From the December 1999 issue of Startups

Business owners often fret over how many shares to issue when going public or seeking capitalization. But they may be putting the cart before the horse, according to experts. "First of all, there's no concrete answer," says James B. Arkebauer, founder of Venture Associates in Denver. "There's no formula. There are huge variables--the business owner looking for $100,000 to fund an ice cream store versus the person seeking $10 million to do an Internet IPO and all the variations in between."

The first step is to determine the amount of money you want to raise, then decide what percentage of your business you are willing to give up in return for the proceeds--all of which must be predicated upon valuation of your company. For an existing business, Arkebauer suggests, "quasi guidelines begin with the familiar P/E [price/earnings] ratio and the valuations other companies in the same industry are getting." To help with the latter estimate, research IPOs during the last 24 months.

Know, however, that "methods of valuation vary widely depending on whether you're approaching private investors, venture capital firms or institutional investors, or planning an initial public offering," cautions the author of Going Public (Dearborn Financial Publishing, $29.95, 800-621-9621).

When working with an underwriter toward an IPO, the per-share valuation, including number of shares, becomes part of the negotiations. The underwriter generally has a target dollar amount that conforms to the firm's typical deals--perhaps $7 to $12 a share for smaller brokers, $15 to $25 a share for larger firms. The number of shares issued will be adjusted to conform with the price per share so you still reach the desired capitalization.

However, the math changes if you're marketing your shares directly to investors, says San Francisco securities attorney and CPA Drew Field. "You decide on a price per share that you believe is best for the investor prospect you have selected," says Field, author of Direct Public Offerings: The New Method for Taking Your Company Public (Sourcebooks, $19.95, 630-961-3900). "Then you divide that number into the total dollar amount you expect to raise. After a little rounding, that will tell you the number of shares to be offered."

In addition to shares offered, remember that the underwriting broker traditionally is awarded warrants equivalent to 10 percent of the offering, and your board of directors and key employees should be equally provided for in stock-option plans. Most importantly, keep at least 60 percent for yourself.

Such determinations are more art than science. Says Arkebauer. "Variables are substantial from one business to the next and may carry more weight in one industry than another."


Paul DeCeglie (MrWritePDC@aol.com) is a former staff reporter for Journal of Commerce and American Banker. George M. Dawson (gdawson@txdirect.net) is a small-business consultant and author of Borrowing to Build Your Business: Getting Your Banker to Say "Yes" (Upstart Publishing, $16.95, 800-235-8866). E-mail your questions to bsumag@entrepreneurmag.com.

The Sub Club

Reluctant to surrender substantial ownership in your business in order to raise capital? There may be an alternative to the quid pro quo demanded by venture capital firms and angels. (Not that either funding source is a dominant player in business financing, according to OffRoad Capital Corp. in San Francisco. The financial services company reports that venture capital and angel investments combined represent just over 7 percent of business funding. No. 1 source: owners, family and friends at 40 percent; No. 2: banks, 20 percent.)

So where else can you turn for capital infusion? To the growing number of institutions making subordinated debt investments, also called sub-debt loans. The tool, once the domain of merchant banks, reportedly is gaining in popularity among venture-leasing companies, financial-services firms, insurance companies and even some commercial banks. Entrepreneurs--including those with start-ups--appreciate sub-debt loans because they provide funding for growth, working capital, acquisitions and the like without requiring the owners to give up a large piece of the business. Other pluses: Loans are usually repaid in three to five years or longer, and a portion of the cost is tax-deductible as interest. While more expensive than a conventional loan, sub debt ultimately costs less than equity funding.

In essence, subordinated debt is an unsecured loan based on the earnings and expected strong cash flow of your business, as compared to a secured loan, which is made against your company's assets, accounts receivable and other collateral. The unsecured loan is subordinate to conventional financing (hence the name), so if your business fails, the lender is repaid only after your other (primary) loans are settled. In return for that risk, sub-debt lenders charge interest above prime and often demand warrants, which give the lender the flexibility to withdraw cash as debt repayment or convert to share ownership. But the amount of such ownership usually is negligible (often as little as 5 percent) compared to the 25 percent or more demanded by venture capitalists and angels.

If sub debt is something you'd like to investigate further, expect the lender to analyze your company earnings, cash flow, management, industry trends, business plans and financial position (with the focus on ensuring that earnings and cash-flow targets can be met). To find an institution active in sub-debt investments, contact a merchant bank, finance company or broker in your area, or search the Web for "subordinated debt" or "venture leasing."

