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Calculating what equity percentage to give

2000px-Cake_quarters.svgMy clients are often in the position of having to offer equity in their company to potential investors.  However, how does one know what percentage to give?

Well, one way is just by gut.  You got a person willing to invest $20,000 into your company but you don’t know want to give up too control so you offer 25%.  Conversely, on Shark Tank we see entrepreneurs be given very little money while giving up a large portion of ownership in their company.

There are other more quantitative methods such as asset-based, comparable, option-based, etc.  However for a start-up without much in assets or earnings per share data, these methods are difficult because there aren’t enough figures to go by.  Also, if the business is truly unique, then comparisons of “similar” companies don’t exist.

One of the more common measurement for valuing public and private companies used by investment bankers is the Discounted Cash Flows Method.  This is useful because with every business plan and financial projection I create for my clients, I create a cash flow statement.  With this I take the total projected cash flows from each year and adjust their future value into their present value.  This is to adjust for interest (i.e. $100 today doesn’t the same as $100 in ten years).  Then I take the discount rate (risk-free U.S. treasury rate is most common) to calculate the present day equity value of the company in X years using this formula:

dcf formula

The amount of investment capital received is the percentage of equity given.  There is obviously room for negotiation because forecasted cash flows is debatable and the amount of involvement (i.e. sweat equity) the investor wants to put in is also a factor.  Nonetheless, it is a gauge one can use to make sure they’re not giving up too much.

 

How founders equity works

A few months ago, a client was looking to expand their company by bringing in more partners.  However, his partners were unwilling to give up equity.  This is fine, however in order to grow while maintain one’s shareholding amount within the company, the shareholders needed to put more money into the company. Either by hiring more workers/consultants or purchasing more assets.  They did not want to expand through labor or capital expenditures.  So they had to bring in new equity partners that were willing to invest money or sweat equity into the company.  But, as mentioned earlier, they didn’t want to give up equity.  The founder ended up leaving the company and starting anew.  Sad but a necessary step when working with partners that could not agree on how to move forward.

In reality, founders almost always have their equity positions reduced over time.  Pretty much every founding CEO you can think of will have a lower % than what they started with.  I will explain why.

Hypothetical Scenario

Typically, when Company A is formed there are a specified number of shares.  Let’s say 100 shares (in reality it’s more like 1 million or more, but for simplicity).  Founder 1 has 40%, Founder 2 has 35% and Founder 3 has 25%.  So that means Founder 1 has 40 shares, Founder 2 has 35, and Founder 3 has 25 shares (assuming all shares are out and none are held as treasury stock).  The founders decide to grow the company by seeking $50,000 (for hiring a consultant).  They can take a loan and keep their respective positions or bring in someone that can invest or do the $50,000 worth of work.

Equity Reduction

So in the hypothetical above for Company A, the board of directors (the three founders in this case) can decide to either 1) issue more shares say 9 more to the new shareholder or 2) give some of their own shares (to keep it at 100 shares).  Either way Founder 1-3 will have a reduction in their equity positions.

  • In option 1 (109 outstanding shares):  Founder 1 will have 36.69% (40/109), Founder 2 will have 32.11% (35/109), Founder 3 will have 22.93%, and New Guy will have 8.25% (9/109).
  • In option 2:  Say each founder gives up 3 shares; Founders 1-3 will have 37% (37/100), 32%, 22% respectively, and New Guy will have 9%.

Equity Maintenance

Let’s say the Founders do not want to give up any position.  They would have to divvy up the $50,000 proportionally so that their respective positions aren’t diluted.  However, in the hypothetical they do not have an extra $50k to invest into the company.  If outside money is not brought in through a loan, then the only way they can maintain their positions while giving up equity is to have a combined ownership of anything less than 100%.  This is because mathematically it is impossible to give more if there is nothing else to give.  So, let’s adjust the hypothetical to say Founder 1 has 39%, Founder 2 has 34%, and Founder 3 has 24% (a 1% reduction for all) for a combined total of 97% and 1,000,000 shares.  That means there are 30k shares available (without having to issue new stock) for New Guy to claim.  If new shares are issued, then New Guy can be given any number of shares as long as Founders 1-3 have 97% of the total amount of shares.

Company Growth

As the company continues to grow it will have to issue new shares (unless it takes on debt, which companies frequently do both).  At some point, the Founders will not be able to or unwilling to keep pumping money into the company to maintain their position.  Hopefully, at this point they won’t have to because the dividends that they may receive will be enough to satisfy their return on investment (ROI) needs.

