).

Indeed, as I explained in my comment to Jason's post, under North American Catholic Educ. Programming Found, Inc. v. Gheewalla, the leading Delaware case, “insolvency” is defined as (i) “an inability to meet maturing obligations as they fall due in the ordinary course of business” (the so-called “Equity Test”) or (ii) “a deficiency of assets below liabilities with no reasonable prospect that the business can be successfully continued in the face thereof” (the so-called “Balance Sheet Test”).

Based on the facts of each case, the Delaware Chancery Court has applied either or both of these tests. Under the Balance Sheet test, however, a company’s assets must be “fairly valued.” Moreover, several Delaware courts have noted that defining insolvency merely as a corporation’s liabilities exceeding its assets (as you have done) fails to take into account emerging corporations that take advantage of business opportunities.

Accordingly, if a startup issues convertible notes it is NOT "insolvent" just because its liabilities exceed its assets on its balance sheet.

Cheers,
Scott

Hey Jason - I'm a big fan of you, Brad and & David; however, I think you missed this one. Please note the following:

1) Your definition of “insolvency” is not generally applied by the Courts. Indeed, under North American Catholic Educ. Programming Found, Inc. v. Gheewalla, the leading Delaware case, “insolvency” is defined as (i) “an inability to meet maturing obligations as they fall due in the ordinary course of business” (the so-called “Equity Test”) or (ii) “a deficiency of assets below liabilities with no reasonable prospect that the business can be successfully continued in the face thereof” (the so-called “Balance Sheet Test”).

Based on the facts of each case, the Delaware Chancery Court has applied either or both of these tests. Under the Balance Sheet test, however, a company’s assets must be “fairly valued.” Moreover, several Delaware courts have noted that defining insolvency merely as a corporation’s liabilities exceeding its assets fails to take into account emerging corporations that take advantage of business opportunities.

2) In Gheewalla, the Court held that the fiduciary duties of directors in an insolvent corporation continue to be owed to the corporation.

3) The Court also held in Gheewalla that the creditors have no right, as a matter of law, to bring a direct claim for breach of fiduciary duty against the corporation’s directors.

That's what we're doing, Mike - see my post "It's Time to Destroy the Billable Hour" here: http://bit.ly/aljovG

Thanks,
Scott
@ScottEdWalker

Excellent post, Jason. You’re absolutely correct that “lawyers are driven by more important things (to them) than helping entrepreneurs save legal costs.” Indeed, that’s why I quit the big law firm in New York City and moved out here to California to open my own shop: to help entrepreneurs save legal costs. I am all for standardized documents, but agree that it “simply doesn’t work.” That being said, like all great entrepreneurs, we shouldn’t stop trying. Kudos to Ted Wang for trying. Take care, Scott (@ScottEdWalker)