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Concepts & Tutorials

The Right Sort Of Company

I write at Yahoo: The Right Sort Of Company

“Good Morning, Sehgal sa’ab”. It wasn’t a reference to Mr. Sehgal’s car. “Sa’ab” was short for Sahib, the equivalent of “boss” or “sir”. In any case, Mr. Sehgal had a Honda.

“Hello, Sudhir. Good to see you after all this time. Don’t tell me you have a tax problem”, said Sehgal, in a worried tone, wondering why a chartered accountant was always the guinea pig during tax return time.

“Not really, Mr. Sehgal. This is Rakesh Mannan. We want to start a company together. Tell us how. We’re going to make software for solar cars, and make loads of money. “

Good luck with that, thought Sehgal. Great ideas, and very little operational knowledge — however, crazier ideas have succeeded and you can’t let an opportunity go. So he started.

“So you have many choices — a partnership, an LLP or a private limited. A partnership is the least cumbersome, but you do have the issue that each of you as a partner has full liability”.

“What does that mean?”, asked Rakesh.

“Rakesh, if your partnership takes a loan or your company gets sued in court, each of you is, individually, liable for everything. That means your personal assets are on the line in case the partnership needs to pay and doesn’t have the money; and if Sudhir doesn’t pay, you will need to  pay the full amount, regardless of your share in the partnership.”

“But he won’t do such a thing”, said Rakesh.

“That’s not the point. Tomorrow you might add more stakeholders — will you have the same opinion? Will that person take on full liability of everyone? Partnerships are great for small businesses, but if you plan to do much more, you need to consider a Limited Liability option.”

“Ah, I see. No partnership, then. What are the options?”

“You can create an LLP or a Limited Company. These take a little more time, but I can turn it around in two weeks. The two concepts are similar, in that your liability is only to the extent of your investment in the company, and if the company is sued, you aren’t personally liable. A Limited company is better than an LLP if you wish you get, for instance, foreign investment or venture capital, and eventually list as a Public company on exchanges.”

“Limited Company it is. So what do we do? We have this great business plan, we know we need just five lakhs to start the business and I’ll put in 3, while Rakesh puts in two”, said Sudhir.

“That’s good. So you’ll create a private limited company — you tell me a name, tell me what you plan to do and I’ll work to register it. The company will have to issue shares. For five lakhs, at Rs. 10 per share, there will be 50,000 shares, and you, Sudhir, will get 30,000 shares, and Rakesh gets 20,000, in proportion with your investment.”

Sudhir thought this was nice, but was it right  to restrict stakes based on money invested?

“But the five lakhs is really the seed capital — over the next six months, both of us will put in a lot of effort, which is worth a lot more. How can we divide our capital accordingly?”

“You can alter shareholding based on effort, if you create a stock option plan that compensates you with stock. This is a more tedious process, and I would only recommend it if you want to bring in external investors. For example, you might decide to issue yourselves 10,000 shares each, every month, for your effort. In a year, your individual holding percentages will change, and will reflect more of your effort and less of the cash you initially invested. Remember your shareholding today will get diluted as you raise more capital tomorrow, and the percentages are likely to come down substantially.”

“Oh. So we can’t own this company anymore?”

“Well, there’s a difference between management and ownership. For example, if you manage the company, you can decide to pay yourself a very high salary. If you own the company, you want to keep salaries down so that profits are higher and you get better dividends.  When you let other people invest, you part with ownership, but usually not over management control. So there will always be a tussle between your investors and you on that note, but people have learnt, over years, that it makes sense for founders and management to have a significant stake in the company. And since you are starting off with such small amounts as 5 lakhs, if you aren’t getting a big stake, you can always quit and start a competing company with a higher stake. To motivate you to stay, investors need to give you a meaningful percentage.”

“But don’t investors require you to sign non-compete clauses?”, asked Rakesh.

