How a $200 Million Profit Could Quickly Become a Loss

By Wayne Mulligan, on Friday, August 23, 2013

Jumptap just sold for $200 million!

The breaking news about Jumptap, a mobile advertising company, came to me by email.  It made me smile. It’s not every day that an early-stage company sells for 9 figures.

And with a $200 million sale, the investors must have made a fortune!

I mean, surely the people who put in the first dollars of risk capital would make out like bandits, right?

Actually, the answer is this: “It depends.”

Don’t Believe The Hype

It’s easy to get sucked into all the hype surrounding start-ups.

Companies getting acquired for hundreds of millions of dollars, or going public for billions – it’s definitely an exciting time.

But don’t let the headlines get to you. All that bold print doesn’t necessarily mean the investors made money on a deal – especially the earliest investors.

Let’s take Jumptap as an example…

By The Numbers

One of the best resources for digging into the details of a start-up is Crunchbase. It’s a database powered by the prominent technology blog, TechCrunch, and it outlines the key people, milestones and financials of early-stage companies in the tech sector.

If you visit Jumptap’s page, you’ll see they’ve raised multiple rounds of financing over the years.

$4 million in 2005, $17 million later that year, $22 million the next — and the list goes on.

That’s normal. When a company continues to grow, even when things are going really well, they typically need to raise additional rounds of capital. And for every new round they raise, they have to issue new shares.

The thing is, when they issue new shares, the percentage of the company owned by early investors becomes proportionately smaller.  This is known as “dilution.”

On top of that, as new professional investors come onboard, they often demand preferential payout rights.  Basically, if and when the company gets sold, they insist on getting paid first. Their shares are “preferred” shares.

There’s nothing wrong with that… unless YOU own “common” shares.

Let’s go through a hypothetical scenario with Jumptap to make the point more clear.

Splitting Up the Pie

Let’s assume in this scenario that the first investors in Jumptap were individual investors (not the Venture Capital firms that actually invested in the round).  Let’s say they received 20% of the company for their $4 million investment.

Let’s also assume that each subsequent round of funding entitled investors to 20% of the company.

Jumptap had 5 more rounds of financing, totaling roughly $118 million.

This would have left the first round investors with roughly 7% of the company at the time of sale.

If everyone were splitting up the pie evenly, the early guys would receive roughly $14 million.  $14 million for a $4 million investment over 8 years isn’t half bad – that’s a 17% return per year, even with all the dilution.

But that’s usually not how it works.

Common vs. Preferred Stock

You see, the earliest investors in the company are generally given common stock instead of preferred stock, especially if they don’t have a lot of experience with early-stage investing. And in some cases, the guys that own preferred stock - specifically, “participating preferred stock” - not only get their percentage of the profits when the company is sold, they also get to take their initial investment off the table before splitting up the pie.

So if Jumptap were sold for $200 million, $118 million would get paid back to the later stage investors first.

This would leave $82 million on the table for everyone to split up.

The early investors would receive 7% of that, or $5.74 million.

While a profitable return, it’s only 5% per year when averaged out over the 8-year holding period.

You can get a return like that in the stock market, even the bond market. From a risk-reward perspective this would’ve been a lousy investment for Jumptap’s earliest investors.

And what if there were even more dilution?  What if the early investor group was diluted down to 4% or 5%? They would have LOST MONEY on a $200 million sale!

Prefer Preferred

Don’t get me wrong: there’s nothing wrong with a 5% return.  But with early-stage investing – where so many companies you invest in won’t succeed – when you get a winner, you need to get a big winner.

So do your homework before you invest in an equity crowdfunding deal. Make sure you’re getting preferred stock.

Sometimes, it’s easy to see what type of stock you’re getting, other times you have to dig a bit deeper.

For example, when my co-founder, Matt, invested in GameCo. last month, he actually had to call the crowdfunding platform and speak to their general counsel to find out whether or not the deal was for preferred or common!

So dig deep.  Explore the deal terms. Look closely to see if you’re receiving preferred stock or common stock. Whenever possible, you want preferred!

The returns for private investing can be tremendous – but only if you’re well prepared!

Best Regards,
Wayne Mulligan

Founder
Crowdability.com

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