Book It

For more information on valuation, check out:

  • Finding Your Wings by Gerald Benjamin and Joe Margulis (John Wiley & Sons, $34, 800-225-5945)
  • The Quest for Capital by Dee Power and Brian E. Hill (Javelina Publishing, $22.95, 480-837-9590)
  • Where to Go When the Bank Says No by David Evanson (Bloomberg Small Business Press, $24.95, 800-233-4830)

Getting' Piggy Wit It

Greed Is Good: The Capitalist Pig Guide to Investing, a new fast read for Generation X written by 23-year-old Jonathan Hoenig, could also have been titled Everything You Wanted To Know About Investing But Were Afraid to Ask Because You Thought the Answers Would Be Too Complex or Too Long. Hoenig doesn't get too complex. If anything, much of the book may be too elementary. For example, Hoenig explains inflation ("a rise in the general level of prices, where buying power of the dollar decreases"), tells us what it means to go public, and points out that CNBC's Maria Bartiromo is a fox.

But the Chicago Board of Trade trader also provides some unique insight and advice on a broad spectrum of financial matters, from spending and saving money to creating wealth through stocks, bonds, mutual funds and speculating. In fact, most of the 250-page book is devoted to describing--quite clearly and entertainingly--each investment and its risks, rewards, fees, market makeup and machinations, including tips on how to a participate intelligently. The final third of the primer is devoted to the thrill and skill of speculating in stocks, options and futures.

While convinced that investing for the long term is the best way to build wealth, Hoenig admits to being "obsessed" with speculation. "Speculation is extraordinarily exciting and potentially profitable," he writes. "It's dynamic. It's dangerous. And it's more fun than I've had in my entire life." If you've got the stomach for it, you also must have the cash for it--a minimum of $7,000 to $10,000 that you can afford to lose, up to a maximum of 10 percent of your total portfolio. And that cash must be separate from your long-term investment funds; Hoenig cautions: "Church and state. Business and pleasure. Burt and Loni . . . When it comes to your speculating money, separation is vital."

Greed is Good (HarperCollins, $15, 800-242-7737) is laced with humor, peppered with Yiddish (and translations), and sprinkled with quotes from such disparate luminaries as Jack Kerouac, Karl Marx and Gordon Gekko (the character portrayed by Michael Douglas in "Wall Street", one of Hoenig's favorite films). The author, who for his years is seemingly mature, knowledgeable and wealthy (having been trading stocks and options since before he was old enough to drive), hosts and produces "Capitalist Pig," a radio talk show about finances, which--like the book--is aimed at those age 18 to 35.

Add It Up

By Karen Axelton

You've been contributing to Social Security ever since the summer you spent flipping burgers at Weenie Barn. To guarantee you get credit for every hard-earned dollar, the Social Security Administration has begun to mail out annual Social Security Statements to workers and self-employed people 25 and older who are not already receiving benefits. When you get your statement (about three months before your birth month), check the "Earnings Record" carefully. It shows your earning for every year in which you paid taxes. Since your Social Security benefits are based on earnings, make sure these figures jibe with yours.

Is That Your Final Answer

By George M. Dawson

Q: We are going for outside financing. What format do you recommend for our proposal?

A: That's the wrong question. Concentrate on content, not format. Regardless of format, all financing sources require detailed answers to seven questions. We went over the first three in last month's column. (Check it out at http://www.bizstartups.com in case you missed it.) Here are answers to the final four. (Note that, for 5 through 7, the answers are different depending on whether you're dealing with a lender or an investor.)

4) Why is this loan/investment good for your company? Loans and investments are for productive purposes--to create profits, asset growth, repayment and wealth. Banks and investors expect you to achieve higher sales and/or better profit margins after the loan.

Show how new equipment will improve your efficiencies or reduce scrap; how the new warehouse saves you money on transportation costs, breakage, insurance, utilities; how research and development will open new markets and so on.

5) When will you pay us back? For banks, your proposal must include a cash-flow projection along with projected income statements and balance sheets. Build the loan repayment plan into the cash projection to conform with bank-repayment guidelines.

For equity investors, your proposal must clearly provide an "exit window" within a three- to five-year time frame.

6) How will you pay us back? Be very specific. The bank wants to see how you will create excess cash flow from profitable operations--inventory liquidation, sale of collateral, profits and so on.

Investors want you to justify your choice of one of three exit strategies--a public stock offering, sale of the company or a future share of cash flow.

7) What if something goes wrong? For the banker, the answer is the personal guarantee of the principal owners of the business and the collateral pledged to the loan. Guarantees have many forms. Understand what you sign.

For the investor, the answer is either your Plan B or the investor's Plan B. Plan B is an alternative strategy to get the company back on its planned growth path. It could be opening new markets, changing technology, turning control of the company over to the investor or changing the business.

Investors stay in close personal contact with companies--often with a seat on your board. Banks monitor your company from your regular financial statements and an occasional phone or in-person call.

Don't ever go in search of money unless you can answer all seven of these questions in detail from the perspective of the financing source.

Contact Sources

Drew Filed, drew@dfdpo.com

Venture Associates, www.venturea.com