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The Finance of Startups: For Dummies (Part Cinco)


In November of last year, I’ve taken upon myself to get more comfortable and knowledgeable (dare I say, “dangerous”) in the world of finance, especially in the realm of startups and entrepreneurship. Take those two things I’m passionate about (startups and entrepreneurship) and layer in a subject I know little about and am… uncomfortable with.

Every month since November, I’ve published a post touching on 3-5 financial concepts ranging from vesting options applicable if you get that offer letter to join a startup to issuing different types of stock like common, preferred, etc. if you’re looking to raise money from a VC as an entrepreneur. I don’t necessarily have a set “path” or “course” through concepts. Instead, I just rely on the things I don’t know or what I read about, and I tackle the concepts from there.

It’s been a fun, humbling, highly informative experience so far. I’ve been reading more news about startups, funding events, offer letters, etc., and I actually know what the authors are talking about! Haha, yes, it’s been fun. Soooo, today, I’ve got my 5th installment of Finance of Startups!

Today’s topics include:
  • Board of… People (Advisors/ Directors)
  • Leverage(d)
  • Par Value

Board of... Advisors vs. Directors

Visit webpages of many startups’ “About Us” pages, and you’ll likely see a group of highly distinguished people grouped either as Board of Advisors or Board of Directors. Do you know the difference? No worries – I got you.
  • Commonalities – Both Boards are made up of a collection of highly knowledgeable, connected, and diverse individuals whose goals are to really help the company succeed. Ensuring all parties’ interests are aligned, Boards are typically compensated with equity on a vesting schedule; though, commonly in startups during funding rounds, Board of Directors may invest in the company (more on this later). Both Boards work at a higher/ strategic level rather than the day-to-day which is left to the management team (CEO, COO, etc.)
  • Board of Directors (BoD) – Provides a collective, broad, strategic vision. Directors have legal requirements and fiduciary duties to the company’s shareholders – meaning they are acting in the best interest of the shareholders – relevant as one of the primary abilities of shareholders is the vote and appointment of members of the BoD. The BoD typically grows with funding rounds as invested interests may want additional direction of the company via the appointment of representative. Also, corporations (C-Corp, S-Corp) are legally required – not so in limited liability companies, partnerships, etc. The BoD is also typically guided by a Chairman.
  • Board of Advisors (BoA) – Made up of specific experts who help mitigate risk that may arise. As such, Advisors are called upon rather infrequently or when a particular needs arise. Well, unless the Advisor is a wicked brilliant entrepreneur which the startup itself may lean on to provide guidance for growth. Both, the startup and the Advisor, may go this route (vs. the BoD) because of the legal ramifications, investment obligations, if any, etc.

Leveraged

The term “leveraged” is used to describe a company’s risk in debt vs. equity (debt-to-equity ratio works, too). Recall from the PART 2 Lessons touching on equity financing and debt financing.
A highly leverage company has a high percentage of debt financing in relation to equity. As debts must be repaid at some point as well as interest being a fixed cost, the costs of the company are much higher (simplistically). If the company was to go under, its assets would likely be sold to satisfy as much of the debts as possible first before any disbursements to shareholders.

So if debt drives up costs and if the company goes under, its assets are liquidated to satisfy the lenders first… you see why there’s more risk for a highly leveraged company? Okay, good. 

Par Value (for stocks)

So “par value” actually arose from recently looking at Etsy’s Form S-1 as they’re seeking an IPO.
Par value is more commonly referred to in relation to bonds, but I’m going to stick simple here since I’m talking about Etsy’s S-1. That is, the issuance of stock.
Snapshot from Etsy's Form S-1 filing
In gist, par value (also known as par, nominal value, and face value) refers to the original price a security is issued. In the case of stocks, companies typically issues stock at a very, very small par value (like Etsy’s S-1 shows above) or no par value at all. This enables Etsy to limit or avoid altogether liability should its stock drop. For example, if Company Not Great issued stock with a par value of $10, and its stock started trading at $5, then it would technically be liable to the shareholder at $5 per stock!

Simple, right? Par value for stocks à very little, or none to limit liability. For bonds, par value works with a coupon rate to determine fixed annual payments. Well, I’ll talk about bonds in Part 6 next month that will be more technical, but hopefully, easy to understand.

Conclusion

Keep on keepin’ on, as ­they say. I’m six months into learning finance, and luckily, it’s such a big, complicated subject that there’s still so much to learn.

Next month’s installment, I hope to touch on bonds, for sure, especially given how lightly I touched on “par value”. Perhaps I’ll also share some insights from the Etsy S-1 as I’m still poring over it. If there are other concepts or questions you have, feel free to send them my way!

Resources: http://www.vcdeallawyer.com/2009/11/28/board-of-directors-vs-board-of-advisors/, http://www.forbes.com/sites/ryancaldbeck/2014/04/17/advisors-versus-directors-how-to-build-better-boards/, http://smallbusiness.findlaw.com/business-finances/debt-vs-equity-advantages-and-disadvantages.html, http://www.investopedia.com/terms/l/leverage.asp, http://www.investopedia.com/ask/answers/106.asp

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