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Need that new investor-partner? Prepare to be ‘diluted’

(Editor’s note: This is another in a series of columns on business finance.)



“The worst mistake is to have the best lad-der 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. Giving his customers an additional 30 days to pay, relaxing collections and neglecting the sale of inventory already on hand wasn’t a complete 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 reminded John to call if he ever wanted to bring in an outside investor. They had never discussed price, terms or amount, but Ted’s name kept coming to mind over the last several days.

“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, and 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 you 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 Windsor 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 leverage, valuation, dilution ... 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 Columnist.

“So, Lary, can you help me understand what this term ‘dilution’ is all about?”

“Don’t be put off by the fancy word, 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 to it later.

“For now, let’s assume your company is worth $1 million and you own 100 percent 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. 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-per-share price.

“After the investment, the share price won’t change – it will still be $100, but there will now be 13,000 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 that your percentage ownership goes from 100 percent to around 77 percent, or 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?”

“That’s absolutely right. If we change our example to say your company is worth $2 million as a pre-money valuation, each share would be worth $200. So, a new investor putting up $300,000 would get only 1,500 shares; and now with only 11,500 shares outstanding, the original 10,000 shares plus the newly issued 1,500 shares, you’d own about 87 percent of the company instead of the 77 percent 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’s situation.”

“Any time will be fine, John. Just give me call.”

•••

Lary Kirchenbauer is the president of Exkalibur Advisors Inc., providing practical business strategies for family and other privately owned businesses in the middle market. He works closely with senior executives and their businesses to accelerate their growth and improve personal and professional performance. Stop by his Web site to offer your comments on the column or other business issues at www.exkalibur.com.

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