Monday, November 26, 2012

A Return to the Story of Best Blogs Ever, Inc. (4)


We will conclude our look back at the story of BBE with the final previously posted chapter.  Here is a  portion of the seventh blog, which was called The Final Monday With The Venture Capitalists:

"Everyone agrees that BBE will amend its Articles of Incorporation to increase the number of authorized shares from the original 1,000 shares of common stock to 10,000 authorized shares with a par value of $1 each.  There had been earlier discussions about more shares being authorized, but to keep the math simple, 10,000 shares at $1 par value is the agreed upon number.  This is equivalent to the original 1,000 authorized shares with $10 par value.  BBE will have 9,500 shares authorized, but unissued shares of common stock plus the original 500 issued and outstanding sharesWith that many shares now authorized, the board of directors will declare a stock split of the issued shares on a 10 for 1 basis.  The original 500 outstanding shares with a par value of $10 each will become 5,000 shares with a par value of $1 each.  The existing shareholders will continue to own the increased number of issued shares in their original percentages.

Based on BBE's earnings of $5,000 for the last year of operations and its retained earnings of $10,000, the old 500 shares might be valued at $30 per share ($10 par value and $20 per share of retained earnings).  Those figures are reduced for the 5,000 split shares by a factor of 10.  The new 5,000 shares could be valued at $3 per share.  The $1,500 of dividends would now be shared in the same proportion.  Before the stock split, each of the original shares received a $3 dividend.  The 5,000 shares would now receive a 30 cent per share dividend.  Someone recalls our president's previous joke about the customer asking for his pizza to be cut into 4 slices as opposed to 8 because he is not that hungry.  The income and dividend numbers continue to apply; they are just spread among more shares.

When VFI purchases common shares, those numbers will be divided among even more shares.  In order to allow the original shareholders to retain control of BBE, VFI will purchase 4,000 shares of common stock.  Although the par value for the new shares is $1, VFI agrees to pay $2.50 for each share of common stock.  The par value has continued to lose its meaning, and it now becomes even less important.  The value of a share of common stock is not its par value or its book value, but rather what someone will pay for it.  Consequently, BBE will issue 4,000 shares of common stock to VFI for a purchase price of $10,000.  After that, BBE will still have 1,000 authorized but unissued shares of common stock.  VFI will also purchase 600 shares of cumulative, convertible preferred stock with a par value of $100 per share.  Unlike par value for the common shares, the par value for the preferred shares does matter.  The preferred shares will have a yield (their fixed dividend) of 2% per share.  BBE will pay $1200 in annual dividends on the 600 preferred shares.  Based on the most recent declared dividend of $1,500, this leaves only $300 in dividends for the common shares.  Everyone hopes that the earnings will continue to increase, resulting in an increase in the dividend paid on the larger number of issued shares.  The original shareholders retain the control they want, but they have to give up dividends to get it.  If the directors of  BBE were to decide, for financial reasons, not to pay the preferred dividend for three consecutive years, VFI will have the right to convert its preferred shares into common stock, again on a 10 to 1 basis.

Focusing on the possibility of  such a conversion, we realize that the Articles of Incorporation must authorize more common shares than the 10,000 we had initially proposed in order to keep the par value in balance.  Everyone agrees that the par value is not that important any more except for accounting purposes.  Our treasurer assures us that it is not a problem to get rid of par value for the common stock.  Both sides agree that the Articles will authorize a total of 50,000 common shares with no par value and 600 preferred shares each with a $100 par value.  If the preferred stock were to be converted because no dividend had been paid for three years, the 600 shares of preferred could be converted by VFI into 6,000 shares of common.  This would give VFI a total of 10,000 shares of common stock, enough to outvote the 5,000 shares held by the original shareholders.  Since the preferred shares always remain worth their par value, VFI would also have the right to convert the preferred shares into common if BBE is sold to other investors or taken public.  By converting the preferred to common, VFI can share in any increase in the value of BBE and, consequently, its common stock.  With final agreement reached, the legal papers are completed, and VFI's money is received.  BBE buys the servers, expands the office and hires new employees."

Here is a link to the entire blog, which was posted on March 14, 2011.

We will now continue BBE's story in the next blog.

Comments are always welcome.

Monday, November 19, 2012

A Return to the Story of Best Blogs Ever, Inc. (3)


We will continue the story of BBE with the next two previously posted chapters.  Here is a  portion of the fifth blog, which was called Venture Capitalists at the Door:

Before the meeting, Venture Funds, Inc. ("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.

Here is a link to the entire blog, which was posted on February 28, 2011.

