Monday, February 28, 2011

Venture Capitalists At The Door


The big day has arrived.  Two women, Kate and Susan, and a man, Daniel, from the venture capital firm, Venture Funds, Inc. (VFI), have come to our office to meet with our directors, officers and our financial consultant, Mary Jo.  After a tour of the office and some initial small talk, our President gives them the following financial information about BBE:  annual earnings of $5,000 for the last 12 months of operations; retained earnings of $10,000 ($20 per share); most recent annual dividends of $1,500 paid on the 500 outstanding shares ($3 per share).  He explains that BBE needs $70,000 for new servers, additional employees and more office space in order to keep up with increased subscriber traffic.

Before the meeting, VFI had asked for copies of BBE's  Articles of Incorporation, Bylaws and BBE's financial statements for each year of operation.  Those statements consist of three different accounting reports.  At the end of each year, our Treasurer prepares a balance sheet, which shows the assets, liabilities and equity of the company as of year end; a profit and loss or income statement, which shows the income and expenses of the company and any profit or loss for the year; and a cash flow statement which shows the cash held by the company at the beginning of the year, the cash generated during the year from all sources of cash: operations, loans, stock sales or any other cash generators; how cash was spent during the year for the purchase of equipment or other assets, investments, loan payments and dividends; and the cash position of the company at year end.  The financial statements provide the information needed to determine how a company is doing financially.

After some discussion of the financial statements, the negotiations get serious.  The representatives from VFI indicate that they are willing to invest in BBE.  They propose a purchase of 7,000 shares of common stock at the stated $10 par value.

Mary Jo, our consultant, tells them that the original shareholders want to maintain control of the company.  She also says that the original the par value no longer represents the true worth of the common stock.  She suggests that VFI purchase a minority interest in BBE common stock at the book value of $30 per share (par value plus the retained earnings per share) and the balance of the $70,000 would be invested in a new issue of preferred shares to be authorized in an amendment to the Articles of Incorporation.  Daniel from VFI points out that if more common shares are authorized, then the value of the common stock will not longer be $30 per share since that value would now be divided among more shares of stock.  Susan adds that, as a result, the price per share of the new amount of common shares would now be too high at Mary Jo's suggested per share price of $30.

We tell them that the Articles would authorize a lot more common shares so that there will be additional shares available for issuance if more money needs to be raised in the future.  After further discussion, the parties agree that BBE will amend its Articles of Incorporation to authorize a total of 30,000 shares of common stock at a par value of $1 per share.  The original shareholders will receive, at no cost, 4,500 additional shares of BBE common stock.

This can be accomplished in one of two ways.  The board of directors could authorize a stock dividend to be paid to the shareholders on a 10 for 1 basis.  Instead of cash, the dividend would be given to the original shareholders in the form of additional shares of stock.  The company would issue an additional 4,500 shares of stock to the owners of the original 500 shares.  In effect, the original 500 shares will become 5,000 shares, held by the original shareholders in the same percentages as the shares are owned now.

Another way to increase the number of shares held by the original 5 shareholders would  be to authorize a stock split.  If the original 500 shares are split into 5,000, again on a 10 to 1 basis, the shareholders end up with the same percentages of ownership spread over more shares.  The par value of the shares would be reduced to $1 per share, but the additional shares distributed to the shareholders at the lower par value of $1 will be the same as the smaller number of shares at the original par value of $10.  Each share would have a smaller portion of the retained earnings attributable to it.

Our president laughingly points out that it would be just like slicing a pizza.  The pizza could be cut into 4 large pieces or 8 smaller ones.  Regardless of the number of slices, the size of the pizza remains the same.

Everyone agrees to the concept of VFI investing in BBE in a combination of preferred shares and common shares, but the common would be less in number than the 5,000 shares to be held by the original shareholders.  Each side wants to take some time to figure out how to value the common shares and what rights the preferred would have.  Another meeting is scheduled for next Monday at VFI's office.

Comments are always welcome.

Monday, February 21, 2011

Preparing for the Venture Capitalists


In the following discussion, we will suspend the accounting rules which would otherwise apply to the numbers we will use for illustration.  In the real world, Best Blogs Ever, Inc.'s (BBE) income, assets, etc. would be decreased annually for depreciation of assets and other adjustments which would be required to be made by accountants auditing its books under Generally Accepted Accounting Principles or GAAP.  For purposes of our story, the following financial numbers will apply:  annual earnings of $5,000 for the last 12 months of operations; retained earnings of $10,000 ($20 per share); most recent annual dividends of $1,500 paid on the 500 outstanding shares ($3 per share).  At the end of our last post, everyone had decided that BBE would issue more shares of stock to raise the $70,000 for new servers, additional employees and an expansion of office space to house the company's operations.  Since the existing shareholders do not have that kind of money to invest in the company, the decision was reached to approach a venture capital firm for an investment in BBE.

