Why should different stock classes in a startup be created?

A useful way to look at it is the difference between current value and potential value.

When an investor puts money into a company in exchange for an ownership stake, mathematics means that the amount of ownership the investor receives for the amount of the investment determines the “value” being assigned to the existing company before the investment.

As an example, let’s say that I invest $100,000 into Company X and receive 10% of the company’s stock in exchange for my investment. Simple math tells me that if 10% is worth $100,000, then 100% of the company must be worth $1 million.

Now, since Company X has $100,000 in its bank account following my investment, we need to back that out to determine how much the company was worth beforemy investment. So we subtract the $100,000 and find that the terms under which I invested mean that I valued the company at $900,000 before I appeared in the picture.

So it would seem on the surface that I contributed $100,000 and you as the founder contributed $900,000, so we should therefore both just get a proportionate number of shares of the same kind of stock, right? That certainly makes sense, except for one thing: there is a substantial difference in the form of the two contributions.

My $100,000 is a suitcase full of dollar bills (or the equivalent) that can be exchanged for anything at all. My late grandmother called them “universal gift certificates”. They are the same dollars that can buy me a vacation, or a Rolex or a trip to the Superbowl, all of which I have passed up on in order to invest in you.

Your $900,000, however, is made up of your ownership in a brand new company that likely doesn’t have revenue yet, let alone profits. So what I am doing by putting in my investment is betting on the future value the company could be worth, after you become successfully profitable.

If everything works out as planned, that’s just what happens! The company is successful and a bigger company comes along and buys it for a lot more cash. We split the sale proceeds 90/10, and we were retroactively proven correct in the value we had originally assigned to the company.

The problem, however, is that with a majority of investments, it does not work out that way.

Let’s say that despite everyone’s best efforts, the company does not succeed, and it is eventually acquired by a bigger company for only $500,000. If we both  owned the same type of shares and divided the cash in the same 90/10 manner, I (who had put in cold, hard cash) would only get back $50,000 of my money. You, however, who had put in little or no real money, would be walking away with $450,000 in cash as your reward for running a failed business and losing $50,000 of MY money!

While that might seem like a nice result for you, that’s certainly not what *I* would consider to be fair. So if that is the only way you would be willing to take my investment, I’ll say “thank you, but I’m going to pass on this particular investment, and instead spend my money on that vacation, watch or football tickets.”

Because THAT isn’t an outcome that either of us really wants, we come to a compromise: instead of us owning the same type of stock, we’ll create another kind (technically called “Convertible Preferred” stock). The primary feature of this new class of stock is that in the first case (the good one) it converts into exactly the same kind of stock you have, we split 90/10, and everyone is happy.

HOWEVER, if the bad case happens, then it works a little differently: we agree that the first money that comes in  should go to fully pay off the cash that I invested (the $100,000). THEN, anything left over (in this case it would be $400,000) goes to you (who own what is called “Common” stock). The effect of this is to retroactively adjust the nominal value we had assigned to your contribution, to match what it turns out to have really been after all.

And that, in a very simplified way, is an explanation as to why there are different classes of ownership in startup companies.

*original post can be found on Quora @ http://www.quora.com/David-S-Rose/answers *

When Are Business People Entitled To Be Entitled?

Image via Flickr

Image via Flickr

Where did this sense of entitlement in our business culture come from? I’ve written about this before, but I was reminded again a while back at a conference for startups when an entrepreneur started berating investors for not funding early-stage startups. It sounded to investors like me that they felt a funding entitlement for their startup idea. Of course, I’m sure entrepreneurs sense that many investors feel entitled to deals with no risk. It’s bad news either way.

As a society, we seem to think we’ve evolved to the point where we can fashion a large portion of existence according to how we wish it to be. We notice what we like and what we dislike, so we work to make society match our dreams. Somehow, these dreams and wishes have morphed in many people’s mind to an entitlement. Read more

How important is trust in business partnerships?

There are three separate questions you’re asking here, so let’s take them one at a time:

How important is trust in business partnerships?

