Lecture 2: Sections 3
(Chad Jardine, University of Utah, FINAN 6310, 2008–)
Section 3: A Model for Entrepreneurs
Let’s follow along with the slides.
Hi there class. We’ve now covered about half of the material we went over in FINAN 6300 adding some depth to the basic concepts.
Here’s the agenda for this video. We’ll go over the entrepreneur’s journey, discuss the concept of overhang, review the right time to sell your stock and cover secondary markets and accredited investors. Again if you feel you have a solid grasp on a concept from 6300, feel free to skim. But keep your eyes out for areas we dive deeper.
This is Victoria. She’s a student at Glasgow Caledonian university in Scotland, where she won an award from the Association of Scottish Business Women for her business idea. For this next section, I want you to put yourself in the shoes of an entrepreneur, and we’ll walk through the steps of creating a startup and growing it. I call this process, the Entrepreneur Model, or the Entrepreneur’s Journey.
Remember the spark? Business ideas start with a spark.
Just like Grugg, as entrepreneurs, your business starts with … an IDEA.
And NewCo is born.
But remember, we need an idea AND execution.
So, now what do we do?
There are lots of questions to be answered and decisions to be made.
We’ve got to make some choices. Like…
What legal formation should we use for our business? And where should we give it a place to live? (We call this a domicile).
Let’s look at formation first. We could run our business as a sole proprietorship.
The cool thing about a sole proprietorship is that you don’t have to do anything. You already are one.
But there are some downsides to this.
The biggest is that there is no separation between you and your business. That means that if your business incurs ANY liability (and it’s common for a business to incur more liability than any one person) you have personal and unseverable liability for any and everything. Something goes wrong with your business, people show up to take your house and car.
Well, that’s a downer.
How about a partnership?
In a partnership, you get to pool resources with a partner or partners. It’s nice that you don’t have to come up with all the money.
Unfortunately this does nothing to decrease your liability. In fact, it actually goes UP because your liability is inseparable from your partners. If they do something wrong, you are on the hook for it.
Limited partnerships can mitigate this somewhat. In a limited partnership, you have a general partner with all the liability and then any number of limited partners who participate and bear risk in a limited way. I’ll show you how venture capital funds are often set up as limited partnerships. But in practice, most of the partners in modern partnerships are actually other types of entities and not individuals.
What about a straight up corporation?
Corporations are separate legal entities. If your corporation gets sued, it’s liability ends with the assets of the corporation. You aren’t on the hook personally for anything it does. That’s pretty awesome.
The downside to corporations, especially for cash-strapped younger companies, is how they approach taxes. So let’s say your corporation earns $1million. That million gets taxed at the corporate tax rate. Let’s say 35% of it gets paid in taxes, so you now have $650,000. But that’s not right. YOU don’t have 650k the corporation does. So, you write yourself a check, or pay yourself a salary from the corporation. But now that gets taxed as ordinary income to you. So you pay another 25% depending on your tax bracket and end up with somewhere around $490k.
That’s called double-taxation and it’s a downside to corporations.
What about an S-Corp? You might have heard of the advantages of an S Corp for small businesses. An S-Corp is not actually a different type of business. It’s still a corporation. But it’s filing its taxes using the S-Corp rules, which protect against double taxation.
So, in my example above, you might get to take home as much as $650,000. Which sure beats only bringing home $490,000 amirite?
S Corp status however has certain rules. You only get to keep that status as long as you keep the rules. How does that affect raising money?
Well, let’s say your company is growing, but you need venture money to really grow as fast as you can. Gosh, I’m sorry an S-Corp can’t have any investors that are other corporations, partnerships, or LLCs. That means no VC money if you want to keep your S corp.
You also can’t have foreign investors, multiple classes of stock which is extremely limiting, or more than 100 investors. What happens if you do? You get treated as a regular corporation, lose the S corp status and are back to double-taxation. If your financial modeling relied on S Corp status, that can be a big surprise.
So, what options are left that don’t result in huge taxation issues but still offer the flexibility to do what you need to do?
LLCs: Limited Liability Companies have many of the benefits of corporations especially when it comes to liability, but avoid double taxation.
