All posts in Startup Jargon/Definitions

Section 1202: Original Issuance

Section 1202 Original Issuance


I am a small business owner and investor who read your informative blog post “Section 1202, Qualified Small Business Stock.”  However, I would like to ask for your clarification of an important requirement for the small business stock capital gain exclusion.

Concerning the “original issuance” requirement, you stated that “QSB stock means any stock acquired on original issuance by the taxpayer from a domestic C corporation…”

My understanding of the meaning of “original issuance,” is that it is stock issued by a corporation at the time of its incorporation, and does not include new stock subsequently authorized and issued by the corporation at a later time.  Practically speaking, this would mean that QSB “original issue” stock could be purchased from a new startup, but not from a corporation that had been in existence for a year, whose directors opted to raise capital by authorizing and offering a new issue.

Alternatively, does “original issue” simply mean stock an investor purchased directly from the issuing C corporation (or through its underwriter), as opposed to acquiring the stock from another investor, or from a broker?  Must an investor desiring the benefit of the gain exclusion provided under Section 1202 purchase only from a startup at its time of incorporation?

Short Answer

The short answer:  Section 1202 can cover shares issued at any time and from time to time after the incorporation of the Company, provided the various requirements of Section 1202 are met at the time the shares are issued and throughout the time the shares are held.

Not-So-Short Answer

Internal Revenue Code section 1202 defines “qualified small business stock” as any stock in a C corporation which is “originally issued” after the date of the enactment of the Revenue Reconciliation Act of 1993, if:

(a) as of the date of the issuance, the corporation is a “qualified small business,” and

(b) except as provided in subsections (f) and (h), such stock is acquired by the taxpayer at its “original issue” (directly or through an underwriter) –

(i) in exchange for money or other property (not including stock), or

(ii)as compensation for services provided to such corporation (other than services performed as underwriter of such stock).

The statute does not define “originally issued” or “original issue.”  But a plain English reading of the phrase would mean to me, as a lawyer, that the shares are supposed to come directly from the company – not purchased from another shareholder.  In other words, shares purchased on the secondary market wouldn’t qualify.

Nowhere does the statute say that the stock has to be issued at the time of incorporation.  If Congress had wanted to say that Section 1202 only worked for shares issued as part of the incorporation process, it could have easily done so.

Plus, there is language in the statute which would be completely incongruous with the meaning of “original issue” being  only at the time of incorporation.  For example, the reference to an “underwriter.”  Underwriters aren’t typically present at incorporation.  Similarly, Section 1202 (c)(3) says that stock acquired by the taxpayer will not be treated as qualified small business stock if at any time during the 4-year period beginning on the date 2 years before the issuance of the stock, the corporation issuing the stock purchased any of its stock from the taxpayer or a person related to the taxpayer.  If the statute only covered shares issued at incorporation, the inclusion of the 2year look back language wouldn’t make sense.

There are a number of things that have to happen in order for stock to be “qualified small business stock,” but none of them is that the stock has to be issued on the incorporation or in connection with the incorporation of the company.

In other words, stock issued several years after the incorporation of the company can qualify, if the various requirements are satisfied.

To give you a sense of some of the things that are required:

  1. The aggregate gross assets of the corporation before and after the issuance of the shares cannot exceed $50,000,000;
  2. The corporation must be a domestic C corporation;
  3. The corporation must be engaged in an active trade or business; and
  4. The corporation’s business must be a “qualified trade or business.”

So, to answer your question, there is no requirement in Section 1202 or the regulations under Section 1202 limiting the benefits solely to stock issuance at the time of incorporation.

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What is a Valuation Cap?

valuation capBy Adam Lieb and Joe Wallin

If you are contemplating raising money through the issuance of convertible notes, you might be wondering – what is a valuation cap?

Convertible notes are designed to convert into equity of the issuing company upon a subsequent financing (usually referred to in the note as a “qualified financing”; e.g., when the company raises more than $1M dollars in new capital). Without a cap or discount (not discussed here), the notes would typically convert into the issuing company’s equity in the subsequent financing at the same price as the equity issued in that financing.

For publicly available example promissory notes, you can see here:

A “valuation cap” entitles note holders to convert into equity at the lower of the valuation cap or the price in the subsequent financing. You can find an example of this provision in both of the above documents.

  • In the Alliance of Angels note, you can find the valuation cap language in Section 4. The pertinent language reads as follows:

the outstanding Principal Amount and accrued interest under the Notes shall automatically convert into shares of the same series of preferred stock as is issued in the Qualified Financing at a conversion price equal to the lesser of (a) the price obtained by multiplying (i) the price per share paid in the Qualified Financing by (ii) the applicable Conversion Percentage (as defined below); or (b) the price obtained by dividing (i) [VALUATION CAP] (the “Valuation Cap”).

