Category Archives: Liquidation

Do Founder Investments Dilute Earlier Investors?

ScalesAs president of Offtoa, a company committed to assisting entrepreneurs succeed, I am often asked by first-time entrepreneurs if their “investments” after founding dilute the ownership stakes of their earlier investors. The answer is always “it depends.”

Specifically, it depends on the type of legal entity that the company is; it depends on the terms laid out in the articles for the company; and it depends on what the founder means by an “investment.”

I’d like to explain the various implications of a founder “investing” money in a company subsequent to its creation and acceptance of earlier investments.

First of all, let me explain how the question is usually posed:

The Starting Conditions

“When I started the company a few years ago, I invested $20,000 and owned 100% of the company. Later, two outside investors made cash investments and purchased 10% and 20% of the company, respectively. Now I want to make another investment of $20,000. Will that dilute the ownership positions of the two outside investors?”

The Answer if your Startup is a Corporation:

If your startup is a corporation, then the outside investors did not purchase a percentage ownership stake; instead they purchased a number of shares.

Investment. If you are purchasing additional shares with your new $20,000 investment, these shares always come from the company’s treasury. Thus, the total number of outstanding shares will increase, and the percentage ownership represented by the outside investors’ fixed number of shares will indeed decrease. So, yes, they will be diluted.

Loan. If you are just lending the company $20,000, then this has no effect on the number of outstanding shares, and outside investors will not be diluted. You become a creditor of the company. The company will need to repay you according to the terms of the promissory note, and in the case of company closure, creditors will be paid before shareholders.

Convertible Loan. It is common practice for insiders who lend the company money to convert those notes into equity if a major investment round occurs in the future. That is, the note is retired, and the outstanding principal including accumulated interest becomes part of the next investment round.

The Answer if your Startup is a Partnership:

Capital Account. Typically, if you invest cash in a partnership, it has no effect on ownership distribution; instead, it is recorded in your capital account and in the case of a liquidity event or other cash distribution from the partnership to the partners, you would be eligible to receive that amount from your capital account.

However, because partnerships allow for “special allocations,” both allocation of profit and loss to a capital account and subsequent distributions is negotiable. So, no, the “outside investors” (i.e., partners) will not be diluted.

Increasing Your Stake. Notice that if you did want your investment to dilute the partners, you would pay the other partners to acquire their positions. This would not provide cash to the company to help its operations.

Loan. If you are just lending the company $20,000, then this has no effect on your capital account or ownership distribution. You simply become a creditor of the company. The company will need to repay you according to the terms of the promissory note, and in the case of company closure, creditors will be paid before partners.

The Answer if your Startup is an LLC:

Because most LLCs are treated as partnerships for tax purposes, the manner of priority, allocations, and distributions are negotiable. However, here is how they typically work.

When you as a founding member invest additional capital in the LLC, it could be treated in either of two ways, based on the LLC’s articles of organization:

  1. Capital Account. Like in the case of a partnership, it is recorded in your capital account and in the case of a liquidity event or other cash distribution from the LLC to the members, you would be eligible to receive that amount from your capital account. So, no, the “outside investors” (i.e., members) will not be diluted.
  2. Like in the case of a corporation, the cash could be used to add to your ownership interest, diluting other members (in this case, the “outside investors”), with their approval.

Increasing Your Stake. As in the case of a partnership, most LLCs also allow you to pay other members to acquire their positions. This would not provide cash to the LLC to help its operations.

Loan. If you are just lending the company $20,000, then this has no effect on your capital account or ownership distribution. You simply become a creditor of the LLC. The company will need to repay you according to the terms of the promissory note, and in the case of company closure, creditors will be paid before members.

Summary:

It is extremely common for founders to want to make additional infusions of capital into companies after starting. But notice that the implications of making such an investment are non-trivial. This is one of the many reasons why almost all startup mentors recommend that first-time entrepreneurs consult with an attorney experienced with entrepreneurial matters prior to creating their companies.

The type of legal entity that you decide upon and the terms you include in your incorporation/organization/partnership agreement will have significant effects on many aspects of your business. The above example of re-investing in the company is just one small example.

Please note that I am neither a CPA not an attorney. If you want to understand how investing in your company will affect your earlier investors, please consult with your CPA or attorney.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.
Photograph of Cover

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money? If you’d like to verify that your great business idea makes financial sense, sign up for www.offtoa.com,.

