The Genesis of a Public Company

There are too many misconceptions among investors as to how companies get off the ground. We are not talking about a local dry cleaner or a franchise restaurant, but a scalable product or service. Scalable means that the company has the potential to have a national or international audience and tens of millions in revenues.

The Angels

The initial financing for product or service development typically is self-financed or financed by an independent investor who may contribute a few hundred thousand Dollars with the realistic understanding that s/he will lose all their money most of the time. The term “angel” comes from the idea that their investment is a total leap of faith… the answer to the entrepreneur’s prayers. The rewards sought by the angels are returns of hundreds if not thousands of percent of their money.

Friends and Family

This group invests when the product or service is partially developed, and the company may have some nascent revenues, but there is no proof of concept yet. Typically, the funding exceeds over one million Dollars and may garner 20% of the company. Often, we find a high net worth family or influential financial advisor behind this funding, hoping for returns projected in multiples of five to ten times the invested capital.

Venture Capital (Early Stage)

To some extent this can be blended with Friends and Family, but typical early stage VC’s look for greater proof of concept. They may also put restrictions on the management requiring them to achieve certain benchmarks. This round most often comes in the form of convertible preferred stock, where the VC gains a liquidation preference over the previous shareholders. It is not uncommon for this investment to be convertible debt with strict covenants tied to company performance. This structure is called “loan to own” and the VC will take 100% ownership of the company if any of the covenants are breached. The returns sought by the Early Stage VC are only slightly less than Friends and Family.

Venture Capital (Standard)

Proof of concept is required to attract this type of investor. In almost every circumstance, this VC is a fund. Although Early Stage VC’s can be funds, this is the case less often now because family offices are becoming more active in Early Stage VC investing. This round will almost always be convertible preferred shares subordinated to the earlier rounds if the company is doing well… or superior if the company has somehow faltered. The earlier investors may be required to subordinate their investments if the latter is the case. “Loan to own” is less prevalent unless the company has faltered. This stage investment fund is looking for greater security of their investment, and companies also tend to have a real liquidation value. The returns sought here are 25 to 35% compounded, and the time frame to a monetization event (when the company is sold or taken public) is much shorter, less than five years.

Venture Capital (Late Stage)

This is ramping capital. Revenue growth is accelerating, and product or service delivery systems need to be established and normalized. The company should be at the neck of the “hockey stick” after spending years in the length of the handle. Convertible preferred shares are again most common. A company must be doing well to reach this stage. Product is proven… the “dog will eat the dog food” and growth is a real prospect. Return expectations are similar to the Standard VC, 20% to 30%, but the time frames are shorter, usually around three years to “take out” (another term for monetization).

Growth Capital

By this point the company’s sales are booming… so Growth Capital investors, typically get common stock, perhaps with some warrants attached to leverage the investor (typically a fund or family office). The investment is needed to build out the delivery system for the product, add/train staff for service businesses, marketing for product and service, and upgrade the “C-Suite.” This jargon refers to the management of the company, the CEO, COO and CFO. It is unlikely that the entrepreneur has the background and experience to scale the opportunity. The entrepreneur may remain as Executive Chairman, but this is the time to bring in the professionals. Growth Capitalists look for 15% to 20% returns for a two to three year time frame with a high degree of certainty. They may also wish to hold the company’s shares after a public offering or “rollover” their interest in an acquisition if possible. “Rollover” here means swap their shares in the company for shares in the successor.

Pre-Public Round

This round is usually invisible to the purchaser of the Initial Public Offering (IPO). The business purpose of the round is most often to lock in the underwriter of the IPO, and the avowed purpose is to raise additional capital to clean up the balance sheet in preparation for a public offering. Frankly, most companies reaching this stage are very carefully managed financially. If a company is destined for the public market, it is important to retain a committed underwriter. It takes time to complete the registration process and market conditions can change, so it is important to keep the underwriter engaged.

The Pre-Public round is typically an equity round that is targeted to be a 15% to 25% discount to the expected public offering price. The underwriter places this round with their most valued clients and “friends.” Only under the worst circumstances will the underwriter want to disappoint these clients. So, the Pre-Public round is an indirect guarantee of performance in bringing and marketing the IPO.

Even in the most perfect company, all of these rounds are not likely to be needed and some will likely be skipped. And, of course, most new companies never get past the Friends and Family stage… they continue to lose money and ultimately disappear. There are also those who cannot reach the Growth phase or are unable to beat the competition. They may be somewhat profitable or at least cash flow positive, so they become the ‘walking dead.’ Reaching the Public stage is also no guarantee of everlasting success. Technology brings competition, new product and other disruptive technologies, which obsoletes slow-footed companies.

Reminder: Sell your Mobileye before the take out on June 21st, otherwise you may be subject to Israeli withholding tax.

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