Now, corporations still may be better if you go public because people are used to trading corporate shares, rather than membership units. But that’s not because you can’t go public as an LLC. There are public LLCs and membership units from LLCs trade just like shares of common stock for corporations, but there’s much more familiarity with investors when you’re a corporation. I know that seems kind of shallow, but the market is fickle and perceptions matter when it comes to keeping your stock price up.
I usually recommend creating an LLC first, and then making the decision to convert to a Corporation later as your circumstances dictate. With rare exception, you should choose either a corporation or an LLC to start your business.
So, what about the next question? Domicile?
You may have done business with a company domiciled in Delaware. Why is Delaware so popular? Over 50% of publicly traded companies and over 60% of the Fortune 500 are registered in Delaware. A huge swathe of Delaware corporations are international businesses. Why? What’s so great about Delaware?
Two reasons: Taxes and Business Law precedent. Delaware has a favorable tax situation but perhaps even more importantly Delaware has a long track record of adjudicating business disputes and issues of business law.
In business, uncertainty is the worst thing you can have. You can’t plan, you can’t execute if you have uncertainty. Knowing how business disputes will come down creates a huge benefit for corporations to domicile in Delaware.
What about LLCs and other states?
Nevada used to be a good choice, but is now expensive and onerous. You want to consider how likely it is that you will have to travel to defend lawsuits, the overall costs, the ease with which you can convert to a corporation (some states make this quite difficult).
There are advantages to locating in your home state. And especially if you are a tech company with plans to be venture funded, many investors recommend you be located where the money is. That means moving to San Francisco. Secondary choices might be New York or Boston, but even in second and third place, they lag far behind the Silicon Valley.
Okay, now that you’ve formed your business, how are we going to fund it?
Remember always to keep in mind the saying that the first rule of finance is to “never run out of cash!”
Well, there are some options out there…
We can self-fund operations. This is called bootstrapping, from the old saying “pull yourself up by your bootstraps” which was an old saw meaning to tackle your challenge without any outside help.
So, companies that wend their way in the early days without outside funding are said to have “bootstrapped” their way to that point.
Bootstrapping includes using your own funds, using credit cards, sweat equity, taking out loans against your personal assets, such as your home or car, or money you might win such as in a pitch or business model competition, or grants you might be awarded.
Options outside of yourself include:
Crowdfunding. In 2012 congress passed the JOBS Act which outlined new rules for companies to raise funds. In late 2015 those rules were written and published by the SEC. If you meet the criteria, this is an avenue that is now open to you.
You can find family members or friends to help you. Personally, I think more angel investing happens this way than just about any other way. In the industry this is sometimes referred to as Family, Friends and Fools, because typically your company is much too early to have any certainty of success.
You can find “Angels,” who are so named because they are seen as gifts from heaven—investors who take a risk on your company when nobody in their right mind would. You can raise money from wealthy people, or “high net worth” individuals. The SEC has a special criteria for when someone is “accredited,” which generally means that they have made over $200k per year for at least 2 years and expect to continue to do so. If it is between an investor and his or her spouse, the amount is raised to $300k. Or individuals with a net worth over $1 million excluding the value of their primary residence.”
Basically the SEC views such people as able to make decisions that could result in them losing their money. Some people also say that this rule means only the rich get access to the best deals. There is probably some truth to both.
Sometimes angels get together and form networks, like the Park City Angels or the Utah Angels locally as a way to combine resources and review potential investments.
Another way companies access accredited investors is through third-party broker/dealers who act as registered investment advisors.
Of course venture capital is an option, including the ever growing number of corporate VCs—these are venture investors formed as an investment arm of a company. For example Google has Google Ventures, Intel has Intel Capital, Salesforce has Salesforce Ventures, etc. In 2016, there were about 200 active corporate VCs in the country.
We could go to traditional banks or look for SBA loans. These are channels for raising money via debt rather than equity. These typically have heavy collateral requirements, so startups with few assets, which includes most of them, struggle to get loans or SBA financing. However, debt is not always a bad option for companies depending on their model. There are a growing number of venture debt deals getting done, as well as more startup friendly option such as On-Deck.
Family Offices are money management arms who invest on behalf of wealthy families. They can be significant across the spectrum of investing.
