Description
During this detailed elucidation relating to on the not so simple steps involved in starting a business venture.
EC100 REINHARDT
ON THE NOT SO SIMPLE STEPS INVOLVED IN STARTING A
BUSINESS VENTURE
1
I. BECOMING A CAPITALIST I: GETTING STARTED
Suppose that you had stumbled upon a cool idea likely to please some of your fellow human
beings. To do so, you will produce and sell to them a new product or service that no one had ever
thought of before.
Starting such a venture will make you a capitalist -- one of the creative, risk taking people who
dream of getting rich by pleasing their fellow human beings. J eff Bezos founder of Amazon.com, is but
one of many such entrepreneurial men and women to come out of Princeton; but his is a truly classic
case of an idea that seems off the wall at first but then survives, thanks to the tenacity of its creator.
Having a multitude of such creative, risk-taking people, supported financially by an equally-risk
taking cadre of venture capitalists who are willing to take a chance on the,, is one of those things making
the American economy the envy of the world. Microsoft, Amazon.com, Yahoo.com, Google, e-Bay,
Starbucks and many, many more relatively young American companies that now dominate their global
markets all started this way.
For some reason, much of Europe lacks that powerful source of economic energy – although, of
course, not Asia, where risk-taking and entrepreneurship have become a highly respected way of life as
well.
A. Your Financial Plan
To launch your new venture, you will, first of all, need some up-front financing.
You can cobble it together from you’re your own savings, from your parents, or from some of
your family’s well-to-do friends.
You may also be able to secure some debt-financing – e.g., a revolving line of credit at a bank.
In return for a periodic fee, the bank lets you borrow automatically up to a certain amount from it. The
expectation is that you will pay back these instant loans as cash comes in, so that you will always have a
little cushion between what you owe at any point in time and the maximum credit line extended to you.
The fee is paid on top of any interest on loans, even if you have not drawn on any credit at all. The
financial flexibility this standby credit offers is worth a monthly fee.
Another way to borrow is to lease space and equipment you may need rather than buying it. For
start-ups, leasing is a great financial contract.
If you do not have access to private venture capitalists willing to invest in your idea, you may
have access to public assistance. Specifically, you may belong to a category of Americans whom the
government is committed to help through loans from the Small Business Administration (SBA) or some
other agency tasked with furthering your category’s economic opportunities. Some entrepreneurs get
started that way.
1
I would like to thank my friend Carlos Ferrer, Princeton ’74, founder and partner of Ferrer Freeman & Co.,
a highly successful private equity firm, for valuable comments and suggestions for improving on an earlier
draft. He bears no responsibility for any remaining or new errors in the commentary.
2
B. Your Business Plan
Potential investors in your venture naturally will want to know what your so-called “business
plan” is for the venture, and who else is willing to risk their money on your idea, and how much.
A business plan must provide credible details on (1) the product being produced, (2) the “value
proposition” of the product, (the price you plan to charge for it relative to the value it brings to the
customers, (3) the “marketing strategy” ( including the probable market for your new product, competition
and “go to market” strategy), (4) the management resources committed to the company and your ability
to attract the properly skilled labor required for the production of the product, (5) the plan for accessing
any additional technical and marketing resources to execute the business plan, and finally, (6) the
financial projections. You will provide information on all six aspects of your proposed venture in prose
and formatted according to accepted industry protocols.
Of these six tasks, the marketing strategy will be the most challenging and the most crucial.
Everything else depends on your being able to sell what you produce. Too many entrepreneurs fall wax
romantic over their own ideas and blithely assume that everyone else will think likewise. In fact,
outsiders may be quite skeptical at first about the merits of you’re a new product. Therefore, it will be
wise to enlist some credible professional advice on your marketing strategy.
The financial projections are conveyed in the so-called “pro-forma” financial statements which
are fairly standard and a major tool of communicating with prospective investors. They will include
detailed assumptions on pricing, labor and manufacturing costs, operating margins, working capital
needs, overhead costs, outside consultants and directors, and maintenance related capital expenditures,
among other things. There are four main components of the financial projections:
1. The Pro-Forma Cash Flow Statement: This statement should show, on a quarterly
or even monthly basis for the first year, and annually thereafter for the first, say 5
years, what cash will flow into your venture and for what purpose cash was spent by
your venture. The statement is fundamental, because cash is the lifeblood of a
business venture. Your cash-flow statement should be fairly detailed, so that
investors can see exactly where you expect the money to come from and on what
particular items you will spend it. They may want to question the wisdom of some of
your proposed outlays – for example, a lavish floor space or number of sales
representatives needed to bring the product to market.
