April 15, 2016 (Vol. 36, No. 8)
J. Leslie Glick Ph.D. Independent Corporate Management Advisor
Financial Structures Can Determine Where Startups End Up
People who want to become biotech entrepreneurs aren’t necessarily fascinated by equity capital. But if they intend to start founding biotech companies, prospective or inexperienced entrepreneurs should at least learn the basics. Otherwise, when it comes time to raise funds by selling stock in their companies, these visionary types may find themselves blindsided.
Fifty years ago, there would have been little reason to take an Equity Capital 101 minicourse. There were sufficient opportunities to find professional investors who would purchase nondividend-paying common stock in a startup or early-stage company. Everybody’s ownership percentage of the company, whether they were founders or investors, was simply based on the percentage of shares of common stock outstanding that they owned.
In general, the shareholders of old would realize a return on their investment only if the company went public or was acquired. In those days, if the company appeared to be capable of growing rapidly, going public was typically the preferred way for both the founders and the investors.
Voice of Experience
For my first startup in 1969, the initial funds came from friends and family. From 1970 to 1972, in three separate offerings, we raised funds from venture capital (VC) firms in return for issuing them common stock. Because we were making progress with both our technology and our market, each time that we raised capital, the share price of the stock increased.
My next startup was formed in 1977, when VC firms were then more likely to finance new and early-stage ventures in return for issuing them preferred stock, convertible to common stock at a 1:1 conversion ratio if the company went public or if a subsequent investor in the company required such conversion. In 1978, my company issued preferred stock to a VC firm that invested in us. The following year, we issued common stock to a publicly traded company that made a much larger investment in us, at which time the VC firm converted its preferred stock to common stock.
In that era, the basic reason for a VC firm to require preferred rather than common stock in return for investing in a company was to minimize its losses if the opportunity failed. Thus, if the company was acquired at a valuation less than what it was when the VC—the preferred stockholder in this example—invested in the company, the VC would get its capital back, provided there were sufficient funds. Only then would any remaining proceeds be distributed to the common stockholders (essentially management, key employees, and seed investors).
However, at a company valuation equal to or greater than what it was when the VC or preferred stockholder invested in the company, the VC, as the preferred stockholder, would instead receive a percentage of the buyout funds equal to the VC’s percentage of ownership. In other words, all shareholders would then receive a percentage of the buyout funds equal to their respective percentage of ownership, regardless of whether they owned common stock or preferred stock.
Dollars and Sense
Let us put numbers to the example. A VC firm invests $1 million in a relatively new company in return for 25% ownership of the company, which means that the market value of the company is $4 million ($1 million divided by 25%). Let us assume that 750,000 shares of common stock were previously issued. Then the VC firm would receive 250,000 shares of preferred stock, which would amount to 25% of the total number of shares outstanding. Several years later, the company is acquired. Now let us look at two different scenarios.
In Scenario A, the acquisition results in proceeds totaling $3 million, which is less than the company’s $4 million valuation when the preferred stockholder invested in it. In this case the preferred stockholder receives $1 million (equal to its investment in the company, which amounts to 33.3% of the $3 million), and the common shareholders receive the remaining $2 million.
In Scenario B, the acquisition results in proceeds totaling $6 million, which is greater than the company’s valuation when the preferred stockholder invested in it. Thus, the preferred stockholder receives $1.5 million (25% of $6 million), and the common shareholders receive the remaining $4.5 million.
Fast-forward ahead a few decades to bring us back to the present. Today, it is no longer uncommon for VC firms and even angel investor groups to require preferred stock that pays dividends, which typically accrue until there is a liquidation event.
If there is a public offering, after payment of the accrued dividends, the preferred stock is typically converted to common stock on a one-for-one basis. However, at a liquidation event other than a public offering, provided sufficient funds are available, the preferred stockholder receives not only the accrued dividends and its capital back but also a percentage of the remaining funds, which is equal to the percentage of ownership in the company when it made its investment.
Shifts in the Calculations
Utilizing the same numbers as in the preceding example, pertaining to the amount of capital invested by a VC firm, the number of preferred shares received, and its 25% ownership in its portfolio company, let us assume an accrued, 6% annually compounded dividend. Let us further assume that the company is acquired three years later. This time we’ll look at three scenarios.
In Scenario A, the acquisition results in proceeds totaling $3 million, which is lower than the valuation when the preferred stockholder invested in it. However, in this case, the preferred stockholder receives $191,016 in accrued interest plus $1 million (equal to its investment in the company) plus $452,246 (25% of the remaining $1,808,984), all of which total $1,643,262 (54.8% of the $3 million). The common stockholders receive the remaining $1,356,738.
In Scenario B, the acquisition results in proceeds totaling $6 million, which is greater than the company’s $4 million valuation resulting from the preferred stockholder’s investment. As in Scenario A, the preferred stockholder receives $191,016 in accrued interest plus the $1 million but now receives an additional $1,202,246 (25% of the remaining $4,808,984), all of which total $2,393,262 (39.9% of the $6 million). The common stockholders receive the remaining $3,606,738.
In Scenario C, the acquisition results in proceeds totaling $20 million, which is five times greater than the company’s $4 million valuation resulting from the preferred stockholder’s investment. Again, the preferred stockholder receives $191,016 in accrued interest plus the $1 million but now receives an additional $4,702,246 (25% of the remaining $18,808.984), all of which total $5,893,262 (29.5% of the $20 million). The common stockholders receive the remaining $14,106,738.
What can be gleaned from comparing these three scenarios is that the higher the price of the acquisition, the lower the percentage of the proceeds going to the preferred stockholder, but in no case will it ever drop to a flat 25%.
Striking a Balance
Clearly, based on how the investment works out, the aim of the VC firm is not just to minimize its losses, but also to maximize its gain in preference to the common shareholders. The VC firm may seem unfairly advantaged by this structure of equity financing, at least as far as the startup company’s founders and seed investors are concerned, but the structure has its justifications.
Even after a VC firm culls through numerous investment opportunities and invests in less than 1% of them, those that appear to have the best growth potential, the likelihood of the VC firm realizing a big gain is only 1 or 2 out of 10 investments. The odds of its portfolio companies failing completely are 2 or 3 out of 10. The remaining five or six investments will essentially break even.
The only leverage an entrepreneur really has with a VC firm, with respect to the structure of an equity financing, is if the VC firm truly believes that the startup company is a real game changer, an investment opportunity other VC firms would be anxious to seize. Startups capable of generating this kind of interest, however, are extremely rare. So my advice is to accept reality, take the money, grow your company, and if you are successful, everybody will be a winner.
J. Leslie Glick, Ph.D. (email@example.com), is an independent corporate management advisor.