Institutional investors are companies or funds whose purpose is to invest. Technically VCs would qualify as institutional investors, but here we are typically looking at real estate investment trusts, pension plans, insurance companies, etc.
Private equity firms. Venture capital is technically a subset of private equity, since both of these types of investors focus on equity investments in private companies, rather than public. But traditional private equity looks to capitalize on undervalued companies. That is often companies that are more mature than startups, but have fallen on hard times and are struggling.
Hedge funds invest in both private and public equity. They typically have a particular strategy for investing that leverages specialized information, technology or processes.
You can of course go public. But in the first lecture, we covered how this is particularly difficult for startups.
And you could court investment outside the country, which would typically fall into one of the same categories, but include the international complexity of putting a deal together across national borders.
Each of these funding sources has its niches.
With this view of the basics of valuation and the potential sources of funding, let me ask another question. Let’s say we have determined that the company is valued at $50k, or $500k, or $5 million, and an investor needs to own 30% to get a good return. Is the same investor going to do all three deals?
No. That’s very unlikely.
Investors have varying tolerance for risk, exit horizons, and desired returns. This slide from Gartner shows various investors and where they might line up with a company’s growth stage. I like to think of this as rungs on a ladder
As your company matures, it moves up the ladder. Over the life of your company, you will likely raise multiple rounds of financing, and that could require that you court investors who match the stage your company is in at the time.
This is also a reason that…
the best investor at this stage may be the one who can introduce you to the investor you need at the next stage.
Here’s a look at some rules of thumb for various investors.
As a founder, you likely put up the initial capital, even if it wasn’t much—even if it was just your time—to get the company started. Founders are typically looking to exit in 5–10 year.
Angels can be anywhere from 50–100k on the low end to several hundred thousand dollars. A good deal for them typically generates 25-100% returns and they are looking to exit in 2–5 years.
There is a crossover category, where the bigger angels and the smaller VCs operate. These deals behave more like VC deals, but with smaller amounts.
VCs themselves often focus on deals of a certain size and company stage. A Series A deal might range anywhere from $1–$10 million.
The series letter just refers to the order in which investments are made. A comes before B, etc. As A’s got bigger, angels and seed investors called themselves something different so as to not bias future investors against the company for taking too small an A-round. But long story short, this is more of a look at what is typical for a company raising an A round.
There is no actual tie that says an A round has to be a certain size—it’s just what is customary. There have been so-called jumbo series A deals between $60 and $200 million, but these have not been the norm.
Also a VC may specialize in advising companies that are raising their first larger money. Typically seed money allows the startup to test out whether it can get initial traction and generate interest from customers that is sufficient to build a sizable company around. Series A is often about solidifying product-market fit and getting the company in a position where it can scale.
Likewise there is a typical range for a series B-focused VC. This investor may be focused on the work it takes for a company to experience hyper growth, to really scale, or to lay the groundwork for its IPO.
And investors in the IPO are looking for certain things. Note that the amount is higher, but the expected return is lower. That is because the company has matured and become much less risky.
In evaluating what’s right for your company, you need to consider the tolerance for risk, the length of time the investor typically expects to be in the investment, and what kind of return they are looking for. You can then design your capital structure to deliver what investors need, making your deal a more attractive option.
People often speak about a match between founders and investors in terms of personality or company industry, but you also need to find a match in terms of investment criteria.
Let’s walk that through for this fictitious company we just formed.
We’ll chart the company’s progress on this graph. The valuation will be above and the equity below. Bootstrap isn’t really a round of financing, but we’ll use that term to describe what the founder does before taking any money.
In this case, you put up $10,000 as founding capital, and issue yourself 2.9 million shares of stock.
The price per share of those shares is 3 tenths of a penny per share. That price is only descriptive at this stage. Whether it’s fair is much too early to say, but the number of shares issues is intentionally looking at the end from the beginning. Keep that in mind as we go through.
That puts the company’s value at its assets, or $10,000. Its capital stack is 2.9 million shares owned by you.
Then, you meet an angel. It could be your rich uncle or your grandmother or someone you met. Grandma is not taking a serious look at your company because there isn’t much to see yet. What she is doing is expressing her faith in you as the founder.
Grandma puts in $100k and you sell her 100 thousand shares. Note that the company is issuing new stock for each round, you are not selling grandma any of your original shares.
