Venture Capitalists At The Door

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

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  She also says that the original the par value no longer represents the true worth of the common stock.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.