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July 15, 2017

Cash Call

It depends how things are structured, but generally a “cash call” means existing investors are required to add funding based on their proportional ownership and if they can’t/won’t their ownership % will decreased based on the amount raised from the other investors.
For example if we have three investors with Investor A having 70% of the company, Investor B having 20% of the company and Investor C having 10% of the company, to fulfill a cash call of $500k they would need to contribute $350k/$100k/$50k respectively in order for their proportional ownership %s to remain the same.
If there was a cash call scenario where only Investor A participated, then the ownership proportions would be redistributed based on overall capital contributions/withdrawals to that point. Basically Investor A’s 70% stake in the venture would increase while Investor B & C would see a proportional reduction in their ownership %s.
For funding with new rounds of investors it is a quite a bit more complicated because there are many permutations that are quite common, however, they are difficult to describe in just a sentence or two.
While I am not an investment banker nor an active CPA, some basic examples of secondary rounds of funding would be:
Scenario 1: Our three investors each put in their 70%/20%/10% for the initial capital round of funding (usually referred to as Series A) and they set aside a specific pool of ownership % that will be used to bring in new investors for later rounds of funding, generally at a higher “share price” than their contributions and while this will typically “dilute” their ownership %s, often times the new rounds of investors will come in a 3x, 10x or even 100x of the original pricing during Series B, C and even further down the alphabet.
Scenario 2: We again have our three investors each put in their 70%/20%/10% for the initial capital round of funding, only this time we have a caveat that Investors B & C can only sell their shares if a specific milestone or set of events is achieved. This leaves Investor A as being able to sell a portion of their ownership % at an exclusively set price point that is agreed to by the new round of investors.
For instance, maybe Investor A sells 10% of the company for $350k (i.e. the amount of his initial contribution) and based on various agreed upon rules set during the initial round of investing, he may be able to keep half of the proceeds, while the other half go into the investment’s general fund. This would then leave Investor B and C still at 20% and 10% of their funding, with Investor A now at 60% and new Investor D now at 10% (though he paid a lot more for his stake than the other investors).
Even though Investor A gave up some of his ownership, he also was able to monetize and now has 60% of the company having only invested $175k (his initial $350k less 50% of the sale of 10% of the company that was given to him as part of the introduction of Investor D).
Scenario 3: Perhaps there is a need for capital for a shorter time horizon (say 18-24 months to get the company through a growth period to a future point where they are generating an increased and stabilized cash flow). Often times one or two of the larger investors may “loan” money to the company at rates favorable to both themselves and the company. This would keep everyone’s ownership %s the same, but provide a new investment vehicle/opportunity for a couple of the current investors.
The difference between another round of investing and a cash call is usually timing. Finding new investors usually means a road show (aka going around to various banks, investing groups, “angel” investors, etc.) and selling ownership into the company (generally though not always at a higher price than what the prior rounds of investing have brought in for “share prices”). This can take several months or even up to a year depending on what type of demand/interest there is in the investment opportunity.
A cash call generally means “we need funding now” but that does not necessarily mean it is a dire thing. Yes, it could be because the company is struggling to meet their day-to-day obligations, but it could also be for a big upcoming capital expenditure or expansion that will take the company to the next level.
Let’s say the investment is a chain of stores and they want to build out a dozen locations as part of an expansion into the Southwest. They may do a “cash call” because they know several of their owners have the funds available to put back into the company and this is a quick way to get it done. Some of the owners may not want to or may not be able to afford to add more to their current investment, so they would likely see their ownership % decrease, while those participating in the “cash call” will see their ownership % increase.
Hopefully these examples help provide a better understanding for the various terms that are being bandied about right now in the DFS world.
EMac

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