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, you are less likely to fall victim to public market pressures on share price, and you are essentially able to maximize the return to your bank account.
2. As efficiently run was 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 regarding access to cheap debt financing and their total access to capital is not going via a “crowd-sourced” public market equity financing. 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
That is relevant for several reasons. The most obvious is that you can easily dictate which portion of the profit is going to your bank account and which portion is re-invested. 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. In addition, the 10% above the 51% are a small leeway to get additional equity financing if needed and adding a potential new strategic investor into the mix.
4. 40% ownership of key investors
100% ownerhsip is bad, because you cannot the 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.
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 can leverage the diversification to 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.
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 oyu would just dissolve the organization and put things 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.
If you achieved this state, there are several comparables to your organization. One is the fairly well known Berkshire Hathaway 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. They are international and industry-diversified conglomerates held by small dynasties.
All those 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 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.