2. The Pro-Forma Statement of Financial Position (“ Balance Sheet” in the
vernacular: This statement is a relatively detailed listing of all of the valuable concrete
things or financial contracts or patents to which your firm has legal title. These items
are called “assets.” The statement also includes a detailed listing of all of the debts
your business owes. They are also called “liabilities.” By definition, a firm’s “net worth”
is the difference between the dollar value of all of the assets it owns minus the dollar
value of all of the liabilities it owes. Because a firm’s Net Worth = Assets – Liabilities
(all in dollar values), from which follows the famous accounting identity:
$Assets = $Liabilities + $Net Worth
This accounting identity explains why the Statement of Financial Position is called the
“Balance Sheet” in the vernacular.
3
The dollar values of assets, liabilities and net worth are calculated on the initial
founding of the company and thereafter as of the end of a so-called “fiscal period,” be
it a month, a quarter or a year. It is a momentary snapshot. Many companies choose
the calendar year as their fiscal year; but a company can choose any other period as
its fiscal year and then stick with it – for example, from J uly 1
st
to J une 30
th
, or from
October 1
st
to September 30
th
.
In your business plan, you will include pro-forma statements of financial positions for,
perhaps, the next 5 years, probably on a more frequent basis (quarterly) for the first
year.
3. Pro-Forma Income Statement: The “accounting income” of a business firm for a
given fiscal period is formally defined as the difference between the “revenues” earned
in that period minus the “expenses” incurred in that period. One can think of “revenue
transactions” in a particular fiscal year as those that, taken by themselves, would
increase a firm’s net worth. Typical revenue transactions are sales of output. Similarly,
one can think of “expenses” as those transactions that, by themselves, decrease the
firm’s net worth. Typical expense transactions in a particular fiscal year are the use of
raw materials in production, rental payments on equipment and floor space, payments
for energy, salaries and wages of employees, and payment of interest on debt and
any other cash outlays made, or liabilities incurred, to support the year’s revenue
transactions.
Note that not all cash inflows in a given year represent “revenues” for that year.
Suppose, for example, the firm borrows $100,000. That will increase its assets by
$100,000 (namely, cash on hand) but also its liabilities, by the same amount. Net
worth is not touched by this transaction. Therefore it does not constitute a revenue
transaction. On the other hand, if we sell 10,000 widgets @ $10 cash per widget, then
this transaction would increase the asset “cash” by $100,000, not increase any
liability, and therefore, viewed by itself, increase net worth by $100,000. (The fact that
we had to give up the widgets will be recognized by the accountant separately).
Similar reasoning applies to expenses. You should not worry too deeply about this
aspect of the problem, as it involves financial accounting and lies beyond the compass
of this course. Here we just give you the general idea.
Income statements are written for entire fiscal periods – a month, a quarter or a year.
In your business plan, you will offer pro-forma income statements for the next 5 years,
perhaps on a quarterly basis for the first year.
4. The Cap Table: This statement details the proposed securities to be sold to outside
investors and the “initial capital structure,” by which is meant the structure of equity
financing and (if used) debt financing used to get the venture launched and sustained
in its initial phase.
The Cap Table is a summary description of the financing’s terms and conditions, and
the prospective stakes held by the founder-owners of the new company and the rest of
the management team, many of whom will agree to work for low cash wages in return
for an ownership stake in the venture. The cap table also lists how much of the total
ownership stake would be reserved for future employees, who will get access to them
through stock options or outright stock grants.
A stock option is a piece of paper entitling its owner to purchase a specified number of
shares of a company’s common stock (usually 1 share or a 100 shares) at a specified
4
“striking price,” regardless of what the actual price of the share is. Thus, if you hold an
option entitling you to buy 1 share of ACME, Inc. stock at $40 per share, and the
stock currently sells at $70 per share, you can “exercise” your option by buying the
share at $40 and then immediately resell it for an immediate gain of $30. That gain,
alas, is taxable at ordinary income tax rates. Alternatively, you could just hold on to the
share you bought, hoping it will rise further in value.
Typically the founders would be entitled to ownership in the form of common stock.
They are ownership certificates, usually printed up in large numbers (perhaps
millions), with each certificate representing a tiny stake in the venture. The venture
capitalists who also have invested in the company would own a different security, one
that ranks higher than the common stock, thus giving these outside investors the right
to get their money back before the founders/management can take out any money
(other than their agree-upon salaries and wages).