That puts the price per share at $1.
Which means you now have a basis for valuing the company at $3 million. Number of shares times the price of the last issuance of stock.
Is the company really worth that much?
Well, maybe. Ultimately valuation is trying to get at the price someone is willing to pay. And you had one buyer at $1 per share. It’s questionable how many buyers you would have, but you legitimately sold stock at a $3 million valuation.
There are now 3 million shares issued and outstanding.
You take the $100k and go to work building the business and increasing its value. Note that each round of financing should not be viewed as adding value to the company, but only realizing value the company has added since the previous round.
As you get ready to raise another round, you realize that you may need to set aside an option pool to use for recruiting your superstar senior management team. You probably can’t pay them top dollar yet and you need them committed to the company.
So you set aside 350 thousand shares for your Employee Option Purchase Plan.
Note that this isn’t a sale of stock, it’s merely a reservation, so we track the number of shares as if these options were exercised, even though they aren’t yet. This is your fully diluted capital stack.
Likewise no money changed hands, so there’s no change in valuation.
Next you raise your Seed round of $1 million. You sell 800 thousand shares, so the price per share is $1.25.
We now have 4,150,000 shares of stock fully diluted. At $1.25 per share, that puts our company valuation by market cap (shares times price) at $5,187,500.
Let me ask you a question. Is grandma happy about this round?
Sure. Her $100,000 is now worth $125,000. Plus, she is no longer alone as the only one you have been able to convince that your company is worth investing in. She always knew you had it in you… but the validation is nice.
You take the seed money and put it to work building the business. You are getting traction with customers and they are loving your product. You’re getting the business figured out.
But your growth is hindered because you can’t hire salespeople fast enough on your own cash flow. It’s time to raise more money.
You raise an additional $5m in a series A from a VC who focuses on that stage. For the $5 million, you issue 2.5 million additional shares of stock. In this case, the VC has asked for preferred stock with certain special rights, but ultimately those preferred shares will turn into common shares, so we won’t worry about those details right now.
Those numbers mean we raised our A round at $2 per share.
We now have 6,650,000 shares and a valuation of $13.3 million.
So, let me ask you. Is grandma happy? Sure, her $100,000 investment is now worth $200,000.
What about our seed investor? Their $1 million investment is now worth $1.6 million.
Looks like everybody has a lot of reason to be happy.
You go back to work building the company. You are ready to scale this thing big time and have your eye on an eventual IPO. You’re going to need to raise more money to really scale to your full potential. So you go out looking for a series B.
You raise an additional $17.5 million in a series B. The Series A investor had some pro rata rights which allowed them to participate in the series B. The series B investor does the lion’s share and combined you issue 3.5 million shares of new stock.
That puts your price per share now at $5.
You’ve now got 10,150,000 shares out there and a valuation of over $50 million.
Going back to the same question, is everybody happy?
Grandma’s $100k is now worth half a million.
The Seed investors $1 million is now worth $4 million
The Series A VC’s initial investment of $5 million is now worth $12.5 million.
Looks like everybody is happy.
Wait a minute, you say. With each new round, the previous investors are getting diluted? Isn’t dilution bad?
When the Series A investor bought 2.5 million shares, that represented about 38% of the company. (see that, 2.5 million divided by the total shares of 6,650,000).
But after the Series B investment, those shares only represent just under 25%. Isn’t that bad for the Series A VC?
This example is illustrating how successive rounds of financing while numerically dilutive, represent an accretive valuation. Accretive is a word that means to lay down in layers. In this sense the value is accretive because even though each investor owns less after each round, the value of their investment is growing. Ultimately these investors are looking for returns, so the numerical dilution is acceptable in order to capture the accretive valuation.
Okay, so you’ve taken the series B investment and scaled the company. It’s really something now as you look back to your initial $10,000 cash outlay. And you’re ready to do an IPO.
You price your IPO at $13 per share. A typical IPO price is $11–13. A particularly hot IPO might price at $16–20, but you planned your capital stack so you could be very happy at a normal price.
You knew ahead of time that going public would require a certain valuation and a certain number of shares in the public float.