How to Read a Cap Table: Advice for Entrepreneurs

A capitalization table (cap table for short) shows how ownership of the company is distributed among all shareholders. It is the de facto standard entrepreneurs use to show investors what they are buying.

sharks When you are seeking investor money, you are essentially selling something, specifically equity in your company. Providing a cap table when you sell equity in your company is similar to providing a CarFax report to buyers when you sell a used car.

In both cases, you are fully disclosing to the buyers exactly what they are buying. It shows you are honest and reveals (in both cases) material facts that buyers cannot otherwise discern.

Although the cap table is a standard tool among entrepreneurs and investors in private companies, it is not a standard financial statement in a larger corporation.  Learn to read one to be credible to investors.

What Does a Cap Table Show?

A cap table shows in a single table a complete breakdown of the ownership of equity of a company. It displays exactly what classes of stock exist, who owns shares, and how many (and what percentages) of each.

Let’s look at an example where the cap table is being used to show “before” and “after” situations as part of a stock offering. In this case, the stock offering is for 200,000 preferred shares of the company.

Capitalization Table for NewCo, Inc.

 

Before

After

Common

Shares

Undi-luted

Fully Diluted

Shares

Undi-
luted

Fully
Diluted

    George

   250,000

25%

17%

 

   250,000

21%

15%

    Harry

   250,000

25%

17%

 

   250,000

21%

15%

    Sally

   500,000

50%

33%

 

   500,000

42%

29%

Total Common

1,000,000

100%

67%

 

1,000,000

83%

59%

Preferred

 

 

 

 

 

 

 

   Series A Shareholders

        –  

0%

0%

 

   200,000

17%

12%

Total Preferred

        –                               

0%

0%

 

   200,000

17%

12%

Total Common + Preferred

1,000,000

100%

67%

 

1,200,000

100%

71%

Options

 

 

 

 

 

 

 

   Granted

   300,000

 

20%

 

   300,000

 

18%

   Authorized, Not Granted

   200,000

 

13%

 

   200,000

 

12%

Total Options

   500,000

 

33%

 

   500,000

 

29%

Total Fully Diluted Shares

  1,500,000

 

100%

 

 1,700,000

 

100%

Here is a description of the various parts of the cap table shown in the above example:

  • Down the left side, a list of all (classes of) shareholders. In some cases, actual names of shareholders are shown (in the case of the figure, common shareholders’ names are shown). In some cases, they are grouped together as a class (in the case of the figure, preferred shareholders’ names are not shown).
  • Along the top, two groupings of columns are shown; they are labeled Before and After, corresponding to how the company’s ownership looks like before and after the investors make their expected purchase of the 200,000 preferred shares.
  • Along the top, within both Before or After, three columns are displayed:
    • Shares. Number of shares that this shareholder has been issued.
    • Percent undiluted. Percent of total outstanding shares that this shareholder’s shares represent. Thus, if this shareholder owns 250K shares (as is the case of George), and 1M shares are currently outstanding, the percent undiluted is shown as 25% (250,000/1,000,000).
    • Percent (fully) diluted. At this time, a certain number of options have been authorized to be granted to individuals. If all these options were to be granted, and all option holders were to exercise their right to convert those options into shares, additional shares will exist. When we include these shares in the overall count of shares, we call the new count (fully) diluted.

Thus, continuing with the above example, if a pool of 1,000,000 shares have been authorized for options, then George owns 250,000 shares out of a total diluted pool of 1,500,000 shares (i.e., 1,000,000 shares sold plus 500,000 options authorized), then his percent diluted will be 17% (250,000/1,500,000).

Number of Shares

Let’s now compare the Before and After sections. The example above shows the following numbers of shares (see the two columns labeled Shares):

  • The number of founders’ shares is unchanged at 1,000,000. We will almost always see the same number of founders’ shares in every round (unless something unusual happens like a founder sells shares).
  • The number of preferred (Series A) shares increases from zero to 200,000 as we move from before to after. These are the shares that are being sold.
  • The total number of outstanding shares (i.e., total common plus preferred) reflects the same increase, i.e., from 1,000,000 to 1,200,000.
  • The number of options granted and the number of options remaining in the option pool are unchanged at 300,000 and 200,000, respectively.