  • In the TechStars note, you can find the language is as follows:

outstanding principal balance of this Note shall automatically convert in whole without any further action by the Holder into such Equity Securities at a conversion price equal to [the lesser of (i)] ____% of the per share price paid by the Investors [or (ii) the price equal to the quotient of $__________ divided by the aggregate number of outstanding shares of the Company’s Common Stock as of immediately prior to the initial closing of the Qualified Financing (assuming full conversion or exercise of all convertible and exercisable securities then outstanding other than the Notes)]


Suppose you have raised $200,000 in convertible notes.  The notes have no discount but a valuation cap of $5M, and they are set to convert upon a subsequent raise of greater than $1M.  You then succeed in raising $2M in Series A funding on a $10M pre-money valuation of $10M.

What happens to the notes?  At what price do they convert?  How many Series A shares do you issue for the note amounts?

Let’s suppose your pre-Series A cap table looks like this:

Pre-Series A Cap Table

Number of Shares

% Ownership Interest




Option Pool





Your post-Series A cap table would then look like this:

Post-Series A Cap Table

Number of Shares

% Ownership Interest




Option Pool



Series A Investors



Series A (convertible note holders)





The price per share for the convertible note holders converting into Series A will be the valuation cap of $5M divided by the same 2,350,000, or $2.13 per share (rounding up).  Assuming a $200,000 loan, the convertible note holder will receive 93,896 shares (assuming no interest on the notes, for the sake of simplicity).

The price per share for the Series A investors will be the $10M pre-money divided by the fully diluted number of outstanding shares immediately prior to the closing (2,350,000), or $4.26 per share (rounding up).  Assuming a $2M investment, the Series A investors will receive 469,483 shares.

You can see from these tables the benefit of the “cap” to the convertible note holders.  Without a cap in this instance the debt holders would have received half as many shares. This makes sense because in my example the valuation cap was exactly ½ of the pre-money valuation in the subsequent financing.

You can also see why debt holders like valuation caps.  They especially like them when it is their opinion that it is their early stage debt money that allows the company to achieve the high pre-money valuation on the subsequent fixed price round. You can certainly see the view point of the convertible note holders in these situations that they ought to participate in that healthy pre-money valuation through the cap mechanism if it was their funds which made it possible.

From the company’s point of view, valuation caps can be a pain, because they are one more thing to negotiate.  One of the reasons you do a convertible note in the first place, rather than a fixed price round, is to avoid having to set a value for the company.  If the cap is supposed to represent the current value of the company (the typical investor view), then you haven’t accomplished putting off the valuation negotiation at all, and it is possible you might get bogged down in an argument about it.

[1] See this blog post from Dan Shapiro, “A Cap is Not a Valuation

Founder viewpoint:  Caps are a necessary evil when raising convertible notes in the current climate. Valuation caps limit crazy situations, for example, the valuation goes up 5-10x. In these situations, without a cap the early stage investors would not be adequately rewarded for their risk. Therefore, they need a cap to put a floor on their price. In most situations a discount on the subsequent round will reward those investors. For example an uncapped note + a 50% discount at the seed stage will ensure that seed stage investors see a 2x paper return on the next round. Caps are NOT valuations.[1]  Entrepreneurs should not let investors get away with the argument that they are. Caps protect investor’s upside risk by setting a floor on their purchase price.

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Three ExemptionsThe law of private company fund raising is getting more complex and varied by the day.  The SEC has now issued its draft Title III crowdfunding rules…all 568 pages of them.

I have put together the below table to help you compare Rule 506(b) offerings to Rule 506(c) offerings to crowdfunding offerings under Title III of the JOBS Act.  Crowdfunding offerings are not yet available.  The rules are now out in draft form which is helpful, but it is unclear when they will become final.  In all cases you should consult with an attorney before engaging in a private company securities offering.

                           Least Expensive—————————————–> Most Expensive


Rule 506(b)

Rule 506(c)


Limitation on Offering Size



$1M during any 12 month period (not including amounts raised in a Rule 506 offering in the same period).[1]

Limitation on number of investors

None, but only 35 non-accredited investors are allowed (and then only if IPO level disclosure is provided).

All investors must be accredited.  Otherwise, none.

Not technically, but the aggregate fundraising cap indirectly works as one.

Advertising allowed

No.  No general solicitation or general advertising allowed.

Yes.  But beware!

General solicitor and general advertising give rise to more company and investor obligations.

Limitations on advertising.  See page 107 of the proposed regulations.

Specific Disclosure Requirements

No specific disclosure requirements, unless non-accrediteds are in the deal (and if they are, then IPO level disclosure is required).

No specific disclosure requirements required by the rules.

Yes, very specific, detailed disclosure requirements.

Third party intermediary required



Yes; companies have to go through a broker-dealer or registered funding portal.  This is required by the text of the JOBS Act itself.

Ongoing SEC reporting

No, but multiple Forms D and amendments may have to be filed.

No, but multiple Forms D and amendments may have to be filed.

Annual filing required via Edgar.  Issuers must also post the annual report on their websites.

[1] This is a silver lining found in the SEC’s proposed crowdfunding rules.  See pages 14-20 of the proposed crowdfunding rules.

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