BBE hires a financial consultant to assist us in the negotiations with the venture capitalists or VCs.  In anticipation of meeting with them, the Board of Directors and the Officers meet with the consultant to discuss terms that we might propose to them.  When incorporated, BBE was authorized to issue 1,000 shares of $10 par value common stock.  BBE issued (sold) the shareholders 500 shares for a total of $5,000 of initial capital.    If you add each share's percentage of the retained earnings ($20 per share) to the original par value of $10, each share could now be valued at $30.  As you can see, par value is, to a certain extent, becoming meaningless.

Assuming the par value remains the same, BBE would have to issue 7,000 new shares of common stock to raise the $70,000.  BBE still has 500 authorized but unissued shares it could sell.  The Articles of Incorporation would have to be amended to authorize an additional 6,500 common shares in order to have enough shares to sell.  If the venture capital firm bought that many shares of BBE common stock, the original shareholders will no longer have control of the company.  The VCs could outvote them on all corporate issues.  Continued control of the company is very important to us.  We do not mind sharing profits with the VCs, but we do not want to lose the right to control the management of BBE.

Our financial consultant tells us that the only way to retain control is to keep a majority of the voting common shares.  We seem to be facing an unsolvable problem: how to keep control of the company while selling shares which could outvote us in a dispute.  One shareholder asks if the Articles of Incorporation could be amended to allow BBE to issue (sell) common shares which do not have voting rights.  The financial consultant tells us that a corporation can have two classes of common stock, one class voting and the other nonvoting.  She says that, although possible, such a step is not a good idea because nonvoting common shares would not be acceptable to the venture capital firm.  In this sort of situation, many corporations issue a different form of stock, one which does not have voting rights, but does have some rights not enjoyed by the voting common stock.  The nonvoting shares could have a preference over the voting shares in one way or another; in effect a trade off of one right for another.  Such a form of stock is called preferred stock.

She reminds us that dividends are usually, if not always, paid out of the earnings of a company.  The Directors are not obligated to declare a dividend, especially if the company has had a bad year and any earnings are needed to keep the company going.  The Articles of Incorporation could be amended to authorize the issuance of nonvoting preferred shares which would receive a dividend before any dividends could be declared for the common stock.  This presents one alternative to propose to the venture capital firm.  BBE could offer them some voting common shares, but not enough to control the company and nonvoting preferred stock with a right to dividends ahead of the voting common.  By dividing the issuance between the two forms of stock, BBE could raise the necessary $70,000.   The consultant also suggests other ideas for retaining control while still meeting any anticipated requirements of the VC firm before it invests in BBE.

A meeting is set with the representatives of the venture capital firm for next Monday.  We will sit in on those negotiations.

You can use the Anonymous profile to leave a comment.

Monday, February 14, 2011

Middle Years - Success Brings Problems


We return to the story of Best Blogs Ever, Inc. ("BBE") to learn more market terminology.  Assume I have now been blogging for several years and every year BBE has had earnings. The company has bought more equipment, hired additional staff and expanded the blog site in profitable ways with a portion of those earning.  The original five shareholders, me included, have pocketed dividends every year.  The earnings have become consistent enough that dividends are now paid quarterly.  One year the business was so successful that the board of directors paid an extra dividend of $1 per share over and above the normal dividend.  Since business has been good, the dividend has increased over time to $3 per share per year.  The retained earnings of BBE now stands at $10,000, and its earnings for the last full year of operations was $5,000.  This represents earnings of $10 for each of the 500 outstanding shares.

However, this success has created problems.  The increase in subscriber traffic has outstripped the capacity of the servers, resulting in slower downloads and complaints from subscribers about difficulties logging onto the site.  As a result, we are worried about losing subscribers.  The directors call a special shareholder meeting to discuss these issues and decide how to avoid a loss of subscribers.  At the meeting, the directors inform the shareholders that BBE needs $50,000 in order to purchase and install new servers to handle current and anticipated traffic on the site. The cost to expand the office space to accommodate the new servers and the additional employees needed to run them will cost an additional $20,000. This is more money than the 5 shareholders have to put into the company.  Everyone agrees that BBE should not borrow the money from a bank.  The monthly principal and interest payments to repay the loan would use up all the money otherwise paid out in dividends.  This is something the shareholders would like to avoid since they have grown accustomed to those dividend checks.

After some discussion, it is decided that the company should issue more stock to raise the necessary capital.  Some of the stock might be bought by the existing shareholders, but to raise the entire $70,000, new investors must be found.  We might be able to find some more individuals to invest in BBE, but securities laws would make such a stock offering complicated.  One of the shareholders suggests that BBE contact a venture capital firm to see if there would be any interest in an investment.  A venture capital firm is considered a sophisticated investor, which would make it easier and cheaper to meet the requirements for a stock sale under state and federal securities laws.

Usually venture capital firms invest at the very beginning of a business.  BBE, although in business for several years now, is still young and small enough that an investment at this time would be almost like getting in on the ground floor.   A venture capital firm raises money from wealthy people and institutional investors such as pension funds, university endowment funds and other sources with the capacity to invest millions of dollars.  Once the funds are raised, the venture capitalists search for start up companies to back with the hope of selling those start ups years later at a large profit.  Venture funds try to get in at the start with many different companies.  Some will fail, but others might be huge successes.  The idea is that by spreading the money around in lots of new companies, a few big wins make up for many small losses.