Sehgal sighed. “Yes, but it’s very difficult to enforce non-compete restrictions in India. Investors might try but they know that it’s better to keep you motivated than to let you run away; legal agreements only make sense to enforce if you succeed.

Only novice entrepreneurs part with more than 50% equity in the first round of fund-raising. In fact, even in listed companies, you find that most founders or “promoters” continue to own a majority (or near-majority) stake in the business”.

Sudhir chewed on his pencil.

“That’s interesting. So we decide how the stake between us is split, and later, someone will put in money. I need to give that person shares, but at that time, I will have a product, and revenues; I might need 50 lakhs — but my share capital is just five lakhs! How does that work?”

“Once you generate revenues and profits the overall valuation of the company increases. Let’s say you generate 20 lakhs in profits, and using industry figures, you are given a valuation of 10 times profit — or Rs. 2 crores. If the number of shares hasn’t changed, it’s still 2 crores divided into 50,000 shares — or Rs. 400 per share. Remember, you bought in at Rs. 10 per share, and you have grown it to the Rs. 400 a share valuation without putting any more money. That’s the power of effort, and that’s how great companies are built — not by money alone”, said Sehgal.

Sudhir and Rakesh gave each other a look. Just five minutes into the conversation, they were worth 2 crores together. But it’s easy to be a millionaire in your dreams, they knew.

Sehgal continued, “Now you need 50 lakhs and your investor agrees to value you currently at 2 crores. That will add 50 lakhs of cash to your company, and you will issue him new shares at Rs. 400 per share, which is 12,500 shares. Now there are 62,500 shares in total. Each of you owns a little less as a percentage, and the new investor owns 20%”.

“So how does the investor make money? I can take a salary and get a return on my investment. Why should a non-involved investor bother?”

Sehgal got up to pace his room, a tactic he often employed when he was about to explain a delicate detail.

“Two reasons. One: you might be successful and give dividends to investors by sharing your annual profits, which can realize great returns on the initial investment. But this is no longer the preferred reason to invest at the early stage. The main reason is to exit at a high value. If I trust the founders, understand the market and believe in a product, the initial seed funding can multiply many times if things go right. You, for instance, might either get acquired by a big company that’s making solar cars, which gives your investors a great return. Or, you might grow big enough to get listed in the stock exchanges, through an IPO — this allows anyone else to come in and the original investors to sell.”

“Nice. That means we, as founders get to exit as well, even partially, I guess. But then, how does one list on a stock exchange?”

“If you choose to list yourself on an exchange, you typically make a public offer, where you offer the shares to just about anyone. There is regulation involved, and you will need to employ bankers and underwriters and have a great track record. With that, the greater investing crowd in the stock markets may see even more value in your shares, perhaps even 20 times profits, and the shares can be richly priced.”

“Like 4,000 rupees a share? Or 40,000?”

“Sure, but because people get scared of large numbers, listed companies tend to reduce the share prices through bonuses or splits. Imagine that when your company was worth two crores with 50,000 shares, you chose to issue another 50,000 shares for free to all shareholders, in the same proportion as current shareholding. Now the same 2 crores of value is  spread across 100,000 shares, which is Rs. 200 per share, versus the Rs. 400 a share earlier. This is how listed companies tend to make their shares look affordable.”

“But if listing is so great, then why doesn’t every company list itself?”

“Many don’t qualify. The regulations require either a good record of profitability or high quality institutional investors on board, plus approval of your specific offer. Then you need to reveal your financial details every quarter, and make sure the exchanges are aware of any large decision you take. And because you have shares listed, any material information needs to be revealed immediately. This could put you at a disadvantage in a competitive field. A number of companies use creative accounting that will not be acceptable in public markets.”

“Whoa. So if we’re clean, we are okay. But this is brilliant, Mr. Sehgal. Thanks for your help. Now to get back to making our solar car software.”

“All the best, Sudhir”, said Sehgal, wondering if he should ask for shares as his fee. The Honda is nice, but petrol isn’t getting any cheaper.

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