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Phil Haslett June 21, 2014
I always find it easiest to boil businesses down to lemonade stands.
Lemonade stands are simple business structures. They have very few inputs (ice, sugar, lemons) and really only one output (lemonade). Profit calculations are therefore easy (Profits = Sales - Ingredients - Labor).
Sensing an opportunity, you've been keeping track of the number of people walking past your front lawn every day, staring at your precious lemon tree. You're onto something.
Being the budding entrepreneur you are, you talk to your wealthy Uncle John. You tell him that you want to launch your new venture, Larry's Lemonade. You need some money to purchase ice and sugar. Would Uncle John be interested in investing in Larry's Lemonade?
Uncle John happily agrees to invest, but he asks that you agree to a few of his terms:
Eager to finance your venture, you agree to Uncle John's terms. After all, you're now the proud owner of 60% of a $125 lemonade stand, with $50 to burn!
Three months later, business is booming. You've earned a reputation as a sterling provider of chilled beverages on your street. A rival refreshment company, Polly's Popsicles, offers to buy your business for $200 in cash. After talking with Uncle John, you both decide this is a great valuation for Larry's Lemonade. You take the deal.
Congratulations, entrepreneur! Your first company sale! Let's see what happens to your 60% equity stake:
First, we have to pay out the Preferred Shares. John, as per his terms, is entitled to up to 2 times his initial $50 investment:
Cash Proceeds: $200
Less: Preferred Shares = 2 * $50 = $100
Balance remaining for Common Shares: $100
John's 40% stake = $100 * 40% = $40
Your 60% stake = $100 * 60% = $60
Sixty bucks. That's it?
But wait: didn't you own 60% of Larry's Lemonade? And didn't it get sold for $200? Shouldn't you be getting $120 (60% * $200)? Where did the remaining $60 ($120 - $60) go?
This Larry's Lemonade story is not uncommon. Apart from avoiding awkward conversations with investor family members, the lesson learned here is that as a private company shareholder (owner or employee), you likely own equity that is lower on the totem pole than that of your investors. It is important to understand this discrepancy. Communicate as best you can with the folks in the know, your employer. Ask questions like:
And just remember, the money's not always in the
banana lemonade stand.
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