ShmoopTube

Where Monty Python meets your 10th grade teacher.

Search Thousands of Shmoop Videos

Principles of Finance: Unit 1, The Sauce Kings 11 Views


Share It!


Description:

Why do Artie and Bernie get common stock, but Reid gets preferred stock? What's the difference, and how will this affect their friendship?

Language:
English Language

Transcript

00:00

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

00:06

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

00:12

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

00:16

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

00:21

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

00:27

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

00:33

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

00:38

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

00:43

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

00:47

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

00:52

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

00:57

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

01:02

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

01:07

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

01:12

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

01:18

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

01:23

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

01:27

the company or disposed of another way right?

01:29

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

01:33

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

01:38

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

01:43

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

01:46

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

01:51

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

01:57

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

02:02

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

02:06

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

02:11

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

02:15

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

02:19

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

02:24

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

02:28

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

02:32

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

02:36

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

02:40

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

02:45

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

02:49

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

02:53

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

02:59

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

03:03

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

03:08

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

03:13

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

03:19

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

03:23

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

03:27

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

03:31

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

03:34

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

03:39

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

03:43

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

03:48

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

03:52

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

03:56

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

04:01

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

04:06

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

04:09

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

04:12

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

04:18

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

04:23

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

04:26

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

04:30

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

04:35

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

04:40

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

04:43

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

04:47

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

04:51

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

04:55

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

04:59

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

05:04

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

05:08

private company it'll have these obligations but in

05:10

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

05:14

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

05:18

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

05:23

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

05:27

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

05:31

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

05:35

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

05:41

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

05:44

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

05:48

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

05:52

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

05:57

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

06:01

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

06:05

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

06:09

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

06:13

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

06:18

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

06:23

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

06:28

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

06:33

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

06:37

hundred times the price next week/ how can this be

06:40

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

06:45

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

06:50

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

06:55

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

06:59

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

07:04

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

07:08

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

07:12

to be printed over time for other investors.

07:14

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

07:19

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

07:24

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

07:29

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

07:33

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

07:37

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

07:42

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

Up Next

GED Social Studies 1.1 Civics and Government
39794 Views

GED Social Studies 1.1 Civics and Government

Related Videos

Fake News
11938 Views

How do you tell fake news from real news?

Finance: What is Bankruptcy?
260 Views

What is bankruptcy? Deadbeats who can't pay their bills declare bankruptcy. Either they borrowed too much money, or the business fell apart. They t...

Finance: What is a Dividend?
1777 Views

What's a dividend? At will, the board of directors can pay a dividend on common stock. Usually, that payout is some percentage less than 100 of ear...

Finance: How Are Risks and Rewards Related?
589 Views

How are risk and reward related? Take more risk, expect more reward. A lottery ticket might be worth a billion dollars, but if the odds are one in...