So you issued 5.5 million shares at $13 per share. That brings your total shares to 15,650,000
We can’t even show all your IPO value on this slide. Let’s tweak that.
Your valuation is now $203,450,000.
How much is each investor along the way worth now?
The public investors own 35.1% of your company, at $71.5 million.
The Series B investors own 22.4% at $45.5 million (remember they put in $17.5 million).
The Series A investors own 16% at $32.5 million (they put in $5 million).
The series Seed investor has 5.1% at $10.4 million (they invested $1 million).
Your key employees exercise their options (after a 6 month lock-up period) and own 2.2% of the company and $4.55 million in stock.
Grandma owns a measly .6% of the company, but that’s worth $1.3 million on an initial investment of $100k
And what about you? You went from owning 100% of the company to only 18.5%, which is worth $37.7 million. That’s a nice increase over $10,000.
You also put in 5-10 years of your life.
Is everybody happy now? They ought to be. This is how each party contributes and benefits from both growing the company and the shift in value from a private company to a public one.
Okay, so there we’ve got a model for how a company goes from inception to IPO.
That covers the Entrepreneur’s Journey. Now NewCo is public and you have a way to get liquid through the public market for your stock. So, the big question is… when should you sell your stock?
This is actually really tough for investors. In fact probably the toughest question for all investors is knowing when to SELL.
Let’s take a look at some of the issues. Well, to begin with, you can’t sell right away.
What!? Seriously? Yup. Can’t do it.
Founder stock is usually subject to a lock-up agreement. This is to prevent people from doing an IPO and dumping their stock on the market, effectively hosing all of the IPO investors.
The lock-up period is typically 180 days from IPO. So, after you IPO, you’ve got 6 months to wait before you can sell your stock.
Here’s a chart of LinkedIn’s stock from the time of their IPO through most of their first year of trading.
LinkedIn went public at $45 per share on May 19, 2011. By the next day, the stock had more than doubled in value at $94.25 per share, placing LinkedIn with a value of over $9 billion.
Not bad.
Over the next six months, they rode the market’s ups and downs, hovering fairly consistently around $80 per share.
Then, predictably, in November, six months after the IPO, LinkedIn’s shares take a slide to below $60 per share—the lowest point since their IPO. They wouldn’t recover until the following year.
Think about it. The company lost 25% of its value, almost overnight. Why?
Because the executive team didn’t manage their overhang. Early shareholders, mostly employees, sold their stock into the market as soon as they were legally able to. The spike in volume was bigger than the demand, and the price fell.
LinkedIn is an example of how the lock up period can create what is called Overhang.
Overhang is essentially cheap stock that threatens to come onto the market in a rush. You understand supply and demand. If the supply is suddenly increased, what happens to the price?
It drops, which is bad for the company.
After an IPO, the company’s ability to raise additional money and be seen as healthy is often a factor of the price and volume of its stock.
Let’s look at a more recent example.
This is Evan Spiegel, CEO of Snap, the parent company of Snapchat. Evan is in his 20s and has built one of the fastest growing companies ever. He made headlines in 2013 when Facebook offered to acquire his company for $3 billion. At that time, his company had revenues of… well they had no revenues. They were running on venture capital they had raised.
The company’s valuation continued to rise. It was the poster child for unicorns. In March of 2017, Spiegel took the company public. They offered special non-voting shares to the public. The company’s offering documents said that they were not profitable, and might never be.
Spiegel seemed to buck everything. But the market forces have resisted being charmed. Snap may ultimately turn out to be a fine company. But they missed their first earnings call and the market brutally punished their stock. IPO investors have lost nearly all their money. And 180 days after IPO, Snap looked a lot like LinkedIn—ignoring the lock up period to their peril.
Locked up shares hit the market and the price plunged. What could LinkedIn or Snap have done?
While it is illegal to manipulate the price of your stock (that is you can’t pull shady shenanigans to defraud your public investors unless you want to go to jail), you CAN orchestrate growth in your stock price. How do you do that?
One is by continuing to grow your business, increase your earnings and show investors you have a great company.f
Lock-up agreements are between the company and its investment banks, not the SEC
Spotify is an example of a company that had no lock-up agreements for employees or founders (they did for an early investor).