This is why founding members rarely have the same percentage as the company grows.

For those that like pictures, check out this great infographic from FundersandFounders.com

how-funding-works-infographic

The power of a good team

Yesterday I was watching the documentary Supermensch:  The Legend of Shep Gordon.  Shep Gordon is an ubermanager that managed Alice Cooper, Blondie, Groucho Marx, helped create the celebrity chef with his management company ‘Alive Culinary Resources’ (subsidiary of Alive Enterprises), and many others.

It reminded me how much entrepreneurs need a strong team around them to make their vision a reality.  In Shep’s case, his entrepreneurs were the musicians.  They were talented people that were passionate about what they were creating but in order to continue to create it and eventually profit from it, they needed a manager.

A lot of times an entrepreneur just has a vision.  An idea and little more than the passion to make it come to reality.  However, there are lots of technical skills that have to be utilized to make an entrepreneur’s vision come to life.

Lots of my clients have the same issue.  They have a great product but don’t have a team to make it happen.  I advise them to find all the areas in which they don’t have the knowledge/skills to make to launch their business.  Then hire the necessary person or hire/outsource that task.

If you don’t have the funds to hire someone, then you will likely have to offer equity within the company.  This is MUCH easier said than done.  Most people cannot afford to go without a steady paycheck for long periods of time in the hopes of future revenues.  That is why you gotta go through lots and lots and LOTS of candidates to find the right match; in skill sets, temperament, and even personalities (if you bring on the wrong person you will suffer, like one of my clients).  You have to sell yourself and your business to this individual.  You have to convince him/her to take this chance on your business.  Being persistent and persuasive is once of the most important skills an entrepreneur can possess.  You’ll need persistence and persuasiveness when finding partners, getting financing, negotiating rental terms, the list goes on and on.  In business school, I took a negotiating course and one of the themes was “You don’t get what you deserve.  You get what you negotiate.”  How right it can be.

292059_10150284148285849_7112693_n

No one said starting a business will be easy.  It is not for the timid.  Nonetheless, for those that make it, the rewards are tremendous.

 

David vs. Goliath

Over the weekend I was doing some industry analysis for a client. She had a great idea and a novel one at that. Well it turns out that there was one other company in the same niche. A direct competitor…that has the early mover advantage.

So what do you do when your the new kid on the block?  Like anything else, with lots of hard work and a great deal of luck.  Let’s look at the case of Netflix vs. Blockbuster for guidance.

In 2004, Blockbuster had about 9,000 stores globally and revenues of over $6 billion.  Netflix had started just 7 years prior.  Fortunately it had several things going for them:

1.  Hard work

  • Competitive Advantage – Netflix’s algorithm takes user ratings on movies they rented and then make (i.e. compute) recommendations for other films that they might like, including movies that the viewer may have never heard of.  This rating based recommendation is very common-place now (seen everywhere from Pandora to Amazon), but in 1997, Netflix’s algorithm was a competitive advantage.  Viewers get recommendations they really enjoy, customer retention & satisfaction increases, money comes in.
  • Constantly Improve – One of Netflix’s criticisms is that DVD delivery was often slow.  Creating a logistics and inventory management system that receives orders and quickly sends out product, in addition to receiving returns and repackaging for reshipment was key to customer retention & satisfaction.  Netflix is still staying current by moving from DVDs to streaming VOD.

2.  Lots of luck

  • Competition was Flat-footed – Blockbuster kept the same mentality of a 1985 video rental shop.  They held on dearly to their late-fee revenue source, and its high fees and strict enforcement soured customers’ views of the business.  The late-80s/early-90s business model put them behind.  All they did was copy.  In 2005, they finally did away with late fees.  In 2009, they introduce Blockbuster Express, a DVD rental kiosk designed to compete with Redbox.  By now customers are streaming videos and renting DVDs at kiosks, while Blockbuster is trying to off-load their many stores.
  • Competition Thoughtlessly Expanded – Blockbuster rapidly expanded adding its 1,200th store by June 1990 and 9,000 stores worldwide by 2004 .  They wanted to be the biggest.  And fast.  The filled their stores with not just movies, but video games, candies, and other goods.  Unfortunately, all these stores require operating expenses.  Operating expenses that where greater than the gross profit (i.e. Revenues – Cost of sales).  Also, among many stumbles (which is much too long for this post but I put some references below so you can read to your heart’s content) is they failed to anticipate how media consumption will change.  From analog to digital.

