Monday, February 14, 2011

Middle Years - Success Brings Problems

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

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.

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