Undiluted Ownership

It shows the following about undiluted percent ownership (see the two columns labeled Undiluted):

  • Although the number of shares owned by founders (total common) is unchanged, their undiluted percent ownership decreases from 100% to 83% because the total pool of issued shares increased from 1,000,000 to 1,200,000.We will almost always see the percentage ownership of founders decrease with each successive round because the total number of outstanding shares increases. This is because investors generally purchase new shares from the company’s treasury as opposed to purchasing existing shares from current owners.Note that if a founder happens to participate as an investor in a round, those shares are shown on the cap table as owned by the investors in that round, not by the founder.
  • The 200,000 new shares purchased by Series A investors represent 17% of the 1,200,000 total shares.

Fully Diluted Ownership

The cap table shows the following about fully diluted percent ownership (see the two columns labeled Fully Diluted):

  • Once we add 500,000 authorized options to both the before and after totals, the 1,000,000 shares owned by founders represent 67% and 59%, respectively, of the total. Said another way, by selling 200,000 shares to investors, the founders’ ownership stake is diluted by 8%.
  • Once we add 500,000 options to the totals, the 200,000 new shares purchased by Series A represent 12% of the 1,700,000 total fully diluted pool of shares.

A cap table enables investors to understand what they are buying. It enables entrepreneurs to make it clear that they have nothing to hide. In summary, a cap table is an essential tool for communication between entrepreneurs and investors.

Alan DavisThis article is an edited excerpt from the book Will Your New Startup Make Money? by Al Davis. Davis is a serial entrepreneur currently in his fifth startup. He is also an angel investor and the author of six books.

Determining Future Valuation of a Startup

Future Valuation

My previous blog post (https://www.offtoa.com/wp/?p=237) described why an entrepreneur needs to determine today the likely valuation of the startup company at  some point in the future. That’s what I will discuss in this post.

How to value?

Let’s assume you predict the company will be acquired in 5 years. You stated all your assump­­tions about your business strategy and transformed them into pro forma income state­ments, balance sheets, and cash flow statements for the next 5 years. You now have enough data to make an educated guess about the value of the company based on other companies who have had liquidity events with similar financials. Of course, there are many problems with such a valuation:

  1. Your assumptions are just assumptions, not facts. In fact, some of them are just guesses. That is why you need to use as many sources as possible to validate your assump­tions. That is why you should show your assumptions (not just your financial statements) to potential investors; let them question the assumptions (and revise as necessary).
  2. Many factors influence the value of a company besides just its financials. Such intangibles relate to the market, the economy, intellectual property, state of competitors, the level of merger & acquisition activity in your industry, the “hotness” of your industry sector [1], and so on.
  3. We will be valuing your company based on multiplying various elements of your pro forma financial statements by multiples specific to your industry. However, the values of these multiples change over time. A big change in the public stock markets will cause a big change to the values that should be used for the multiples for your industry.

To value your company at the end of the fifth year, do the following

  • Take the annual revenue for year 5 (aka “trailing revenue”) and multiply it by the industry revenue multiple. The industry revenue multiple is computed in one of the following ways: (a) Look at the last n acquisitions of private companies in your company’s industry [2]. Compute the average of their acquisition prices divided by their last year’s annual revenues. (b) Look up the average P/S (Price/Sales) ratio for the industry on any finan­cial website; this will give you a high valuation because publicly traded stocks are more liquid (and thus more valuable) than private stocks.
  • Take the annual gross profits for the 5th year (aka “trailing gross profits”) and multiply it by the industry gross profits multiple. The industry gross profits multiple is computed in one of the following ways: (a) Look at the last n acqui­sitions of private companies in your company’s industry [2]. Compute the average of their acquisition prices divided by their last year’s annual gross profits. (b) Look up the average P/S ratio for the industry on any financial website; divide it by the average gross profit margin for the industry; this will give you a high valuation because publicly traded stocks are more liquid (and thus more valuable) than private stocks.
  • Take the annual EBITDA for the 5th year (aka “trailing EBITDA”) and multiply it by the industry EBITDA multiple. The industry EBITDA multiple is computed in one of the following ways: (a) Look at the last n acquisitions of private companies in your company’s industry [2]. Compute the average of their acquisition prices divided by their last year’s annual EBITDA. (b) Look up the average P/S ratio for the industry on any financial website; divide it by the average EBITDA/sales ratio for the industry; this will give you a high valuation because publicly traded stocks are more liquid (and thus more valuable) than private stocks.
  • Take the annual EBIT for the 5th year and multiply it by the industry EBIT multiple. The industry EBIT multiple is computed in one of the following ways: (a) Look at the last n acquisitions of private companies in your company’s industry [2]. Compute the average of their acquisition prices divided by their last year’s annual EBIT. (b) Look up the average P/S ratio for the industry on any financial website; divide it by the average EBIT/sales ratio for the industry; this will give you a high valuation because public stocks are more liquid than private stocks.
  • Take the annual earnings after tax for the 5th year (aka “trailing profits”) and multiply it by the industry profits multiple. The industry profits multiple is computed in one of the following ways: (a) Look at the last n acquisitions of private companies in your company’s industry [2]. Compute the average of their acquisition prices divided by their last year’s annual EAT. (b) Look up the average P/E (Price/Earnings) ratio for the industry on any financial website; this will give you a high valuation because public stocks are more liquid than private stocks.
  • Compute the average of the above five averages. This will give you as accurate an estimate as you can compute for the valuation of the company . . . given the three caveats above

