Business Finance | The Big River | Chapter 4 – What happens if we need an outside investor?

The Big River series
The Big River series is a 12 part installment about a company desperately seeking cash to fuel their growth and the struggles they face trying to find it.

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.

What if bank financing isn’t enough?

Ted Deepockets, his long-time friend, had periodically needled John about the pros and cons of outside investors. He always seemed like he’d be interested in investing if the opportunity was presented.

[pullquote]“The worst mistake is to have the best ladder and the wrong wall.”~ Donald Rumsfeld[/pullquote]

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.”

Is it possible to run out of cash while sales are still growing?

“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.”

Equity Investors raise a lot of new issues

[pullquote]Please note that if you hover your mouse over a defined term that is underlined with a dotted line, the definition will appear alongside. A complete Glossary is also available.[/pullquote]
“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 Dilution … Leverage … Valuation … 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.

Make sure you’re getting the right kind of advice

“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.”

What is dilution … exactly”

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.”

How much money do you need?

“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, John, 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.

Consider this dilution illustration

“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.

“In our example, let’s assume there are 10,000 shares such that each share is worth $100/share ($1,000,000 value divided by 10,000 shares).

“Just to make the math easy, 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). Are you with me, John?”

“Yes, Lary. I think I understand. We’re issuing new shares based on the current value and based on how much money we raise, that’s how many new shares will need to be issued.”

“You’ve got it, John … so, let’s go on.

“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).

What does dilution do to my ownership?

“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).”
“So, Lary, if I understand you correctly, the valuation of my company is pretty critical to this process. The higher it is, the less dilution I’ll experience. Is that right?”

What can I do to minimize dilution?

“That’s absolutely right. Let’s take our previous example and assume that the company is actually worth more, say $2 million is the pre-money valuation where each share is worth $200, using the same 10,000 outstanding shares.

“In this case, with a new investor putting up $300K, they would only get 1,500 shares.

“Now, 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.

Is Valuation an Art or a Science?

“I understand, but valuation is pretty subjective, isn’t it?”

“Yes, John, it is as much art as it is science.”

“Thanks, Lary. Could we get together in person next week 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.”

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