“Financial Adrenaline” is a term we love around here because it reflects our commitment to help you turbocharge your business with practical tips and techniques to improve free cash flow, the lifeblood of business. As a further extension of our Financial Adrenaline program, we’re going to share a new Business Finance Tidbit every Wednesday specifically for those business executives who don’t have a finance background. Our current Big River series started with We’re Making Money. Why are we broke? … then No Cash? Can we borrow what we need? Last week, we faced What if our loan collateral doesn’t cut it?
“The worst mistake is to have the best ladder and the wrong wall.”
~ Donald Rumsfeld
John Wilson, CEO of Ace Business Stuff, was thinking about several of the issues that he discussed earlier that day with his controller, Tom Sampson, and what Tom told him:
“Giving our customers an additional 30 days to pay, relaxing collections and neglecting the sale of inventory already on hand, isn’t a very sound strategy.”
Instinctively, he knew that Tom was right and that whatever bank loan they could obtain, it wouldn’t be enough.
Ted Deepockets, his long-time friend, had periodically needled John about the pros and cons of outside investors. They had never discussed price, terms or amount, but Ted’s name kept coming to mind over the last several days. John decided to call his attorney first.
“Hi, Frank. What’s new in the legal world these days?” Frank Lee Documents was John’s long-time friend and the company attorney.
“Same-o, John. The legal work keeps piling up so I guess that’s good. How about with you?”
“Frank Lee,” John drew out the syllables to emphasize the double entendre, “business is great, if that’s what you mean. Too good, in fact, but a few sloppy decisions on my part has us with booming sales and no cash. I’m actually thinking about taking on an investor.”
“That’s quite a change, John. You’ve never been inclined to consider that in the past.”
“I know, Frank, and I’m still very skeptical about taking on a partner, but we’re really growing. I don’t think we can borrow enough to fund our growth. Even if we tighten up a few things, we’re going to run out of cash before we run out of sales.”
“So, how can I help, John? Do have any kind of proposal or plan in front of you yet?”
“No, but I’m thinking of calling Ted to talk about it.”
“Deepockets might be a good place to start. He always speaks highly of you and what you’re doing, and after that windfall sale of his Saratoga property, he can probably spare a few bucks.”
“Probably so, Frank. But I’m not sure how to approach him. We’re still figuring out how much money we’ll need and even then, I’m not sure how this works. You and I have chatted before about DilutionA reduction in earning per share of common stock that occurs through the issuance of additional shares or the conversion of convertible securities. … LeverageLeverage can mean several things. 1) The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment, or 2) The amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged.. … ValuationThe process of determining the current worth of a company. An analyst valuing a company may look at the company's management, the composition of its capital structure, prospect of future earnings, and market value of assets. Judging the contributions of a company's management would be more subjective, while calculating intrinsic value based on future earnings would be an objective technique. . . . a lot of concepts that remain pretty unfamiliar to me. I need to understand this stuff – and sooner than later.” John could hear Frank’s stubby pencil scribbling across the page of the dog-eared notebook he always had at hand.
“Here’s what I think, John. Of course, we can help you with the documentation, and you certainly better make sure any transaction like this is well documented. But I think there is someone else who is better prepared to guide you from a business perspective.
He’s had a lot of experience with middle market companies, and has helped companies raise capital during some difficult times. Let’s try to get him on the phone.”
After a brief introduction and a few pleasant exchanges, John briefly described his issue to Lary Blogger.”
“So, Lary, can you help me understand what this term “dilution” is all about?”
“Don’t be put off by the fancy term, John. In this context, it simply means that by issuing additional stock to a new partner, you’ll own a lesser share of the company than you own now. You’ll be ‘diluted’. The subject can get pretty complex because there are a lot of ways that dilution occurs, but we can deal with those issues if and when they come up.”
“So, Lary, how much dilution are we talking about? How can I make that as small as possible?
“The key question is how much money do you need and what will it cost, which quickly gets around to ’what’s the value of the company’ today? Here’s a simple example to make the point. Don’t get hung up on the math, though, because we can go back over it later.
“For now, let’s assume your company is worth $1 million and you own 100% of the stock. The $1 million is known as the “pre-money valuation”, meaning that it’s the valuation before any investment is made.
If, for example, there are 10,000 shares, each share is worth $100/share ($1,000,000 value divided by 10,000 shares). Let’s say you need to raise $300,000 to meet your capital needs. To do that, you will have to issue 3,000 new shares (the $300,000 investment divided by $100/share price).
After the investment, the share price won’t change – it will still be $100/share but there will now be 13,000 shares (the original 10,000 shares plus the 3,000 newly-issued shares). The value of the Company will also increase by the amount of the investment so that the total “post-money valuation” will be equal to $1.3 million (the original pre-money valuation of $1 million plus the $300,000 investment).
“From this, you can see two things. First, as I said earlier, the share price doesn’t change. Secondly, although you still have the 10,000 shares you started with, the Company now has 13,000 shares outstanding, so your percentage ownership goes from 100%, when you owned all of the 10,000 shares, to around 77% (your 10,000 shares divided by the total number of outstanding shares of 13,000).”
“That’s absolutely right. Let’s take our previous example and assume that the company is actually worth more, say $2 million as a pre-money valuation where each share is worth $200.
Now, with a new investor putting up $300K, they would only get 1,500 shares. In this example, there would be only 11,500 shares outstanding (the original 10,000 shares plus the newly-issued 1,500 shares), and you would own about 87% of the company, a full 10% more than the 77% in our earlier example.
“I understand, but valuation is pretty subjective, isn’t it?”
“Yes, John, it can be as much art as it is science.”
“Thanks, Lary. Could we get together in person in a few weeks to talk more about some of this stuff? That would really help me and by that time, I’ll know more about our company situation.”
“Anytime will be fine, John. Just give me a call when you’re ready.”
This is Part 4 of a 12 part series called the “Big River“. The Big River signifies the growth path that so many companies follow, or are seeking, and the dangers that lurk along the shoreline as the Big River races forward trying to consume everything in its path. Next week, we’ll begin to talk about valuation and how that is such an important consideration when evaluating the potential need for an equity investor. Make sure you sign up now so you receive every update in this practical series.
FINANCIAL ADRENALINE is the most powerful program available to educate middle market business executives about the value of Business FinanceOur Business Finance section will include the core of business finance principles that drive superior performance at a strategic level and that can be integrated into your everyday business decision making.. Let us help you inject Financial Adrenaline into the cash flow of your business to drive lower risk and sustainable cash flow ... and prevent finance from being the reason for business failure.