The business plan is the most crucial document in starting the new venture. You may think that
this statement is so obvious as to be a condescending remark. One wishes the geniuses who ran the
hundreds of ill-fated dot.com ventures in the late 1990s had understood this obvious requirement as
well. They did not. These failed dot.coms tend to have this in common: they lacked a credible business
plan and were, instead, based on romantic lyrics that were swallowed up by eager and ignorant
investors that were feeding on “Greater Fools Soup”. The “Greater Fools Theory” of investing holds that
even smart and fully informed investors will buy vastly overpriced financial securities on the belief that
there will always be a “greater fool” onto which such paper can be foisted at an even higher price. (In
many areas of the country, the real estate market now operates in that mode.)
Particularly disturbing in the later 1990s was that the investment bankers and financial analysts,
who, in theory, are to function as the ever vigilant watchdogs over our capitalist order, not only bought
the fables gushing forth from eager dot.com entrepreneurs – or pretend to buy them – and eagerly
promoted this junk to private investors.
C. Your Capital Expenditure Plan
You must estimate what floor-space and capital equipment will be needed to support your
venture in the early years and describe these requirements to outsiders as well. At this stage, you will
probably wish to rent as much of that floor-space and equipment as you can, which, in our wondrous
economy, means virtually all such fixed inputs.
Renting rather than owning these fixed assets, as they are called, may be more expensive per
unit of capacity and time period; but you will not be saddled with owning such assets and can write the
rental contract so that you can easily return rented assets if the marketing plan was too optimistic. To be
sure, canceling renting contracts prematurely usually brings with it stiff financial penalties. Even so,
renting still remains a more flexible way to procure required structures and capital equipment. That
flexibility is worth some extra expense at this stage of your venture, when the risks are high and financial
capital to buy structures and equipment outright is expensive. (Don’t forget, you give up sizeable chunks
of your business to procure financial capital from venture capitalists).
The capital expenditure plan can be made part of the Business Plan or developed as a separate
document. I would favor the latter to convey that you have given it much thought. Often it is simply made
part of the detailed assumptions used to make the previously described financial projections.
5
D. Legal Counsel
You will also need to provide potential investors in your venture assurances (1) that your product
does not infringe on any patents held by others, (2) that you will not run afoul of any federal, state or
local ordinances – e.g., environmental laws or local zoning laws or relevant labor laws, and (3) that the
securities being offered properly convey title and are in conformity with securities laws.
There is no way around it: you would run enormous risks starting a new venture without the
advice of legal counsel. If you do not have money to pay for that counsel, perhaps the lawyer(s) will
accept an equity position in your venture instead. Many lawyers have an entrepreneurial streak in them.
Ideally, though, it is probably best to pay them their proper fees, if there is the cash to do so.
II. BECOMING A CAPITALIST II: MEZZANINE FINANCING
Now suppose you have successfully run your business for a few years and you would like to
expand it. The profits you have made and retained in the business – rather than paying it out to
yourselves and the other investors – have not accumulated enough capital to finance the planned
expansion. You can then look around for later-staged growth capital, also called “mezzanine” financing.
A mezzanine, as you know, is a sub-floor in a building between to main floors.
Mezzanine financing is supplied by so-called “private equity firms.” They tend to be partnerships,
rather than publicly traded companies. The partners themselves are savvy investment people who really
understand the businesses they invest in. Typically they invest their own money in this way, along with
that of other wealthy individuals or institutions (such as university endowments and employee pension
funds). To procure such outside moneys, the private equity firms establish funds that have a name and
will try to collect, say, $200 million or so before the fund gets closed to additional investors. It is then
invested by the partners on behalf of themselves and the outside investors. In return for their work, the
partners get a management fee (a percent of the invested funds) and share in the profits they have
earned for the outside investors.
After a private equity firm has invested mezzanine capital in your ongoing firm, one or more of
the partners will take a continuous interest in how you run the business, and typically become members
of the Board of Directors watching over your firm. They are both, friends and your own business
consultants, and hard task masters, watching vigilantly over your so-called “burn rate,” that is, the rate at
which you spend cash on hand, and for what purposes. They will help you and goad you to nourish your
business along, sometimes making connections to other friends and business partners that can be
helpful to you. Most often, they will have control over major decisions, such as capital spending over
established minimums, financing events, and the sale of the business.