Another is identifying overhang early. LinkedIn or Snap could have identified shareholders likely to sell and either found ways to stagger them into the float or found buyers for the extra supply hitting the market.
Remember this, only one thing is required to get your stock price to go up… that is more buyers than sellers at the end of… Every. Single. Day.
There are companies that track lockup expirations.
That covers Overhang, now back to the big question..
When is the best time to sell? Well, let’s look at an example and do a little easy analysis.
Here we have earnings per share projections for NewCo going out five years. From these projections, we can estimate the growth rate.
Here we see the Compound Annual Growth Rate, or the growth rate compared to the previous year.
It starts pretty high, but settles into a more stable pattern over time. Earnings are still growing, but the rate is slowing down to something we would expect from a more mature company.
We used our rule of thumb of 20x trailing earnings and we cap the P/E ratio at 40. Do you see how the Growth Rate and the P/E ratio start to converge? That is a sign that the company is fair valued. In other words, investors are paying a reasonable price based on the earnings the company is producing and the rate at which those earnings are growing.
Next we’ll estimate the price per share.
If we track the high side of the price per share, we can see here that the most profitable time to sell is here in year three at $100 per share.
That gives you an idealized structure from inception through successive and accretive rounds of financing to an eventual exit at the best price.
You remember that the VC’s goal is to buy low at private valuations and sell high at public ones. That’s one exit. There are actually four possible exits for a company.
Investors harvest their returns at exit. Companies only have four potential exits:
The company may pay dividends or throw off cash from operations. This is the kind of business that is sometimes referred to as a “lifestyle” business. So-called because it generates enough money, perhaps several million dollars per year of profit, enough for the founders or the senior management to live a comfortable lifestyle. But the company is not destined to be large. The founders may intentionally not want it to be large, or it may serve a niche market.
Mergers and Acquisitions. When a company sells, shareholders harvest their returns in the sale.
As I mentioned, the company could do an IPO and sell shares in the public markets. After an IPO, investors and founders have a public market to sell their stock and capture returns.
The company could crash and burn. If the company fails, investors effectively walk away from their investment.
Only two of these are really acceptable for VCs. Founders sometimes make the mistake of thinking that a lifestyle business is a good business for VCs, but without huge growth, the business doesn’t have the ability to generate the returns VCs are looking for.
And that breaks down the principles behind the best time to sell your stock. Let’s take a look at the final section.
Remember we’ve discussed how private shares are not liquid. There isn’t a market for your shares. That is true… most of the time.
In fact secondary markets exist for selling shares of stock in private companies. These are not the same as public markets, but you should know that they exist.
Typically private shares are restricted from sale for at least one year. They are most often purchased with disclosures indicating that there may never be a market to sell the shares. This means that regardless of the investor’s desire to sell, without any buyers, there’s no real market.
Also, if you want to sell your private shares because you have a disagreement with the founders or the board, etc. you should know that any sale of private shares will likely require the company’s permission.
Finally, these sales are most often restricted to only accredited investors, further shrinking the potential buying pool for them
So, What’s an accredited investor anyway?
Well, remember this slide where I referenced these two acts which were part of FDR’s New Deal?
The Securities Act required that ANY sale of securities, private or public, requires registration. In layman’s terms, for you to sell one share of your company’s stock to your sister, you would have to do an IPO.
Which seems a little ridiculous. So there were some safe harbor exemptions written into the law. These exemptions allow the sale of securities without registration. Some of the key provisions are that the offering of securities is “non-public” and that rules are followed around “accredited investors.”
By selling stock only to accredited investors, you meet one of the safe harbor rules for selling private stock. So, let’s ask again, what’s an accredited investor?
Accredited investors are individuals who have earned at least $200k for the past two years (or $300k together with their spouse) and expect to continue that level of earning into the future. OR, they are individuals with over $1 million dollars in net worth (excluding the value of their primary residence).
Companies can also be accredited investors under different rules.
These investors are viewed as “sophisticated” in the eyes of the SEC. Basically, they can afford to lose their investment. The SEC doesn’t want to hear about widows and orphans who got swindled into investing into someone’s company which subsequently went broke and took all of that poor widow’s savings with it.
The other side of that argument is that only the rich have access to the most lucrative investments. You have to decide which you think is more accurate.