Here is a  portion of the sixth blog, which was called Round Two of Negotiations with the VCs:

"It was agreed that the directors of BBE would have the right not declare any dividends; however, there would be a cumulative dividend provision in the Articles of Incorporation.  If a company has cumulative preferred stock, then any and all unpaid dividends on the preferred shares must be repaid before the common shares could receive any dividends.  Kate suggested that if the company was unable to pay the preferred stock dividend for a number of years, this would be an indication that the company was not being run properly.  In that case, VFI should have a right to take control of the company and install a new board of directors.  The new board could elect new officers to manage the company.

Susan said that a way to provide VFI with additional shares of common stock would be to add a convertibility provision to the Articles.  If the preferred stock dividend was not paid for a number of consecutive years, then VFI would have the right to convert some or all of its preferred shares into common shares with voting rights.  Preferred shares with that type of right are called convertible preferred shares.  The convertibility provision would set forth how and when the preferred shares could be converted.  She also pointed out that if BBE were to be sold to another company or group of investors, VFI's preferred shares would not share in any increase in the value of the company.  Preferred shares do not appreciate in value.  Their value remains at the original purchase price, and the owners receive their investment back if the shares are redeemed.  She proposed that the VFI's preferred shares should also be convertible into common shares if the shareholders voted to sell BBE or take it public at some point in the future.  By converting the preferred shares into common, VFI would share in any increase in the value of BBE and any consequent appreciation in the common shares."

Here is a link to the entire blog, which was posted on March 7, 2011.

We will look at the final chapter of BBE's story in the next blog.

Comments are always welcome.

Monday, November 12, 2012

A Return to the Story of Best Blogs Ever, Inc. (2)


We will continue the story of BBE with the next two previously posted chapters.  Here is a  portion of the third blog, which was called Middle Years - Success Brings Problems:

"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.

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."

Here is a link to the entire blog, which was posted on February 14, 2011.

Here is a  portion of the fourth blog, which was called Preparing for the Venture Capitalists:

"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 ('VC') for an investment in BBE.

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.

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."

Here is a link to the entire blog, which was posted on February 21, 2011.

We will look at the next two chapters of BBE's story in the next blog.

Comments are always welcome.

Monday, November 5, 2012

A Return to the Story Of Best Blogs Ever, Inc. (1)


Starting at the end of January of last year, I wrote a series of blogs on the formation of a business.  The purpose of the series was to introduce readers to investment and financial terms, including some accounting concepts.  After several blogs chronicling the progress of the business, I turned to other topics, but promised to pick up the story again at some point.  Now is the time to return to the story of the blog company, which I called Best Blogs Ever, Inc. ("BBE").   The business terms are highlighted in bold and are explained as the story of the business unfolds.  Before I pick up the story where I left off, I think it is appropriate to acquaint new readers who may not have read the earlier blogs with the story of BBE.   I will include small sections of each blog and provide a link to the entire blog.  I will include sections from two blogs in each of the next few blogs until I bring the readers up to the point at which I stopped the story.  Then we will continue to follow the course of this fictional business learning more terms as we proceed.

Here is a  portion of the first blog, which was called Birth of a Business:

"After badgering my friends and family, I get 5 people to commit to buying shares.  They could be called angel investors, since their money seems almost heaven sent.  However, not everyone is willing to invest an equal amount, in this case, $1,000 from each of the 5 investors to raise the necessary $5,000.  Some are willing to invest only $200, while others may have more money to risk.  I have $1,000 to put into the business.  Having secured investment commitments, I organize a corporation and call it Best Blogs Ever, Inc. We will call it BBE for short.  BBE will issue (sell to the investors) shares of its common stock for $10 per share.  The price per share is called the stock's par value.  Someone with $200 to invest will get 20 shares.  I get 100 shares for my $1,000 investment and so on with each of the other investors.  For their money, the investors each get a stock certificate indicating the number of shares they own in BBE.  The corporate papers I file with the state, the Articles of Incorporation, provide that the company has the right to issue up to 1,000 shares.  Those shares are authorized, but only 500 of them are needed at this time in order to raise the $5,000.  The 500 shares sold by the corporation at $10 each to the investors are now outstanding.  Each investor owns a percentage of the corporation equal to the percentage his or her cash investment represents of the total $5,000 of capital raised.  Since I put in $1,000 of the $5,000, I have a 20% interest in the business and its profits or losses.  The money raised is the equity in the company.  It is invested in, not loaned to, the company.  The company need not pay it back."

Here is a link to the entire blog, which was posted on January 31, 2011.

Here is a portion of the second blog, which was called Early Days:

"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."

Here is a link to the entire blog, which was posted on February 7, 2011.

We will look at the next two chapters of BBE's story in the next blog.

Comments are always welcome.