III. BECOMING A RICH CAPITALIST III: GOING PUBLIC IN AN “ IPO”
Now suppose you have “grown your business,” as the jargon goes, and by now you have a
flourishing business ready to be sold to the general investing public – e.g., regular mutual funds, hedge
funds, institutional money managers or individual investors. Typically with the aid of an investment
banking firm, you will organize a so-called “initial public offering” or IPO.
As already noted earlier in the section on “The Cap Table,” even before that step, you had
issued ownership certificates to yourself, to your closest co-workers, who took these certificates in lieu of
cash compensation, and to the outside investors, both original and mezzanine. In toto, you might have
issued, say, 5 million of such certificates. They are also called “stock certificates” or simply “shares of
stock.”
6
In an IPO, those who now hold shares of stock in the still private venture will sell a certain
fraction of them to the general investing public, with the help of an investment banking firm that may form
a “syndicate” with other investment bankers and retail the stocks through their networks of brokers. The
investment bankers will prepare all of the documentation requires for such a sale (including a
“prospectus” which describes the business in fine detail, includes financial statements, and highlights the
potential risks faced by the firm, so that investors are fully informed). The firm will have gotten a formal
charter for the proposed, publicly traded company, usually from the State of Delaware which specializes
in serving corporations in that way. You may even have registered your hitherto privately held company
in stat state. All of these proceedings will be closely supervised by the federal Securities and Exchange
Commission (SEC), which will make sure that all statements you make in the prospective are true, that
you have not withheld pertinent information, and that the sale of the securities to the public will take
place in a fair and orderly manner.
Particularly important these days is that you comply fully with the Sarbanes-Oxley (SOX)
requirements. SOX was introduced to Congress a few years back by Senator Sarbanes and
Congressman Oxley, in the wake of the financial accounting scandals that had driven so much of the
stock-market bubble in the late 1990s. The strictures on financial reporting imposed by SOX can be
excruciating. (If your parents are business executives, mention casually at dinner that you are a great
fan of SOX 404 and wish there were more such requirements. Dinner will stop early that day, I can
assure you, and you will be sent to your room. If your parents are not business executives or
accountants, of course, they will think you are talking about a baseball team, which generally like to be
known by the color of their socks.
Suppose of the 5 million shares of common stock you had issued earlier, you, the founder,
owned 500,000. Your colleagues on the management team would own other chunks of the stock. The
outside investors, you will recall, may own similar securities, but priority over yours.
Your firm will sell a total of 3 million of the 5 million shares in this IPO. Your investment banker
advises you to offer the shares to the market at a price of $70 a share. At that price, the bankers tell you,
the issue will sell quickly into the market, and you won’t face the embarrassment of having a large block
of unsold shares on your hands. That is never an image-enhancing circumstance.
If public investors agree that the stock is worth at least $70 per share, they will snap up the
offering quickly. Included in the 3 million shares are 300,000 of your own. Figure it out. You are now a
multi-millionaire, at least on paper. Alas, for you, usually the management team cannot sell any of the
shares it owns for at least 180 days after the date of the IPO – the so-called “lock-up” period, and there
may be other restrictions on such sales imposed by the venture capitalists. Your Porsche will have to
wait.
Many times in the 1990s, the investment bankers put too low a price an initial offering price on
shares in an IPO, and their market price shot up quickly thereafter. It helped the bankers to sell the issue
quickly through their network of brokers. Knowing that quick and almost certain profits could be made in
the hours and days just after the IPO, the investment bankers (through their brokers) would allot a
certain number of shares at the unduly low prices to each of their business and personal friends, among
them politicians whose favors they needed. These lucky ones then could make hundreds of dollars of
profits in one or two days, without lifting a finger. (What a way to purchase the good will of politicians!)
The lucky ones also included the CEOs of still private or already public companies, who promised in
return for such quick profits, once again off the record, that they would use the kindly bankers handing
them these sure and quick profits, should their own companies’ sell newly issued bonds and stocks in
the market, even if that might not have been in these interests of these firms’ shareholders. The SEC
now frowns upon this practice, which is considered unfair. As far as I know, the SEC has made it much
more difficult to bestow such favors on friends and favored business partners.
In any event, here’s the final deal: Some time after the IPO, when you will be a millionaire –
initially on paper, eventually in cash – you will receive a friendly visit from Princeton University’s
7
Development Office, reminding you of what a great place Princeton is, forever should be, and certainly
was for you. You will be tithed appropriately. That is only fair. After all, you have learned all you know,
and so much more, in Economics 100, not even to speak of English 101, which helped you write the
lucid prose in your business plan.
doc_906605474.pdf
During this detailed elucidation relating to on the not so simple steps involved in starting a business venture.
