The weird and wonderful world of corporate finance (by alaric)
How do you get to be a director? (or: Shares and shareholders)
Well, that's specified in the M&A document of the corporation (so the people who made the company get to choose), but usually: directors are appointed by a majority vote of the "shareholders".
You see, every corporation is owned; and the owners each own a share of it. So they're the "shareholders" of the corporation.
To form a company, you have to get together a bunch of stuff. You need to write an M&A (or, most likely, copy an existing standard one), and choose the initial set of directors (and, under UK law, also choose a person to be the "secretary" and a postal address called the "registered office" for official post to the company to be sent to and a few other things) - but you also need the initial property the company will have (usually, some money that you've raised for the company to do whatever it will do with). That property, before the company forms, is owned by some people who are offering it to the company. But they're not expected to just donate it - they swap that property for a corresponding share in the new company. All this is detailed on a form you send to Companies House, and they get back to you if it's all filled in right and now you have a limited company.
The M&A sets out rules for shareholder meetings. For example, a company might have an Annual General Meeting (AGM), where notice is given to all shareholders in advance, and the directors might present a bunch of things they'd like the shareholders to vote on (adding new directors, for instance). Or the directors might announce an ad-hoc Extraordinary General Meeting (EGM) if they need something done and can't wait until next year. Or the shareholders might be able to call an EGM themselves, if enough of them support the notion, perhaps if they want to un-appoint all the directors and appoint new ones because they're idiots.
At these votes, the shareholders get to vote with a voting weight depending on their share. So, somebody with a 51% share of the company might be able to do whatever they want, as even if all the other shareholders disagreed, they'd only be able to add up to 49%, and so would lose the vote.
Sometimes it's a little more complex than that, as a company might (in its M&A document) define multiple classes of shares, which hold different voting weights. Famously, Mark Zukerberg set up the original Facebook corporation this way, and gave himself a class of share with inflated voting weight so he retained absolute control of Facebook even though he no longer owned a majority of the company.
For instance, if I start a company all on my own, I might appoint myself as a director (and in the UK I'll also need another person, as there's a minimum of two directors), and I might put £100 into the company as the initial shareholder. So I own 100% of the company, which has £100 to its name. Effectively, I still have £100 in the form of 100% ownership of a company with £100 cash, especially as I'm a director of the company so can spend that £100 that the company owns however I want. Or I might start a company with my trusted business partner, and we each put in £50 and get an equal split. Or we might decide that I'm the boss so we'll go for a £51:£49 split. It's common that the initial founders of the company will be the initial shareholders and initial directors, but that doesn't have to be so.
The initial share setup of a company is usually done with trivial amounts of money like this, to set up an initial split in shares - the real money from investors can come in later. This is where corporate finance starts to feel like "engineering" because things get used in all sorts of interesting and non-obvious ways to solve different problems...
Oh, and by the way, shares are often also called "stocks". Stocks is more common in the US and shares in the UK.
Actually, shares are quantised
This is kind of an implementation detail of how shares work and really doesn't mean much, but it has a few implications for practicalities: You can't just own arbitrary fractions of a company. When a company is created, on that initial Companies House form, you'll say "The company initially issues 100 shares of £1 each", and you and your friend might then pay £51 for 51 shares and £49 for 49 shares, respectively. Or you might initially pay £1 each for 1 share each, and you have a 50:50 split, and the company still has 98 shares "issued" but not sold to anybody, that it can sell later.
This is great, but it means that all the shareholders have to hold a whole number of percentage point shares of the company, and nobody can own less than 1% if there's only 100 shares to play with. So the company can (through a process detailed in the M&A) decide to issue more shares later, and then sell them. And there's a thing called a "stock split" where the company decides that each of its shares splits into, say, ten new shares worth a tenth as much each.
Dilution and Goodwill
So, a company can have shares in itself that haven't been sold yet, and still belong to the company. And it can create more shares whenever it wants to. And it can sell those shares it owns, meaning that shareholders give the company money in exchange for then owning a share in the company.
There are two interesting details of this process:
When more shares in a company are sold, the share fraction of existing shareholders is reduced. If our company starts off with 100 shares, and the initial shareholders split them 50:50, they each own 50 shares: 50% of the company. If the company then creates 50 more shares and sells them to somebody, there are now three shareholders with 50 shares each, 150 shares total, so they each now have one third of the company.
The company is free to name a price when it offers to sell some shares.
If I have a super clever idea for a new product, I might team up with a friend who has useful business skills to try and make a business out of it. We might make ourselves the initial two directors, and create 100 shares of £1, and I get 60 of them (it's my clever idea) and they get 40 (they're doing all this scary corporation paperwork and setting up a web site while I work on the product). But once I've made a prototype and they've made a fancy web site, it's time to spend a million pounds getting a factory set up to mass-produce the thing.