Another shareholder asks about contacting a private equity fund to see if an investment might be possible. Private equity funds are similar to venture capital firms in that they raise money from the same type of investors, but their method of investing the funds is different.  Private equity funds look at fewer companies.  Private equity funds have seasoned, professional business managers on staff and prefer to buy an entire company.  Private equity funds want to have their own management team take over the operations of the company, with the goal of increasing the company's size, revenues and profits; to take the company to "the next level."  Venture capitalists want to just invest money and let existing management grow the company.  However, VCs will reserve the right to take over management if the company is not being run well.  Existing shareholders may continue to own a portion of their company in either case, but usually lose management control to private equity.

Both the venture capitalists and the private equity operators have the same ultimate goal, which is to sell the company to another group of investors at a profit after a few years or to take the company public.   That means the company's stock is sold to investors in an initial public offering or IPO on a stock exchange.  Because everyone is satisfied with the way the directors and officers of BBE are running the company, the decision is made that new management from private equity is neither needed nor wanted.  Therefore, BBE will approach a venture capital firm.

In the next post, we will sit in on the type of discussions that might lead to a VC firm's investment in BBE.

Comments are always welcome.  Remember to use the Anonymous profile to more easily leave your comment, which would be posted immediately and replied to on Friday.

Monday, February 7, 2011

Early Days


When we left off last post, Best Blogs Ever, Inc. ("BBE") had been organized and the business was started.  It has shareholders, a board of directors, officers and employees.  Now it is time for me to start churning out those blogs which would attract subscribers willing to pay for the privilege of reading my posts.  Either I was right and my blogs will bring in paying subscribers or my blogs will be lost on the Internet, never to be read.

If, after the first year of operation, BBE has not made enough to show a profit after expenses, the shareholders may decide to "throw the bums out" at the next annual meeting and elect a new board of directors to run the company.  In all likelihood, I won't be the blogger-in-chief anymore.  If no money has been made and the $5,000 capital has been used up paying expenses,  the shareholders face a different issue.  They could decide to keep the business going, which means putting more money into the company, or they could vote to dissolve the corporation, sell the assets, pay those proceeds to the corporation's creditors and move on.  Such a vote would be for the liquidation of BBE.  If there is any money left after the assets are sold and all liabilities paid, the shareholders get some money back.  If nothing is left, their investment is lost, worth zero, and that's the end of the story.

On the other hand, let's assume that my blogs have been well received on the Web, and BBE made some money over and above the expenses of the business, a profit.  Gross revenue is the term for all of the money paid by the subscribers to read the blogs.  The goal is for gross revenue to be greater than the rent, payroll, utilities, advertising, computer maintenance and the like.  Once those expenses are deducted from the revenue, the remaining funds are the company's income or earnings.

The shareholders will want to know what the board of directors proposes to do with the earnings for the year.  For purposes of our story and to keep the math simple, let's assume BBE had earnings of $1,000 after the first year.  Remember that the shareholders put in a total of $5,000 of equity or capitalization in the company.  If however, the shareholders had said no to my requests for their money, they might have put that cash into a savings account at a bank and earned some interest on it.  Unless they can get a return on investment, some money back on their stock investment, the bank account might look like the better decision.  To reward the shareholders for buying stock in BBE, the directors could decide to pay some or all of the earnings out to the shareholders.  Since BBE might need some of that money in the future, the directors decide to pay the shareholders a dividend of $1 per share. Since each share was purchased for $10 and a $1 dividend is paid per share, the rate of return on the investment of the shareholders is 10%, which far exceeds the interest rates paid on bank savings accounts these days.  A 10% return should make the shareholders very happy.  For my $1,000 investment, I receive $100 after only one year.  The other shareholders receive the same return, $1 for each share of stock they own.

The rest of the money is kept for future equipment purchases or to pay increased wages or provide a "rainy day" fund for unexpected expenses.  The $500 which is not paid out in dividends is called the company's retained earnings.  Those retained earnings, which are one of the assets of BBE, have increased the value of BBE because the company has additional cash, the $500, in its bank account.  If you add that money to the value of the $5,000 of initial capital, there is now $5,500 of equity shared by the 500 shares.  Technically, each share should now be "worth" $11.
I say technically because a share of stock is only "worth" what someone will pay for it.  It may have an accounting value of $11 but unless someone is willing to buy my shares at a price of $11,  I can not realize the shares "worth".  Another term for that "worth" is book value.  A company's book value is the difference between the assets of the company and its liabilities, what the company owes to third parties, usually loans or obligations to anyone who has extended credit to the company.  So, the first year of operations has been a success.  BBE made money and increased its assets.  From an accounting standpoint, the shareholders' investment has also increased in book value.

We will continue to follow BBE in the next post, picking up some more business terms along the way.

You can leave a comment below.  It is easiest to post it using the "Anonymous" profile, but feel free to add your name to the comment.  All comments are posted within 24 hours of receipt and replied to on Fridays.