EC100 REINHARDT
ON THE NOT SO SIMPLE STEPS INVOLVED IN STARTING A
BUSINESS VENTURE
1
I. BECOMING A CAPITALIST I: GETTING STARTED
Suppose that you had stumbled upon a cool idea likely to please some of your fellow human
beings. To do so, you will produce and sell to them a new product or service that no one had ever
thought of before.
Starting such a venture will make you a capitalist -- one of the creative, risk taking people who
dream of getting rich by pleasing their fellow human beings. J eff Bezos founder of Amazon.com, is but
one of many such entrepreneurial men and women to come out of Princeton; but his is a truly classic
case of an idea that seems off the wall at first but then survives, thanks to the tenacity of its creator.
Having a multitude of such creative, risk-taking people, supported financially by an equally-risk
taking cadre of venture capitalists who are willing to take a chance on the,, is one of those things making
the American economy the envy of the world. Microsoft, Amazon.com, Yahoo.com, Google, e-Bay,
Starbucks and many, many more relatively young American companies that now dominate their global
markets all started this way.
For some reason, much of Europe lacks that powerful source of economic energy – although, of
course, not Asia, where risk-taking and entrepreneurship have become a highly respected way of life as
well.
A. Your Financial Plan
To launch your new venture, you will, first of all, need some up-front financing.
You can cobble it together from you’re your own savings, from your parents, or from some of
your family’s well-to-do friends.
You may also be able to secure some debt-financing – e.g., a revolving line of credit at a bank.
In return for a periodic fee, the bank lets you borrow automatically up to a certain amount from it. The
expectation is that you will pay back these instant loans as cash comes in, so that you will always have a
little cushion between what you owe at any point in time and the maximum credit line extended to you.
The fee is paid on top of any interest on loans, even if you have not drawn on any credit at all. The
financial flexibility this standby credit offers is worth a monthly fee.
Another way to borrow is to lease space and equipment you may need rather than buying it. For
start-ups, leasing is a great financial contract.
If you do not have access to private venture capitalists willing to invest in your idea, you may
have access to public assistance. Specifically, you may belong to a category of Americans whom the
government is committed to help through loans from the Small Business Administration (SBA) or some
other agency tasked with furthering your category’s economic opportunities. Some entrepreneurs get
started that way.
1
I would like to thank my friend Carlos Ferrer, Princeton ’74, founder and partner of Ferrer Freeman & Co.,
a highly successful private equity firm, for valuable comments and suggestions for improving on an earlier
draft. He bears no responsibility for any remaining or new errors in the commentary.
2
B. Your Business Plan
Potential investors in your venture naturally will want to know what your so-called “business
plan” is for the venture, and who else is willing to risk their money on your idea, and how much.
A business plan must provide credible details on (1) the product being produced, (2) the “value
proposition” of the product, (the price you plan to charge for it relative to the value it brings to the
customers, (3) the “marketing strategy” ( including the probable market for your new product, competition
and “go to market” strategy), (4) the management resources committed to the company and your ability
to attract the properly skilled labor required for the production of the product, (5) the plan for accessing
any additional technical and marketing resources to execute the business plan, and finally, (6) the
financial projections. You will provide information on all six aspects of your proposed venture in prose
and formatted according to accepted industry protocols.
Of these six tasks, the marketing strategy will be the most challenging and the most crucial.
Everything else depends on your being able to sell what you produce. Too many entrepreneurs fall wax
romantic over their own ideas and blithely assume that everyone else will think likewise. In fact,
outsiders may be quite skeptical at first about the merits of you’re a new product. Therefore, it will be
wise to enlist some credible professional advice on your marketing strategy.
The financial projections are conveyed in the so-called “pro-forma” financial statements which
are fairly standard and a major tool of communicating with prospective investors. They will include
detailed assumptions on pricing, labor and manufacturing costs, operating margins, working capital
needs, overhead costs, outside consultants and directors, and maintenance related capital expenditures,
among other things. There are four main components of the financial projections:
1. The Pro-Forma Cash Flow Statement: This statement should show, on a quarterly
or even monthly basis for the first year, and annually thereafter for the first, say 5
years, what cash will flow into your venture and for what purpose cash was spent by
your venture. The statement is fundamental, because cash is the lifeblood of a
business venture. Your cash-flow statement should be fairly detailed, so that
investors can see exactly where you expect the money to come from and on what
particular items you will spend it. They may want to question the wisdom of some of
your proposed outlays – for example, a lavish floor space or number of sales
representatives needed to bring the product to market.