Fast forward to today, Netflix has a share price of over $400, revenues of $4.37 billion USD, and over 2,000 full-time employees.  Blockbuster is bankrupt.

netflix v blockbuster

However, like most engaging stories, the end is never the end.  Dish Network purchased Blockbuster and its remaining 1,700 stores on April 6, 2011 for $233 million and took over Blockbuster’s $87 million in debt and liabilities.  Dish now continues to license the brand name to franchise location, and keeps its “Blockbuster on Demand” video streaming service and the “Blockbuster@Home” television package for Dish subscribers.  Maybe this strategy to resuscitate a nearly-dead brand  sounds foolish.  However, so did mailing out DVDs.

For more info:

http://www.referenceforbusiness.com/history2/93/Blockbuster-Inc.html

http://www.ibtimes.com/sad-end-blockbuster-video-onetime-5-billion-company-being-liquidated-competition-online-giants

http://www.fastcompany.com/1690654/blockbuster-bankruptcy-decade-decline

http://www.getfilings.com/o0000930661-02-000951.html

http://www.lundholmandsloan.com/Case%20Materials/12.%20Netflix/BBI_10_K.pdf

What is in a name?

One of the most important decisions an entrepreneur has to make is what to name his/her company.  It should be short, memorable, and capture the essence of the business.  Not an easy task.

Skype got its name from the shortening of sky-peer-to-peer, which turned to skyper, then finally Skype.

3M was originally Minnesota Mining and Manufacturing Company.  Not as creative sounding now but probably very unique at the time.

You can read the inspiration of other famous companies in the article here.

Logos are another mountain in itself.  Fortunately, there are lots of companies (such as 99 Designs) with talented graphic designers that can help you create a beautiful and practical logo for a relatively inexpensive price.

Loving this site!

So you tried commercial banks for a business loan for your startup.  Well, there are other sources of funding.  Namely, Angels.  Great!  Now where to find angels?  Angel.co (without the ‘m’) is a great resource to find investors that have invested in the types of business you’re starting.

Maybe, I should back up.  What are ‘angels’?  Angels are wealthy individuals that invest relatively small amounts (below $1 million) of their own money, usually in exchange for equity, into your business.

Now that you’re all caught up, checkout Angel.co and get searching!

private-company-life-cycle

The year is winding down and New Year’s Resolutions are coming. So…

Clients

Over the past few years I’ve had the great pleasure of helping many clients create and expand their business.  Here are a few projects I have been fortunate to work on.

9 bar

9 Bar Roasting is a coffee kiosk in one of the busiest intersections in Los Angeles — Hollywood Blvd. and Highland Ave.  I wrote a business plan for 9 Bar Roasting so they could move into an existing business.

 

adrADR Solar Solutions is a solar panel installation company based in Woodland Hills, CA.  Among their many projects they are credited with the largest residential installation in the world — at the 6,000 sq. ft. house of esteemed green architect Mr. Carl Harberger.  I wrote a business plan to help ADR expand their current operations to a retail space in Calabasas.

 

dgaplusDGAPlus is a specialty firm providing innovative strategies and solutions that meet the many requirements of enterprise utility companies and agency partners.  I created a business proposal for DGAPlus to present to partnership targets to incorporate their patented systems. 

 

 

her houseH.E.R. House is a private women’s only lifestyle club in Newport Beach, CA.  I made a business plan so that H.E.R. House could find the startup capital and equity investors needed to launch this rather large operation.  Coming soon.

 

maitri Maitri Yoga Store is a yoga clothing  and accessories specialty store based in Culver City, CA.  I wrote a business plan for Maitri so it could attract startup capital from lenders and investors.  Open Feburary 2015!

 

 

 

 

hakeemSkyview Consulting Group is an advisory firm based in Beverly Hill, CA, specializing bringing foreign companies into the US.  I wrote several business proposals for Skyview to help them with a roll-up strategy for multiple business sectors in the Antelope Valley, Santa Clarita and surrounding areas.

Once you have a rough idea of what you want to do…

It’s time to hash out a business model. What’a business model? Glad you asked!

It’s a (generally) one-page chart that addresses key elements of your business: Key partners, Key activities, Key resources, value propositions, Customer relationships, Channels, Customer segments, Cost structure, Revenue streams.

Each element takes a considerable about of work to define, refine and establish but that comes later in the business development process.

Before diving head-first into a business plan or into all the many many MANY pages of info on starting a business, start out generally and work down to the details.

Here’s an example of the Nespresso business model.

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