Minority Shareholders, Revisited

A friend of mine finally resolved a longstanding situation in which he was involved, and I thought I'd revisit a commonly queried subject of mine--buying shares of stock in startup companies.

During the Dot Com bubble, my friend, and many other intelligent, financially astute professionals, were talked into investing in a startup corporation. What it did or was supposed to do don't matter for the purposes of this discussion, but recently, the corporation was bought out by a larger company. My friend received five cents on the dollar for his investment, and by the time it had arrived, was happy that he even saw that much of his money back--he'd resigned himself to having lost it all.

The purpose of this blog is not to speak to that company's business plan, or why the business never really took off. However, in retrospect, my friend's experience demonstrates a cautionary tale for investors who are buying minority shares in a startup company.

1. Understand what you're buying into. Ok, in the strictest sense, this isn't legal advice, but it bears repeating. At the time this company was started, technology companies were the rage, and everyone wanted to be a part of a new tech startup that "took it public" (sounds like the recent "flipping" craze, doesn't it?). I listened to my friend and other investors describe the company's goals, but I never could understand it--and I don't consider myself too terribly slow. What I heard were lots of big academic words, such as "shifting of paradigms," but I never was satisfactorily told exactly WHAT the company would do. Looking back on it, I'm not sure my friends understood either. If you don't understand what it is the company is supposed to do, I'd submit that you shouldn't invest in it.

2. Understand what it means to be a minority shareholder. Being a minority shareholder means that, unless specific safeguards are put into place, you have very few rights. For example, you can't force the sale of a company, you can't get your money back upon demand, and you pretty much have to do what the majority dictates.

3. Understand the value of stock offered. Let's say this startup corporation issued 100,000 shares, each of which were valued at $1.00. Pretty simple right? You put in $25,000, and you own 25 percent of the company. Except you might not. Unless a shareholder's agreement is put into place, there's no restriction against the company issuing additional stock. Stock can be issued when needed to bring in additional money. For example, using the above example, if the corporation needed another $100,000, it could issue 100,000 more shares. But what if some of the shareholders were issued shares because they were the startup engineers (i.e., the "idea men")? What if, even though your stock was valued at $1.00 per share, the company issued 100,000 shares to monetary investors, and then 200,000 shares to the two guys who thought up the idea, yet put no money into the company. That simple math can show you that the company would take quite a bit of growth before the stock you had might really sell back at $1.00 per share. Worse yet, what if the two original startup guys decided to issue more stock--to themselves? They might be able to do it--they're the majority, after all.

When buying stock in a startup company, understand the real value of the stock--in other words, is its value initially diluted by investors who are holding stock but have contributed no money or assets? Can the stock value later be diluted by the issuance of additional stock without your consent? Think about these things. In the case of my friend, the only person who appears to have profited from the corporation was the "idea guy," who'd issued himself so much stock with having placed a minimal amount of money into it that, even being paid a nickel on the dollar, he has profited well.

4. Understand what it means to own stock that's not publicly traded. Lots of stocks on publicly traded exchanges gain and lose value every day, sometimes because of the poor acts of the officers or directors. However, when you buy publicly traded stock, you know that, at the very least, you're not captive--you can sell your stocks on the open market for whatever price it will bring. However, when stock is in a very small company and isn't publicly traded, you may simply be stuck--as my friend was. He knew for years that the company was doing poorly, and simply had to watch as the value of his stock went down the drain.

There's nothing wrong with investing in a private startup company--in fact, I've both invested and started such companies. However, at least understand your rights when you invest!