Monday, February 21, 2011

Preparing for the Venture Capitalists

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

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.

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