Right now, our company has whatever change is left from £100 after buying a Web hosting setup for that web site plus some materials for me to make the prototype; and that's a bit short of a million pounds. So, we need an investor, and we need them to give the company a million pounds for that factory. But if we make the company issue a million more £1 shares and sell them all to the investor, we now have a share split of 60:40:1,000,000 and the investor has complete and absolute control over the company. That's not a great deal! They're just paying for a factory to produce my brilliant idea. I want to retain control, and I think they only deserve a third of the profits for that.
So what we do is say "Well, I've developed my brilliant idea within the company, so the company's value is the £15 in cash change from our initial £100 investment and £3,000,000 in the value of the brilliant idea. So the total value is £3,000,100 and we're willing to sell you a third of it for £1,000,000. Deal?"
If the investor likes your idea enough, they might be happy with that. So you issue 50 more shares (making a total of 150) and sell those 50 new shares for a million pounds. The company has a million pounds in the bank, and a 60:40:50 share split between you, your co-director, and the investors. Your 60 shares are now worth a lot more, in theory, because you've made the company more valuable by donating your work to it (this is sometimes known as "sweat equity").
So what is a company really worth? If you sold anything our company owned at the point before we got investment, you'd have a bit less than the £100 we put in (because everything is second hand, stuff got used up, etc). That's it's "Net Book Value". But we managed to convince an investor to agree that it's worth around £3,000,000 because it has a cool idea. And a more established company might claim a higher valuation than its Net Book Value because it has a widely-known and trusted name that people like. Because this gap between the net book value and the value you managed to obtain for the company is based purely on what people think about the company, it's called "Goodwill", and the company accounts will actually count it as an asset: A company worth £3,000,000 might list its assets as £45 in the bank, £150 worth of stock, and £2,999,805 of goodwill. You can also have negative goodwill, if your company is tainted by a terrible reputation because it's owned by Elon Musk, so people will only buy its shares based on a valuation LESS than its Net Book Value. But it's not all bad - you might also get negative goodwill if you sell a company for less than its NBV because you're selling it deliberately at a discount for charitable purposes, selling one of your companies to another of your companies as part of some rearrangement of the structure of a group of companies, or something.
Anyway, every time a company "takes on investment" by selling shares, previous investors get "diluted"; their share of the profits (and voting power) goes down. But, at the same time, if you believe the company valuation the investors accepted to buy their share, the value of your share has remained the same as it was before the dilution; 50% of a company worth £1000 is £500, and 25% of a company now worth £2000 is still £500.
A company can also do the opposite: a "stock buyback" where it spends cash to buy shares in itself. Fewer shares out there means that they remaining shares represent a bigger fraction of the company, and so are worth more.
Angels and Vultures
Where do you find investors for your startup, anyway?
The traditional path is to start with an "Angel Investor", who is often somebody you're introduced to through your social/professional circles, or a rich uncle, although I gather there's also events held where you can explain your great company idea to potential investors and they might be interested. Needless to say, having potential angels in your social/professional/family circles is one of those ways in which people from rich families have a significant leg-up in starting businesses compared to people who grew up on council estates.
Angels tend to put in relatively small amounts as corporate finances go, perhaps only a few tens of thousands of pounds; not enough to run a business on for any length of time, but maybe enough to fund the company founders to build a prototype over the course of a few months. They usually invest purely on the basis of liking your idea; as they invest in companies at that early stage, they don't tend to require much work to have been done already.
Venture Capitalists (VCs), on the other hand, invest in companies that have generally already demonstrated some kind of demand for their product, and who have had time to prepare a flashy presentation explaining their business plan, the results of prototyping and trialling the prototype in test markets, financial projections, and that sort of thing. In exchange, they tend to invest many millions of pounds, with the general expectation that the company is "ready to go" and just needs a load of money to build production-scale facilities to make enough of their product to fill the market, sales/marketing to get everyone knowing about the product, logistics to be able to deliver it, and all that sort of thing. VCs tend to be companies in their own right, rather than rich individuals.
VCs tend to expect massive growth. For the money they have available to invest, they want to get the best return for it, as quickly as possible, so they can re-invest that back into the next generation of startups (creaming off a profit as they go). So they are very interested in the "exit strategy". They want the company to grow ten or more times in value from when they bought shares in it, and then have somebody to sell those shares to - either a bigger company that acquires the startup, or the startup "going public" on the stock markets, whereupon the VCs can sell their shares to whoever wants them on the market (more on that in the next section). And they tend to want that to happen within a few years.
As such, they tend to not care about the long-term viability of the company. The Internet startup world was dominated by VC-funded startups who will throw money at getting their product noticed and talked about, giving away services online for free in order to get more users as quickly as possible, because a lively expanding company that everyone has heard of can get a better price if it's sold to somebody. A sustainable business model that might actually turn an ongoing profit isn't prioritised at all. This often leads to a lot of really stupid things happening.
Cryptocurrency, Society | alaric | 
Tue 8th Oct 2024 5:25 pm
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