Finance For Founders

By Evan Miller

September 7, 2010

If you are thinking of starting a company, it is imperative to understand a little bit of finance. If you do not understand finance, your investors and creditors are in a position to take advantage of you. Not that they will. I'm sure your investors and creditors are nice people.

I've noticed that when people in the technology sector talk about “finance,” they usually discuss the difference between angel funding and seed funding, a Series A round versus a Series B round, stock options versus restricted stock units, and so forth. These are the details that startup people like to talk about, but really, they're just a set of investment conventions that venture capitalists in Silicon Valley have adopted. They are useless without knowledge of the underlying mechanics of capital. I only “got it” after learning some economics and studying several Wikipedia pages on accounting.

In this note I want to talk about the more fundamental questions of investment and credit for people who have no background in finance. In particular: What is capital? What is equity? What is debt? Where do they come from? Where do they go? When someone invests, what's the difference between the founder selling shares and issuing new shares? Why are most small companies financed through debt, and why are technology startups are financed through equity?

And will things continue that way?

What Is Capital?

Capital is money. Sort of. Capital looks like money, but really, it's anything to which monetary value can be ascribed. Things have monetary value under two conditions: when someone wants to buy it, or when there's a chance it will generate money in the future.

There are four categories of capital that founders should be aware of.

Financial capital is money and other valuable pieces of paper.

Intellectual capital includes the capital inside the heads of owners and employees. It can be an employee's skills and contacts, a team that works well together, a board director's experience and judgment, or a company with a well-functioning bureaucracy.

Brand capital is a form of capital that exists inside the heads of consumers. The fact that you know Tide laundry detergent comes in orange boxes is a type of capital for the makers of Tide: it is likely to generate money for them in the future. (Advertising is really a form of capital investment.)

Physical capital includes capital that's not on paper and also not inside a person's head: trucks, land, computers, and so forth. This is the easiest to conceptualize, but for technology companies, it is becoming the least important form of capital.

What Is A Company? What Is Equity?

A company is just a way of bringing together different people's capital. If those people can agree to use their capital to generate wealth for themselves, the company is called a for-profit corporation. There are other types of corporations that pool capital for purposes other than the generation of private wealth. These include the non-profit corporation and the public benefit corporation.

What's the trick? In a for-profit enterprise, how does my capital and your capital become our capital? It's very simple: first we pool our capital together into this thing called a company, and then we give ourselves equity shares in the company we just made.

Equity shares are simply a means of controlling a for-profit corporation. In practice, this means that the holders of equity shares vote on what the company does, and they decide what to do with the company's profit. They may keep it for themselves (this is called a dividend), or they may reinvest in the company.

A shareholder's control over a company is not limited to voting. If the management of a for-profit corporation fails to maximize the company's profits, shareholders retain the right to sue the management for lost profits. This is called breach of fiduciary duty. Minority shareholders can even sue majority shareholders for breaking the original agreement to only use the capital to make money. So even if you own 99% of the company, you can't use company money to throw parties for yourself (without inviting the 1% owner, at any rate).

In theory, equity shares are issued in proportion to the capital that each partner brings to the company. It is trivial to follow this formula when each partner is only contributing cash. The formula is still fairly easy to follow when partners are contributing physical capital. If I have a mule-cart, and you have a mule-cart of similar quality, and we want to make a company with two mule-carts, it is simple to see how we would arrive at a 50/50 split of equity shares. If I am contributing a mule-cart to the new company, and you are contributing a fancy silver bell, we would just use the market prices of mule-carts and silver bells to determine our relative equity.

Deciding on equity shares is much more difficult with non-physical capital. For publicly traded companies, there is an entire industry dedicated to pricing both physical and non-physical capital, but unfortunately, its services are not available to pre-IPO startups. (That industry, of course, is the stock market.) Figuring out the relative value of my skills versus your judgment, or my contacts versus your experience, or my ideas versus your reputation, is purely a matter of negotiation.

But the central point of negotiating equity shares should have nothing to do with what is “typical,” or how hard each person promises to work, or who had the first conversations with whom, or anything other than this question: how much capital is each partner contributing?

What Is Investment? What Is Reinvestment? What Is Debt?

There comes a time when partners in an existing company need more capital in order to grow the business. They have three options, each with its own advantages and disadvantages: they can take on investment, they can reinvest profits, or they can take on debt.

Investment

Taking investment is essentially starting a new business with the same name as before but a slightly different set of partners.

Let me repeat that.

Taking investment is essentially starting a new business with the same name as before but a slightly different set of partners.

Taking investment is essentially starting a new business with the same name as before but a slightly different set of partners.

Taking investment is essentially starting a new business with the same name as before but a slightly different set of partners.

A new investor is bringing capital to the existing partners and asking to form a new company. The existing partners are contributing capital to the new company, too: their own existing equity shares. Because the new company has the same name as the old one, and the existing partners now own a smaller percentage than before, this is called “diluting the equity shares.” But really, the partners are trading equity shares in a smaller company for shares in a larger company — the new company that includes the new investor.