2. The Pro-Forma Statement of Financial Position (“ Balance Sheet” in the
vernacular: This statement is a relatively detailed listing of all of the valuable concrete
things or financial contracts or patents to which your firm has legal title. These items
are called “assets.” The statement also includes a detailed listing of all of the debts
your business owes. They are also called “liabilities.” By definition, a firm’s “net worth”
is the difference between the dollar value of all of the assets it owns minus the dollar
value of all of the liabilities it owes. Because a firm’s Net Worth = Assets – Liabilities
(all in dollar values), from which follows the famous accounting identity:
$Assets = $Liabilities + $Net Worth
This accounting identity explains why the Statement of Financial Position is called the
“Balance Sheet” in the vernacular.
3
The dollar values of assets, liabilities and net worth are calculated on the initial
founding of the company and thereafter as of the end of a so-called “fiscal period,” be
it a month, a quarter or a year. It is a momentary snapshot. Many companies choose
the calendar year as their fiscal year; but a company can choose any other period as
its fiscal year and then stick with it – for example, from J uly 1
st
to J une 30
th
, or from
October 1
st
to September 30
th
.
In your business plan, you will include pro-forma statements of financial positions for,
perhaps, the next 5 years, probably on a more frequent basis (quarterly) for the first
year.
3. Pro-Forma Income Statement: The “accounting income” of a business firm for a
given fiscal period is formally defined as the difference between the “revenues” earned
in that period minus the “expenses” incurred in that period. One can think of “revenue
transactions” in a particular fiscal year as those that, taken by themselves, would
increase a firm’s net worth. Typical revenue transactions are sales of output. Similarly,
one can think of “expenses” as those transactions that, by themselves, decrease the
firm’s net worth. Typical expense transactions in a particular fiscal year are the use of
raw materials in production, rental payments on equipment and floor space, payments
for energy, salaries and wages of employees, and payment of interest on debt and
any other cash outlays made, or liabilities incurred, to support the year’s revenue
transactions.
Note that not all cash inflows in a given year represent “revenues” for that year.
Suppose, for example, the firm borrows $100,000. That will increase its assets by
$100,000 (namely, cash on hand) but also its liabilities, by the same amount. Net
worth is not touched by this transaction. Therefore it does not constitute a revenue
transaction. On the other hand, if we sell 10,000 widgets @ $10 cash per widget, then
this transaction would increase the asset “cash” by $100,000, not increase any
liability, and therefore, viewed by itself, increase net worth by $100,000. (The fact that
we had to give up the widgets will be recognized by the accountant separately).
Similar reasoning applies to expenses. You should not worry too deeply about this
aspect of the problem, as it involves financial accounting and lies beyond the compass
of this course. Here we just give you the general idea.
Income statements are written for entire fiscal periods – a month, a quarter or a year.
In your business plan, you will offer pro-forma income statements for the next 5 years,
perhaps on a quarterly basis for the first year.
4. The Cap Table: This statement details the proposed securities to be sold to outside
investors and the “initial capital structure,” by which is meant the structure of equity
financing and (if used) debt financing used to get the venture launched and sustained
in its initial phase.
The Cap Table is a summary description of the financing’s terms and conditions, and
the prospective stakes held by the founder-owners of the new company and the rest of
the management team, many of whom will agree to work for low cash wages in return
for an ownership stake in the venture. The cap table also lists how much of the total
ownership stake would be reserved for future employees, who will get access to them
through stock options or outright stock grants.
A stock option is a piece of paper entitling its owner to purchase a specified number of
shares of a company’s common stock (usually 1 share or a 100 shares) at a specified
4
“striking price,” regardless of what the actual price of the share is. Thus, if you hold an
option entitling you to buy 1 share of ACME, Inc. stock at $40 per share, and the
stock currently sells at $70 per share, you can “exercise” your option by buying the
share at $40 and then immediately resell it for an immediate gain of $30. That gain,
alas, is taxable at ordinary income tax rates. Alternatively, you could just hold on to the
share you bought, hoping it will rise further in value.
Typically the founders would be entitled to ownership in the form of common stock.
They are ownership certificates, usually printed up in large numbers (perhaps
millions), with each certificate representing a tiny stake in the venture. The venture
capitalists who also have invested in the company would own a different security, one
that ranks higher than the common stock, thus giving these outside investors the right
to get their money back before the founders/management can take out any money
(other than their agree-upon salaries and wages).
