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principles of finance. a la shmoop. the sauce Kings. common versus preferred

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stock. and a few other flavors of shares thrown in for rest spice. yep we're back

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to the sauce Kings. let's see how things are looking for them Artie and Bernie [Artie and Bernie in the kitchen]

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shake hands with Reed but then notice something odd in the contract. reads

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$500,000 buys a different class of stock than the stock that Artie and Bernie own.

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hmm well Reed stock is preferred and while theirs is just common. feeling

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gently insulted they ask Reid about this and he explains that this flavor of

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preferred stock doesn't pay a dividend and has no fancy terms really. in many

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venture deals preferred stock at this stage will carry other terms usually

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favorable to the investor. the most common of which is liquidity preference

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multiples. for example for a 2x lick prep the investor gets double his money back

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before the common shareholders get a dime. in this story Reid owns convertible

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preferred stock and the founders own common stock. so that means when he wants

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to Reed can convert his preferred into common. also in most cases and especially

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in public firms preferred shares don't vote or have any pre-emptive rights like

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anti-dilution provisions, and like us for food stocks don't mature. they just sit

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there paying out dividends twice a year until they're called ie bought back by

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the company or disposed of another way right?

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so as Reid points out since he's risking his own cash and has little control over [amazon tries to eat the sauce kings]

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the day-to-day operations of the business he deserves to get his cash out

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preferentially before they do. it's the only protection he has though you know

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that's it if things go great well then who's prefers convertible into common,

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like at an IPO, or if they sell the company to Google, and then everything is

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all the same common flavor of stock but if things go awry and Reid must step in

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and liquidate the company, because Artie and Bernie missed their profitability target

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numbers and have to raise more money diluting themselves and diluting Reid

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well then Reid should have a preference over that right? if bad things happen in

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Reid can sell the company for only 3 hundred a grand well then Reid keeps all that [pie chart]

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300 grand. he still lost money. by the way Artie and Bernie well they get nothing.

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if Reid can sell the company for only 600 grand and some eBay style auction

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well then Reed gets back his full 500 grand first, then of the remaining

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hundred grand while the guy, split the proceeds a third third third.

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alright well Reid wrote a sharp term sheet he's done this before. the claim

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that the common stockholders would have against this kind of liquidation is

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called a residual claim to assets. its last thing the breadline soup kitchen

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should things go awry that's common stock. well Artie and Burnie consider

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the various options and recognize that Reid is one smart cookie. the first thing

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he points out is how poorly the portable barbecue business scales. it requires

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huge amount of labor, it can't operate on rainy days, it carries all kinds of risk

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of an explosion or a customer burning himself on the grill and other possible

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disasters. right? Reid suggests they put a barbecue set up in the top thousand [flaming BBQ]

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malls in the country just so that the smoky smell of their awesome sauce acts

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as a marketing agent. the way mrs. Fields Cookies did in the 80s the baking

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chocolate smell in those days filled the air ducts and the halls of malls and

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lured people to the kiosks like mosquitos to that little buzzing purple

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light thingy. well the guys thought wow what a great idea.

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and they agreed to just bottle the sauce and sell it as their only product the

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same way wd-40 and well really Google is a one product company. Artie and Burney

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dream a bit and realized that as young 21 year olds well they have more greed

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than fear about this opportunity. they think that there is a company worth

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millions in here somewhere and they want to ferret it out. well at this juncture

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the guys shake hands and assess their situation. consigliere hy does the legal

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work to create the sauce company corporation out of thin air by filling

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out a few forms with government and registering the company in Delaware.

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forming the sauce company into a corporation is a really good idea

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because it protects Artie burney and bubby and likely anyone else remotely attached

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to the company from liabilities arising from say a bankruptcy. if company went

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bust only its assets would be lost the assets [bankruptcy defined]

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from a A and B's bar mitzva savings would be left intact. like lawyers couldn't

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touch it. this is called limited liability and it's good if you're a

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founder owner and it exists to protect founder owners from you know getting

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sued into it living in a station wagon or something. there's a fair amount of

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record-keeping that must be done here how many tons of onions will be bought

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how much will they will cost how much will be collected from the sale of sauce

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bottles to Safeway etc. well a and B know that if they produce great results in

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some day go public ,well they'll live under the scrutiny of public investment

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regulators way stricter than private ones and we'll have to annually produce

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conforming financial statements give lists of stockholders and so on, as a

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private company it'll have these obligations but in

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order to go public in the future well they'll need to have an auditable trail

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of years of Records. so Reid's advice is heard they start the record-keeping now

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the company high creates has a million shares outstanding at first which he

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normally sets as being worth one penny each . Artie and Bernie by five hundred

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thousand shares each for five grand they made this much just from their one

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barbeque stand. in the three months during which it operated. they are the

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founders right ?that penny a share is the initial par value of the stock. it really

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doesn't mean anything for future investors but there needs to be some [man in checkered suit]

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value assigned to that stock when a company is formed. that term by the way

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also has nothing to do with golf. for par value stock you get a pretty piece of

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paper that's supposed to feel like it was printed on the McCobb dead skin of a

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sheep .it's called the stock certificate. but the company sold read convertible

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preferred stock for a buck a share. well the preferred is worth way more

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than the common at this point but the common is clearly worth more than a

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penny. so what's it worth? a nickel a dime? well the company will have to place a

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value on that comment at some point with the help of the bank's lawyers. to 409a

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evaluation that's what it's called 409 a/ if it's a nickel well then the four cent [409a valuation defined]

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theoretical gain is now a balance sheet asset yay for them they have assets/ and

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it's called paid in capital or capital surplus/ yep something like that /all

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right well then a and B turn around and sell the preferred stock to read at a

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hundred times the price next week/ how can this be

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you may reasonably ask? well the odds of the sauce company going bankrupt at this

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point are extremely high. if it does there really no assets to sell. so it is

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in fact reasonable that the common stock is worth a small fraction of what the

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preferred stock is worth. at this point anyway the dream of Dreams in times gone

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by is that while someday the two classes of stock convert into that one class and

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that common truly does become worth about to share. the company realizes that [common and preferred stock pictured]

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it will need to raise more capital over time and that many more shares will have

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to be printed over time for other investors.

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so it has authorized another 10 million shares to be printed in the future.

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they're just authorized or like provisionally optionally okey dokey that

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is if company needs to bring them out of the back vault of buddy's garage it can.

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but while they sit there they mean almost nothing as far as valuation or

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ownership of the company goes. they're that nerdy guy who watches Star Trek on

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DVD Saturday nights if ever needed he's a phone call away from being a drinking

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buddy or a date you know depending on your persuasion. [man answers phone]

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