It is critical. Vital. The single most important thing. Without trust you will spend the entire relationship looking over your shoulder and second-guessing everything your “partner” does and says. This may well destroy your entire business.

Are a lot of business people sneaky?

No. Are there some who are ‘sneaky’. Sure. Just like there are sneaky teachers and artists and construction workers. But people in business are no more ‘sneaky’ as a class than anyone else. Contracts are not primarily designed to prevent sneakiness; instead their purpose is to make absolutely sure that everyone involved in a transaction or relationship understands explicitly clearly what everyone’s rights and responsibilities are, and what exactly is expected from each party.

What should my company do about this specific potential business partner?

Skip him and move on to someone else. Our intuition is an extremely powerful and little understood faculty that subconsciously integrates all of our experience and knowledge into one ‘feeling’.  If your co-founders are telling you that they don’t trust this person, then you should run, not walk, in the other direction. When entering long term partnerships (especially in ones where they are representing you, your products and your reputation) it is imperative that you enter into the relationship with trust, and if that’s lacking, the partnership is doomed regardless of how attractive it might otherwise be.

*original post can be found on Quora @ http://www.quora.com/David-S-Rose/answers *

If I have a great startup idea why should I ask for funding?

“would a great idea be promoted without any marketing?”

By whom?

According to that theory, Apple should cut out its entire multi-billion dollar sales and marketing and retail store divisions, because all of its great products will sell themselves.

It’s wonderful that you can (now and forever) program, maintain, market and support your product yourself. But if you ever expand to the point where that becomes difficult, you may find that you need to bring on some help. If you can pay the salaries for that help from the profits you have already made, that’s great too.

But if you need to expend money for salaries, hosting, advertising or anything else before your venture is successful enough to pay for it out of your profits, you may want to consider whether it is worth parting with some of your future profits in exchange for access to immediate cash today.

But rest assured that nobody can force you to take an investment against your will if you don’t want to (or need to.)

*original post can be found on Quora @ http://www.quora.com/David-S-Rose/answers *

 

Think Hard Before Jumping From Corporate To Startup

Photo via Flickr by Eric Chan

Photo via Flickr by Eric Chan

I talk to many people who have spent years struggling up the corporate ladder who dream of jumping ship and becoming an entrepreneur. I hasten to tell them that every job move is fraught with risk, but the move from employee to entrepreneur is on the high end of the risk curve. It’s a big jump, especially in today’s economy, so do your homework first on this one.

According to an article in the Harvard Business Review a while back, “Five Ways to Bungle a Job Change,” there are at least five common missteps that professionals make when moving to a new job. I will assert that each of these has a comparable relevance for those of you contemplating leaving a company employee role to create or join an entrepreneurial startup as follows: Read more

Is there a difference in expectation and attitude between Angels in the USA vs those in other Geographical regions and are there disadvantages because of this?

Surprisingly, no. Angels of a certain ‘level of professionalism’ have more in common with each other regardless of geography, than do novice and ‘super angels’ in the same city.

I am friends with many professional angels from around the world, and my analyses (allowing for our individual investment preferences) are virtually identical to those of Dave Berkus in Southern California, Matey de Nedkov in Montreal, Phillippe Gluntz in Paris and Dušan Stojanovic in Sweden.

That said, I have seen slight regional differences, including: a preference for Big Ideas on the West Coast, financial and advertising technology on the East Coast, and gaming and retail in Europe.

*original post can be found on Quora @ http://www.quora.com/David-S-Rose/answers *

What is the best advice a boss/supervisor ever gave you?

Make a decision.

This one I learned in reverse from watching my very first boss, who would not/could not make a decision to save his life. The result was an office that descended nearly into paralysis, before everyone else (including me) started making decisions around him.

Keep in mind that not making a decision IS making one, because something is ultimately going to happen, but now it won’t be under your control. One of the essential components of leadership is being decisive and taking your best shot; hopefully you’ll be right more often than wrong, but indecision leads to disaster.

*original post can be found on Quora @ http://www.quora.com/David-S-Rose/answers *