Recently I met Chris Spencer-Phillips (S-P) and Chris Brigden of First Flight Placements; they are aware of the difficulties that experienced investors have when finding companies to invest in and they are also aware of the difficulties young companies have raising funds. They propose a different approach... and it is one that is working well.
Today I’m going to look at the financials for a company seeking a CEO roughly how it was presented to me (numbers and details changed to keep it anonymous). I’ll review the assumptions and identify a few additional risk factors.
The company concerned had already raised $3M and spent it all researching a product that ultimately didn’t sell. On the way they discovered another product but it would need a complete software re-write. The company’s goal was to go for a trade sale in 5 years’ time for $100M. The CEO will be working full time and get his 5% payback when the company is sold. An investment round of a further $3M will be required to create the new prototype, market and sell the new solution.
So how do we make sense of all this? First we can work out the payback and opportunity cost.
The CEO has 5% of the shares when he joins (for simplicity let’s assume he doesn’t buy them). With the additional $3M coming into the company, this holding will be diluted. Assuming that 100% more shares had to be issued to accommodate this investment, the CEO’s overall share of the company will now be 2.5%. So in 5 years’ time, he will receive a cheque for $100M * 2.5% = $2.5M.
If the CEO is capable of building this company from an idea into a sellable proposition in just five years, he is a sought-after person which means he could command a significant salary for another company. This is the opportunity cost. Let’s say he could earn $300K per year in another company that means he would earn $1.5 M in the five years of this opportunity.
So, from an income point of view, our CEO would earn $1M more taking up this opportunity. Is this enough to cover any discrepancy caused by the assumptions?
Testing the assumptions
Let’s change some of the assumptions to see what affect there is on this scenario:
- The company sells for $10M instead of $100M. That means the CEO would receive a cheque for $250K. That’s a $1,250K loss compared to working for someone else.
- The company needed to sell 75% of its shares to raise $3M. That means the CEO would have 1.25% of the shares yielding a cheque of $1,250K on sale. A loss of $250K compared to working for someone else.
- The CEO buys his shares. To purchase 5% of shares at the first investment rate, he would need to pay (approximately) 3,000,000 * 5% or $150K. So now he earns just $850K as a result of this venture.
- It took 8 years to sell the company instead of 5. That means the CEO would have earned $2.4M from his outside job. So only $100K less than working for the start up.
Of course, we have not added any premium for any of the other risks. In addition to the usual risks, there are additional risks that the potential CEO may want to consider:
- Shareholder objections. The current shareholders may reject or make it difficult to dilute their ownership of the company making it difficult to raise more capital. Further, sale of the company may fail completely because some shareholders may be determined not to take a loss.
- Culture risk. If the company has a history of burning through $3M and not sold any substantial products could this happen again? Are the right people (still) in place to sell the product? Are there customers waiting for the product with a cheque waiting?
- Product risk. Why is version 2 going to be so different and better than version 1 given that the previous idea was so good it raised $3M?
- Future trade sale risk. The proposed sale of the company presupposes a market large enough for players to buy this solution. Is the market really this big and will it still exist in five (or eight) years’ time?
It is possible to create an Excel spread sheet to express all the risks and returns directly but this is beyond this blog post – let me know if you’d like to see one.
Would you take up this offer? I didn’t. However, if I was offered 75% of the company and didn’t have to worry about the $3M already invested, I’d think about it!