The business plan is the most crucial document in starting the new venture. You may think that
this statement is so obvious as to be a condescending remark. One wishes the geniuses who ran the
hundreds of ill-fated dot.com ventures in the late 1990s had understood this obvious requirement as
well. They did not. These failed dot.coms tend to have this in common: they lacked a credible business
plan and were, instead, based on romantic lyrics that were swallowed up by eager and ignorant
investors that were feeding on “Greater Fools Soup”. The “Greater Fools Theory” of investing holds that
even smart and fully informed investors will buy vastly overpriced financial securities on the belief that
there will always be a “greater fool” onto which such paper can be foisted at an even higher price. (In
many areas of the country, the real estate market now operates in that mode.)
Particularly disturbing in the later 1990s was that the investment bankers and financial analysts,
who, in theory, are to function as the ever vigilant watchdogs over our capitalist order, not only bought
the fables gushing forth from eager dot.com entrepreneurs – or pretend to buy them – and eagerly
promoted this junk to private investors.
C. Your Capital Expenditure Plan
You must estimate what floor-space and capital equipment will be needed to support your
venture in the early years and describe these requirements to outsiders as well. At this stage, you will
probably wish to rent as much of that floor-space and equipment as you can, which, in our wondrous
economy, means virtually all such fixed inputs.
Renting rather than owning these fixed assets, as they are called, may be more expensive per
unit of capacity and time period; but you will not be saddled with owning such assets and can write the
rental contract so that you can easily return rented assets if the marketing plan was too optimistic. To be
sure, canceling renting contracts prematurely usually brings with it stiff financial penalties. Even so,
renting still remains a more flexible way to procure required structures and capital equipment. That
flexibility is worth some extra expense at this stage of your venture, when the risks are high and financial
capital to buy structures and equipment outright is expensive. (Don’t forget, you give up sizeable chunks
of your business to procure financial capital from venture capitalists).
The capital expenditure plan can be made part of the Business Plan or developed as a separate
document. I would favor the latter to convey that you have given it much thought. Often it is simply made
part of the detailed assumptions used to make the previously described financial projections.
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D. Legal Counsel
You will also need to provide potential investors in your venture assurances (1) that your product
does not infringe on any patents held by others, (2) that you will not run afoul of any federal, state or
local ordinances – e.g., environmental laws or local zoning laws or relevant labor laws, and (3) that the
securities being offered properly convey title and are in conformity with securities laws.
There is no way around it: you would run enormous risks starting a new venture without the
advice of legal counsel. If you do not have money to pay for that counsel, perhaps the lawyer(s) will
accept an equity position in your venture instead. Many lawyers have an entrepreneurial streak in them.
Ideally, though, it is probably best to pay them their proper fees, if there is the cash to do so.
II. BECOMING A CAPITALIST II: MEZZANINE FINANCING
Now suppose you have successfully run your business for a few years and you would like to
expand it. The profits you have made and retained in the business – rather than paying it out to
yourselves and the other investors – have not accumulated enough capital to finance the planned
expansion. You can then look around for later-staged growth capital, also called “mezzanine” financing.
A mezzanine, as you know, is a sub-floor in a building between to main floors.
Mezzanine financing is supplied by so-called “private equity firms.” They tend to be partnerships,
rather than publicly traded companies. The partners themselves are savvy investment people who really
understand the businesses they invest in. Typically they invest their own money in this way, along with
that of other wealthy individuals or institutions (such as university endowments and employee pension
funds). To procure such outside moneys, the private equity firms establish funds that have a name and
will try to collect, say, $200 million or so before the fund gets closed to additional investors. It is then
invested by the partners on behalf of themselves and the outside investors. In return for their work, the
partners get a management fee (a percent of the invested funds) and share in the profits they have
earned for the outside investors.
After a private equity firm has invested mezzanine capital in your ongoing firm, one or more of
the partners will take a continuous interest in how you run the business, and typically become members
of the Board of Directors watching over your firm. They are both, friends and your own business
consultants, and hard task masters, watching vigilantly over your so-called “burn rate,” that is, the rate at
which you spend cash on hand, and for what purposes. They will help you and goad you to nourish your
business along, sometimes making connections to other friends and business partners that can be
helpful to you. Most often, they will have control over major decisions, such as capital spending over
established minimums, financing events, and the sale of the business.
