I want to kickstart this series on the fundamentals of business as to guide entrepreneurs into the decisions they have to make if they want to become successful businessmen. The best way to tell this story is to start with the best possible outcome of their endeavour, a fully privately owned MNO with billions in revenues in which they as solo founders control more than 50% of the company. From that outcome as a key goal, one can understand why young companies typically do not end up here and one can explain the challenges entrepreneurs and businessmen are facing in our modern world. As a side efffect, one learns about the essence of equity financing and the structure of todays innovation ecosystems.
The end game
So let’s start with the end game scenario. Ideally, you are ending up with the following set-up.
1. A privately owned company
Because privately owned means there is less regulatory overhead creeping into your G&A – compliance, processes, auditing, investor reporting, yada yada. The lack of liquidity for your shareholders means a lower sensitivity of your share price to your decisions, which means your strategy can focus on long term goals a bit more reasonably without putting your equity position at risk, increasing your ability to lever your company for growth if you have decently stable profit and cash flow patterns and your company remains well managed.
So you are essentially able to maximize the return to your bank account. Being better at processes than your publicly listed competitors at lower cost due to lack of overhead from “no-value add” activities. Of course, at the sacrifice of potentially less ideal debt financing conditions. After all the liquidity and market pressure increase your debt ratings.
2. As efficiently run as a public company
The challenge of the privately held companies is that they are more likely to have inefficient management, they suffer from worse conditions. As mentioned, access to cheap debt financing is worse. Access to equity financing is worse, due to lower liquidity and hence lower total market for financing – due to investor appetite. But at the same time, the sophistication of your private investors that provide equity goes up. Good thing. But of course, that is also a downside if you want to raise massive equity-based financing for a risky strategic endeavour. You cannot use hype and good PR to create a hype that lures tons of unsophisticated investors into your stock. That is a challenge, especially when raising capital to finance a completely new segment with massive capital expenditure up front.
3. 60% ownership of the founder
In the ideal world, your ownership in the company is very relevant. Ideally, you might say, you own 100% of your company. So 100% of profits that are not re-invested go to you. You can buy yourself a boat or invest into other opportunities with better return profile. But even below 100%, if you hold a majority, you can pretty much define what you do with profits. Are you re-investing or distributing to yourself. This makes the investment more liquid. Dividend policy changes in public companies don’t work so well, since all investors rely on the liquidity stream and ROI based on stock price and dividend policy. Stupid to lose 30% of investors if you cut dividends because they wanted that cash and now your share price drops 15%. Ooops.
Even more important, we talk about you. Not you and your co-founder. Because you are the sole owner of the stake, there are no coordination issues among several founders/owners and it is clear who owns and runs the company. That is clear control and power.
But then, being below 100% and having others invest in you, gives you the chance you lobby, add value-adding investors and so forth. As long as you retain 60+% to retain a lever – better 60% than 50% – in case you want to release new equity to get new money in, you won’t lose your control.
4. 40% ownership of key investors
As mentioned, 100% ownerhsip is or may be bad, because you cannot tie the interests of key stakeholders of your company to the success of your company. Having 40% of your equity allocated to people that help you organization navigate lobbyism, industry relationships, politics, market and industry entry strategies is one thing. Having them oversight your privately held company and being a critical advisor to your business strategy is another thing. Diversifying ownership of your company to very important individuals is a key element here. The only reason you should own 100% if there is truly no smarter guy to put into your shareholder mix than you or you get those smart guys to help you without having an equity stake. Maybe if you buy their kids boats or college admission. In that case retaining your equity might be a bit simpler. But then, again, there are some very smart people that don’t like this kind of behaviour and prefer the steak – or equity stake – to the pop/beverage – the bribe / favor. Just make sure those shareholders are indeed smarter than you and add value to your game plan and network.
5. You are a diversified MNO
This means you are not relying on any particular business branch to be the cash cow of your organization and if supplier or buyer power increases in one segment, you can shift focus on more attractive markets. You are not bound to local regulation and political power and can shift capital around the globe to manouver around threats from politial and economic instability. Instead, you can re-shift capital allocation of your organization to new regions, tap into regulatory and political opportunities and so forth. And you are overall an organization with more stable and consistent cash flow generation, which makes planning and financing more attractive and cheaper. That overall might sound a bit boring. But that cross-regional and global approach is also a hard to learn skill and having that as a security in your portfolio is a very strong defensive and conservative tactic. Just saying. Plus you get around and have a reason for a jet.
6. Your return profile exceeds comparables
Of course, you organization is only interesting to you or your investors if the returns generated are more lucrative than an investment into an alternative. Otherwise you would just dissolve the organization and put your money into a set of different investments in case the total amount of value you hold is too large to alocate it in a single entity. You should of course not choose one strategy over the other because you suck at the specific other alternative. You should know investing and operating an MNO. Otherwise you are an idiot that just simply does things because he is not capable of doing other things. That is generally bad and a last resort.
If you achieved this state, there are several comparables to your organization. Meaning there are some people around the globe that already managed to do the same. One of them is the fairly well George Soros. Operating form his Berkshire Hathaway vehicle that started as an investment company and is now a massive conglomerate. Another classic example are the Chaebols in Korea and old family owned businesses in Japan that mix their investment portfolio in putting money into good family offices and binding capital into their MNOs. They are international and industry-diversified conglomerates held by small dynasties. And yes, if you are not confident in raising good kids, investments are maybe better for your. Without good succession, there is really no reason to build a privae corporate empire. Just invest in Bitcoin.
All those big companies started small in the beginning. Their owners navigated the global financing environment well, they managed to build cash cow after cash cow by capitalizing on their core competencies. Berkshire started as an investment company. Samsung and Mitsubishi started by specialized consumer goods, Thyssen and Daimler started as heavy industry manufacturing businesses.
But why is Twitter, Facebook, Google and Apple public? Why did they choose venture capital based financing? How did they end up as non-privately held companies? Is the time over for privately owned companies? Are the market forces and the need to take markets fast now requiring equity financing? Did equity financing such as Venture Capital manage to control a market-entry resource that wasn’t controlled prior to their existence? Or did the East India company as first big success stock company prove as such a lucractive model that public equity market based financing was deemed as a more attractive route of developing a company? Is it maybe, that the interest of the company warrants equity financing, and it is only the dillusional dream of the individual founder that holds on to the wealth and power that makes refusing equity financing a viable option?
I think the trend is clear. In the end game, a public company with a very diversified investor mix of active and passive investors and strong regulation of the market is good for debt financing which pushes the NPV of every project by reducing the cost of financing. The higher the share of non-value-add investors, however, the more likely the company is giving its valuable return on equity to people that do not deliver value to the company. And the entire idea of having interests of investors tied to the company performance as to leverage access to their resources and networks is being diluted. If the company in its own respect is strong and powerful enough to open all doors it needs to open, and the market mandate that it has – such as Apple and Google – is clearly defined, no risky endeavours in long-term repositionings of the company are part of the strategy, public companies are an attractive means. But that does not give any guidance on how founders should look at the equity financing game. They must aggressively be hostile against any equity financing that isn’t paying its due to the company on its long-term growth and stability potential. Which is why getting financing from a tier 2 or tier 3 venture capital fund is a very bad option.
The story line
This article is only the entry point to a series that explains challenges of entrepreneurs and the story line is that equity markets and business can and should be understood as an attempt of founders to build a privately owned MNO as described in the end game. Only with this mindset, the market inefficiencies and challenges the entrepreneur faces become visible and the cost of equity becomes transparent in its full dimension.