February 28, 2000

Stump the Geeks

Section: Connect
Edition: Final
Page: D8
Estimated Printed Pages: 3

Index Terms:
hi-tech
Letter

Article Type:Letter

Article Text:

Q. Last week, in the second part of a two-part question a reader asked "What happens to large sums of money that are invested in companies that do not make it? Do they lose those millions they invested?" Geek Paul Jones decided a fuller explanation of investments was in order. His answer follows.

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A. A wonderful, sad and true song by John Prine, "Sam Stone," has a chorus which begins, "There's a hole in Daddy's arm where all the money goes." Prine was singing about real money and real people in real pain. But when we talk about money invested in Internet companies, we are talking about value, which is not the same as money - quite.

Let's assume that you and I start a company to do Internet commerce, selling pineapples. We each put in $10,000 to get our company going. This is real money. We each own half the company. Value = $20,000.

We get set up and quickly dominate the net.pineapple realm. We decide to go to the next level. We call in an analyst to assess the value of our company. She rates the value at a half million dollars based on our position in the market, our past success record and our market potential. Value = $500,000. Actual cash available = less than $10,000 after start-up expenses and some minor income from pineapple sales.

We each own a value of a quarter million dollars in the company, but we need cash. We now offer 10 percent of the company's stock and a seat on the board of directors to a parade of venture investors and hopefully to at least one angel.

We get no angel, but we do attract some savvy venture capitalists.

The VCs want their stake back in 18 months with what they hope is a good appreciation on their initial investment. They also want an opportunity to stay invested or increase their involvement if they choose. But they aren't interested in only 10 percent. They ask for 35 percent, two board seats (which will actually be valuable if they're filled correctly) and an opportunity to appoint at least one officer, specifically the chief financial officer (since neither of us has an accounting background). Our company's value increases after the money and the involvement of the VCs is announced. Value = $750,000. Actual cash available = $175,000 from the first round of VC investment and none left from our initial start-up contribution, as we've spent all our original cash getting the company going. You and I each now own 32.5 percent of the company.

We start running to increase our value so that we can pay off the first-round VCs in 18 months when they plan to sell their portion of the company. We can go for either greater market share or greater income or greater profit. Knowing the current climate, we opt for greater market share and spend the new cash like crazy. We advertise on the Cooking Channel. We fly pineapple reporters to the Pineapple Park in Hawaii. There we announce a new partnership with a famous beverage maker. We have nice tans, but we've burned out all our cash. Still, our value increases - in the eyes of the analysts - to $15 million.

Our VCs decide to stay but want us to raise more cash. This time we offer only 10 percent and stick to that number even though it costs us another seat on the board. The new VCs and the old VCs name an experienced president. Our value increases to $25 million. Our cash influx is $1.5 million but we were already in debt due to the Hawaii project and a big commitment to our beverage partner. Suddenly, pineapples get bad press. Howard Stern blames his divorce on them. (I can't explain in a family newspaper.) Our sales, such as they were, die out. Our beverage partner exercises an escape clause in our contract. Our value drops to $1 million and continues dropping. We each own less than 30 percent of our company. Our cash is vanishing. Where did it go? To pay for our cost of business and our wonderful Hawaii project.

Our venture partners decide to sell out. We guaranteed their stock price such that if we were to shut down the company immediately, we'd each only have $5,000 in hand. Value approaches zero now and is dropping. Cash is also vanishing.

We both blame each other for what happened. I suddenly give up my seat on the board to someone to whom I owe money based on a loan I took out when our value was high. I now own my home outright and am out of the company.

The board strips the company's assets to pay everyone off. You get nothing but an office chair. Our name and the remaining furniture are sold to another company held by our VCs for a small amount of stock; we get none of that stock.

You've lost $10,000, your self-confidence and 18 months of your life. The investors have spread out their losses, so that even though they collectively dropped more than $2 million, they made it back through an investment in Prunesthatmove.com, an elder-focused health site.

But we have great tans, great experiences and are on our way to start new companies. If only "Sam Stone" had had it so good.

Copyright 2000 by The News & Observer Pub. Co.

Record Number: fqnfru89