III. BECOMING A RICH CAPITALIST III: GOING PUBLIC IN AN “ IPO”
Now suppose you have “grown your business,” as the jargon goes, and by now you have a
flourishing business ready to be sold to the general investing public – e.g., regular mutual funds, hedge
funds, institutional money managers or individual investors. Typically with the aid of an investment
banking firm, you will organize a so-called “initial public offering” or IPO.
As already noted earlier in the section on “The Cap Table,” even before that step, you had
issued ownership certificates to yourself, to your closest co-workers, who took these certificates in lieu of
cash compensation, and to the outside investors, both original and mezzanine. In toto, you might have
issued, say, 5 million of such certificates. They are also called “stock certificates” or simply “shares of
stock.”
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In an IPO, those who now hold shares of stock in the still private venture will sell a certain
fraction of them to the general investing public, with the help of an investment banking firm that may form
a “syndicate” with other investment bankers and retail the stocks through their networks of brokers. The
investment bankers will prepare all of the documentation requires for such a sale (including a
“prospectus” which describes the business in fine detail, includes financial statements, and highlights the
potential risks faced by the firm, so that investors are fully informed). The firm will have gotten a formal
charter for the proposed, publicly traded company, usually from the State of Delaware which specializes
in serving corporations in that way. You may even have registered your hitherto privately held company
in stat state. All of these proceedings will be closely supervised by the federal Securities and Exchange
Commission (SEC), which will make sure that all statements you make in the prospective are true, that
you have not withheld pertinent information, and that the sale of the securities to the public will take
place in a fair and orderly manner.
Particularly important these days is that you comply fully with the Sarbanes-Oxley (SOX)
requirements. SOX was introduced to Congress a few years back by Senator Sarbanes and
Congressman Oxley, in the wake of the financial accounting scandals that had driven so much of the
stock-market bubble in the late 1990s. The strictures on financial reporting imposed by SOX can be
excruciating. (If your parents are business executives, mention casually at dinner that you are a great
fan of SOX 404 and wish there were more such requirements. Dinner will stop early that day, I can
assure you, and you will be sent to your room. If your parents are not business executives or
accountants, of course, they will think you are talking about a baseball team, which generally like to be
known by the color of their socks.
Suppose of the 5 million shares of common stock you had issued earlier, you, the founder,
owned 500,000. Your colleagues on the management team would own other chunks of the stock. The
outside investors, you will recall, may own similar securities, but priority over yours.
Your firm will sell a total of 3 million of the 5 million shares in this IPO. Your investment banker
advises you to offer the shares to the market at a price of $70 a share. At that price, the bankers tell you,
the issue will sell quickly into the market, and you won’t face the embarrassment of having a large block
of unsold shares on your hands. That is never an image-enhancing circumstance.
If public investors agree that the stock is worth at least $70 per share, they will snap up the
offering quickly. Included in the 3 million shares are 300,000 of your own. Figure it out. You are now a
multi-millionaire, at least on paper. Alas, for you, usually the management team cannot sell any of the
shares it owns for at least 180 days after the date of the IPO – the so-called “lock-up” period, and there
may be other restrictions on such sales imposed by the venture capitalists. Your Porsche will have to
wait.
Many times in the 1990s, the investment bankers put too low a price an initial offering price on
shares in an IPO, and their market price shot up quickly thereafter. It helped the bankers to sell the issue
quickly through their network of brokers. Knowing that quick and almost certain profits could be made in
the hours and days just after the IPO, the investment bankers (through their brokers) would allot a
certain number of shares at the unduly low prices to each of their business and personal friends, among
them politicians whose favors they needed. These lucky ones then could make hundreds of dollars of
profits in one or two days, without lifting a finger. (What a way to purchase the good will of politicians!)
The lucky ones also included the CEOs of still private or already public companies, who promised in
return for such quick profits, once again off the record, that they would use the kindly bankers handing
them these sure and quick profits, should their own companies’ sell newly issued bonds and stocks in
the market, even if that might not have been in these interests of these firms’ shareholders. The SEC
now frowns upon this practice, which is considered unfair. As far as I know, the SEC has made it much
more difficult to bestow such favors on friends and favored business partners.
In any event, here’s the final deal: Some time after the IPO, when you will be a millionaire –
initially on paper, eventually in cash – you will receive a friendly visit from Princeton University’s
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Development Office, reminding you of what a great place Princeton is, forever should be, and certainly
was for you. You will be tithed appropriately. That is only fair. After all, you have learned all you know,
and so much more, in Economics 100, not even to speak of English 101, which helped you write the
lucid prose in your business plan.
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