What to do with that future valuation?

Let’s assume that you follow the procedure described above and you determine that the company will be worth, say, $20,000,000 in 5 years. What good is that knowledge? The answer is: You can use it to determine what percent ownership of the company today will be worth in 5 years. Continuing with this example, if you have determined that the company will have a value of $20,000,000 in 5 years, then a 25% stake will have a value in 5 years of $5,000,000. Therefore, if you offer an investor a 25% stake in the company today for, say, $1,000,000, you are

  • Explicitly stating that the company is worth (today) $4,000,000, which you will have to justify!
  • Implicitly (via your financial statements) stating that the $1,000,000 investment can create a $5,000,000 return if all the assumptions become reality, and the company has a liquidity event in five years at the valuation multiples that are currently being assumed. The IRR for that $1M investment becoming $5M in 5 years, by the way, is 38%.

The above is extracted from my latest book, Will Your New Start Up Make Money? Buy your copy in Kindle or paperback format at http://www.amazon.com/Will-Your-Start-Make-Money-ebook/dp/B00JOOZQNE. By the way, Offtoa.com does future valuation automatically for you based on your answers to a few simple questions.



[1] According to Mark Andreessen (http://techcrunch.com/2013/01/27/marc-andreessen-on-the-future-of-the-enterprise), valuations can vary by as much as fourfold based on the hotness of the sector.

[2] Inc. Magazine occasionally publishes this data on their website at www.inc.com. The latest data is available by subscription from Hoover’s at www.hoovers.com.

 

Liquidation Preference and Avoiding Dilution

For me, as an early investor, straight dilution is not a scary thing. Since I have no interest in “control,” owning 10% of a $1,000,000 company is identical to owning 2% of a $5,000,000 company. What scares me as an early investor is the idea of later investors demanding liquidation preferences greater than 1x. When they get such preferences, they end up taking more than their fair share, and squeezing out the earlier investors down to zero ownership. Here is an example:

  • Let’s assume 1,000,000 shares currently exist.
  • We invest $250,000 (let’s call it Series A) and acquire 20% of the company with a pre-money valuation of $750,000 (post-money valuation of $1,000,000). We’ll be purchasing 250,000 shares at $1/share. Let’s assume we negotiate 1x liquidation preferences.
  • At the next round (let’s call it Series B) one year later, the company has a pre-money valuation of $3,200,000 (post-money valuation of $4,000,000), and other investors invest $1,000,000 to purchase 20% of the company with 2.5x liquidation preferences. They’ll be purchasing 312,500 shares at $3.20/share. We decide to not invest.
  • If the company is acquired with a huge windfall, everybody will be thrilled, but let’s say the company gets acquired for $4,312,500 after 2 more years. The first thing that happens is we (the Series A investors) get $250,000 and the Series B investors get $2.5M. Next, the remaining $1,562,500 gets divided on a pro rata basis among all shareholders. There are currently 1,562,500 outstanding shares, so each receives $1.00 per share. Thus founders receive $1,000,000 (i.e., $1.00 x 1,000,000 shares). We receive $500,000 (i.e., $250,000 preference, plus $1.00 x 250,000). The Series B investors receive $2,812,500 ($2,500,000 preference, plus $1.00 x 312,500). 
  • As you see, that liquidation preference really screwed the earlier investors. The Series A investors received just a 19% IRR while the Series B investors received a 41% IRR even though the Series B investors presumably took a much lower risk having invested later in the company’s life.

So, bottom line is, dilution is not a fear. Liquidation preferences by future investors who demand high liquidation multiples is a great fear. Just my two cents.