The level of “dilution” — that is, the rate of exchange between old shares and new shares — depends only on the value of the new capital versus the value of the existing equity, just as equity shares in the mule-cart/silver-bell company depended on the relative value of mule carts and silver bells. Of course, as with pricing any non-physical capital for which there is not a market price, the value of the existing equity may be subject to some debate.

Note that issuing new shares and diluting existing shares is completely different from a partner selling off his own shares. Issuing new shares results in the company having more capital and possibly different partners; selling existing shares results in the company having a different set of partners, perhaps, but the company has the exact same amount of capital as before. It's the difference between giving up your seat at the table and adding a chair.

Many people seem to think there is something magic about being a founder of a company and receiving those initial equity shares, and that later investors are “just” investors. On the contrary, except for a measure of moral authority enjoyed by members of the founding team, as soon as a company takes on additional investment, a founder becomes just another investor who is legally bound to generate profit for the other investors.

It would clear up confusion over these concepts if companies were required to change their name every time they received new investment, but that would generate several additional layers of confusion.

Reinvestment

I mentioned earlier that upon making profits, shareholders can choose to pay themselves a dividend or to reinvest the money into the company.

If they choose to reinvest, it's exactly the same as if the shareholders had paid themselves a dividend and then individually used their dividends to buy newly issued shares (i.e. invest) in the company.

An example will make this point clear. Suppose I have 1 share in Standard Peanuts and you have 4 shares. Profits are good this year, and we can either pay out a one dollar-per-share dividend, or reinvest in the company.

If we pay the dividend, I make a dollar and you make four dollars.

If we let the company keep the money, now the company has five more dollars in capital, and I still own 20% of the company, and you own 80%.

Now suppose instead we use the dividend to buy newly issued shares. With your four dollars, you'll buy 80% of the new shares, and with my one dollar, I'll buy 20% of the new shares. Since you're contributing all of your old equity to the “new company,” you'll get 80% of the converted shares, and I'll get 20% of the converted shares. On net, you have 80% of the new company, and I have 20%.

Where does that leave the company? It now has five more dollars in capital (the new investment from our dividends), and at the end of the day, I still own 20% of the company and you still own 80%. Reinvesting profits is exactly what the name implies — each partner individually taking his dividend and investing it in equity shares of the company.

Debt

Throughout this discussion I've left out the other way to finance a company: debt.

Debt is easier to understand than equity because we've all incurred various debts in our lives (but few of us have issued equity shares).

Debt is simple: A company receives some amount of money now and promises to pay back a larger amount at some point in the future.

The owners of debt are called creditors. Creditors do not exercise any control over a company during its lifetime, nor are they entitled to dividends. However, in the event of the company's bankruptcy, they are paid what is owed to them before the equity owners can receive anything. Owning a company's debt is safer than owning equity in the sense that you stand to lose less; however, you also stand to gain less from the company's success.

The interest rate on the debt depends on the perceived probability that the company will fail and default on its debt. The greater the likelihood of failure, the greater the interest rate. The actual likelihood of a company's failure, of course, is subject to judgment.

Financing a company through debt can occur in several ways. New companies will max out the owners' credit cards, obtain personal loans from friends and family, or attempt to get a bank loan. Companies might incur debt by having a line of credit with their suppliers. Large companies can issue bonds, which can be purchased by members of the public. A bond is just a piece of paper that promises to pay back a specific amount of cash at a specific date.

Why Equity? Why Debt?

To summarize the two methods of financing a company

Small companies

Most small companies have partners who receive equity but are otherwise financed through debt. There are several reasons for this:

Large companies

Large companies are usually financed through equity. There are several reasons:

In addition, there is the issue of incentives. If a company's owner has difficulty distinguishing good work from bad work, giving equity to employees and advisors creates an independent incentive for them to contribute to the overall value of the company.

Conversely, the owners of debt have an incentive to prevent the company's demise. It is a curiosity to me that debt is not used more often as an incentive for executives and employees. By creating an incentive to prevent bankruptcy, “debt options” would provide an appropriate counterbalance to stock options, which appear to encourage executives to take excessive risks.

Startups

Anyway, a startup is a small company that seeks to become a large company. Startups are financed primarily through equity, because:

Venture capitalists contribute several types of capital to a startup: cash, contacts, judgment, and so on. However, the type of capital contributed really should be independent from the method of financing the capital. If they did not perceive the need to control the companies they financed — that is, to retain the right to fire the founders — venture capitalists could just as easily be in the business of owning startup debt rather than equity. (Presumably, the debt would come with a very high interest rate so that the return on a successful debt investment was comparable to a similar-scale equity investment that resulted in a successful IPO.)

Conclusion

Taking on equity versus debt is largely a matter of control, but it is also a matter of what is available. Your bank will want debt, but your venture capitalist will want equity. But some brief concluding thoughts:

Finally, I predict that in the future, as the services offered by venture capitalists more closely resemble commodities, startups will stop being financed by selling equity to investors. Instead, startups will sell debt to their own customers. Early customers are in an excellent position to judge the skill and character of the founders as well as the viability of the product. The large companies of the future may well have only a handful of equity owners before going public, if they choose to go public at all.


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