by Mike Volker
Here is a table which is very typical for a modestly successful technology company which in its first five years of operation achieves sales in the $10 million (annual) range. You can see how value is increased at each stage of growth and funding.
WEALTH CREATION TIME LINE # SHARES PRICE MKT CAP EQUITY FOUNDERS STARTUP 3,000,000 .01 $ 30,000 $ 30,000 100% SEED 1,000,000 .25 $1,000,000 $ 280,000 75% GROWTH 1,000,000 .75 $3,750,000 $1,030,000 60% MATURE 1,000,000 5.00 $30,000,000 $6,030,000 50%
The term, "cap table", or capitalization table, is often used to refer to this type of presentation. Usually a cap table, will show who, by name, is represented in each group - e.g. the founders and investors will be identified along with their equity stake in the business.
At the Seed stage, characterized by the actual start of revenue generation, usually in small pre-production prototype or trial amounts, more equity capital can be found externally from arms-length investors or Angels. Angels are well-heeled investors who risk their capital and also spend time and effort on the company by assisting the management group in a coaching fashion. Companies may also be able to attract small amounts from a broader circle of friends and acquaintances and even from strangers who meet the criteria of being defined as "sophisticated investors". This entails a certain amount of red-tape and compliance with securities regulations.
At the Growth stage, characterized by a rapid ramp-up in sales, companies need "serious" equity infusions. This invariably comes from investors, such as venture capital companies, merchant bankers, or wealthy individuals, who perform extensive "due diligence" and research before making an investment. These investors expect sizable equity positions (say 10% to 50%) in exchange for $500,000 to $2,000,000. However, at this stage of business development, companies are well positioned to approach such investors insofar as they have proven the viability of their products in the market, the market demand can be verified, and the company has an effective competitive advantage or competitive strategy.
At the Mature stage, characterized by a strong market position, continued sales growth (over 10%), and a profitable bottom-line, companies still need on-going financing to take advantage of new opportunities. At this stage, equity offerings become easier to accomplish because of the track record to which management can point. New treasury issues can be negotiated on an on-going basis with investors or underwriters in accordance with prevailing financial market conditions.
Answering this question becomes more difficult the younger the company is. Well established companies with several years of financial history are much easier to analyze and to ascribe a value to. However, young companies, especially those with little more than an idea (remember - ideas are a dime a dozen!), are very difficult to assess. It usually comes down to a buyer's opinion or even better than the buyer's opinion is the buyer's checkbook! In most cases, this matter is addressed by negotiation between the parties involved. However, if you are the entrepreneur who is selling a piece of the action for some investment capital, you might think of this process, at least at the early stages, as one of bringing in partners more so than a process of giving up or selling some equity.
Therefore, the real question to answer is that of dividing the pie. Who is contributing what to this venture and what percentage ownership does each contributor get in return? Early stage investors will generally not fuss too much over whether they get 25% or 30%. Usually, if they are making an up-front high-risk cash contribution, they will want some "meaningful" stake in the company, but in the final analysis what they are interested in is a several-fold, i.e. multiple, return on their investment. They will be thinking more in terms of: "is there a chance that I will get back 100 times my capital?". With this approach, a few percentage points at the outset will not make or break the deal. They are simply not interested in a a marginal type of return! Keep that in mind when you speak to these investors. Also keep in mind that they may very well make your own percentage worth a great deal more as a result of their participation!
Here is a story which clearly demonstrates this process. In 1988, I made an agreement with a Waterloo company, Research-In-Motion (RIM) to invest a modest $30,000 for 15% of the company. How was 15% determined? I asked the founder and his immediate need was to fill some orders. His annual sales at the time were about $200K and in his opinion the company should be worth a bit more than $200K based on the accomplishments to date. (Today, people in similar circumstances would likely place a higher value on such a company but in 1988 there was very little "seed" capital for startups). To me, it was important that my interest was "meaningful" (i.e. not just a percent or two), with the prospect of a high return some day. However, my investment was conditional on getting an Ontario Government grant for making the investment and because of delays in getting this, along with my decision to move to British Columbia, we agreed not to proceed. In October, 1997, RIM went public on the TSX at a valuation of approximately $600 million. After taking dilutions into account, my $30,000 investment would have returned $30 million - a 1000 times increase! At the market's peak in 2000, that $30 million was then worth almost $500 million! How's that for a virtual profit?
Traditionally, IPOs are done on major exchanges when companies require serious growth or expansion capital (at least several million dollars). However, junior stock exchanges such as Canada's TSX Venture Exchange, the TSX-V, allow companies to do IPOs at much earlier stages of development - at the startup or seed stages. The TSX-V was formed when the Vancouver (VSE) and Alberta (ASE) stock exchanges merged in the late 1990's. This type of IPO may appeal to a company if it seeks a relatively small amount of risk capital from a large number of investors (e.g. to spread the risk). Another reason this may appeal to companies is that the valuations realized are generally higher on IPOs than they are on private or venture capital investments. A junior stock exchange, e.g. TSX-V, IPO really just replaces a good Angel or Venture Capitalist giving companies who find it difficult to find such large investors an alternative in the form of numerous smaller investors.
However, one might question if the market capitalization of a company on a junior exchange such as the TSX-V in Canada or the OTC-BB (Over-the-Counter Bulletin Board - soon to be called the "BBX", in late 2003) in the USA is realistic. For a small company whose shares are thinly traded, i.e. nominal daily trading volumes, share price can fluctuate dramatically if someone tries to buy a large block of stock or sell a large block. I once attempted to buy shares in a small ASE-listed technology venture which was trading at $.25. By only buying 50,000 shares, I drove the price to well over $.50. This inadvertently attracted attention to the stock, and before I knew it, a few others bought in and soon the price was at a $1.00! But surely, the value of the company didn't increase! So - just keep this in mind.
Another aspect of doing a TSX-V IPO is that you will likely need to get a valuation "opinion" from an independent, third party, "expert" consultant who will, for a fee of $25,000 or so, put a value on your company. This opinion is commissioned by the underwriter but paid for by the company! Presumably, the exchanges do this in order to perform some type of due diligence for the investing public. This is absolutely absurd! It would be so much healthier to simply let the market decide by fully disclosing who the people are (in fair detail) behind the venture and what they plan on doing. The underwriter (and her clients) should suffice as the third-party independent assessment of value. There is another "problem" with the Exchange's need for such an opinion: If a prominent firm such as KPMG gives a strong opinion which is accepted by the Exchange, investors could be mistakenly be lead to believe that the Exchange "approves" or endorses the valuation. Then, if the company bombs, it is the Exchange which looks stupid! We still have a few lessons to learn from our American friends who simply insist on plain, true, and full disclosure! (Sorry to be on a soap-box!)
Please check the chapter on "Dividing the Pie" for more discussion on the subject of determining ownership.
Copyright 1997-2003, Michael C. Volker
Email:firstname.lastname@example.org - Comments and suggestions will be appreciated!
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