You’ve likely heard of Elizabeth Holmes, the former biotech entrepreneur whose company was once valued at $9 billion. She dropped out of Stanford University to become Silicon Valley’s newest founder and CEO of Theranos, which was hugely successful. Her company focused on rapid blood testing; however, as we know, the entire operation was a monumental wire fraud scheme.
In 2015, she topped Forbes’ list of America’s Richest Self-Made Women with an estimated net worth of $4.5 billion and graced covers such as Forbes and Inc. Just two years later, Forbes revised that estimation to exactly zero.
Fraud, technology, and product issues aside, we will highlight the key reason why Theranos CEO Elizabeth Holmes went from billionaire to broke in such a short span of time. Additionally, we will explore why her net worth may have been saved from a company structure perspective.
How does 50% of $800 Million = $0?
Although Theranos is not a public company, Forbes states that external investors purchased shares in 2014 at a share price that implied a $9 billion valuation. In 2016, it was still worth $800 million, with Holmes possessing over 50% of the shares. The plummeting valuation means that her shareholding should, in theory, have been worth $400 million (as opposed to $4.5 billion in 2014). However, in actuality, it was worth $0 because she issued preference shares.
This guide provides key information on how to manage a business dispute as quickly and cost-effectively as possible.
Company Share Structure
Holmes could potentially have avoided becoming broke, but for one key thing: she was a ‘billionaire’ who ranked last in her own company.
Theranos issued both ordinary and preference shares. While Holmes owned over 50% of the company’s shares, they were all ordinary shares. As such, all shareholders with preference shares would, therefore, receive payments before her in the event of a liquidation event.
As previously discussed, the company is now valued at approximately $800 million. However, external investors injected over $720 million into the company in exchange for preference shares.
In the event of liquidation, preference shareholders, who only have a one-time purchase price preference, will receive a one-time payment of the money they invested. Additionally, they will receive their $720 million before ordinary shareholders (including Holmes) receive any payments.
Further, if the preference shareholders have a higher liquidation preference, they will be entitled to more than the $720 million they invested. For example, if the preference shareholders have a two-times purchase price preference, they will receive twice the amount they invested before the ordinary shareholders. If the company is worth just $800 million, in the case of a two-times purchase price preference, there wouldn’t even be enough to repay the preference shareholders what they are owed, and the ordinary shareholders would receive nothing.
Moreover, this is likely why Forbes estimated Holmes’ net worth to be zero. The liquidation preference attached to the preference shares in Theranos meant that her shares had no value whatsoever.
Continue reading this article below the formWhy should founders issue ordinary shares rather than preference shares?
The main advantages for founders to issue ordinary shares revolve around maintaining control, aligning interests, and simplifying the capital structure. The key reasons are as follows:
-
Aligned Interests: Issuing only ordinary shares ensures all shareholders’ economic interests are completely aligned – to drive maximum profits and company valuation. Preference shares can create misaligned incentives, where preferred holders focus on short-term exits or dividend returns over long-term value creation;
-
Maintain Control: Ordinary shares subject all shareholders to the same rights and voting powers based on their ownership percentage. Preference shares often come with additional voting rights, board representation, and veto powers over major decisions that can undermine the founders’ control;
-
Organisational Culture: A single class of ordinary shares contributes to an organisational culture of teamwork and equality. Multiple equity classes like preference shares can create an “us vs them” divide between shareholders;
-
Simpler Administration: Issuing just ordinary shares avoids the administrative complexity of tracking different rights/preferences. This simplifies actions like issuing dividends, share buybacks, future fundraising rounds, and exit scenarios; and
-
Future Fundraising Flexibility: An ordinary share structure is more attractive for later-stage investors who prefer a cleaner capitalisation table. Preference shares can deter future investors concerned about a convoluted and rigid capital structure.
By emphasising these factors, founders can make a case for issuing only ordinary shares if possible. Ultimately, it comes down to negotiating leverage and agreeing on investor protection through other means. This includes vesting schedules and veto rights. Often, investors will still request preference shares, which take on less risk. Therefore, you should assume a lower cost of capital that equates to issuing less equity than otherwise.
Key Takeaways
If you are a founder, avoid your company issuing preference shares if you’d like your 50% to equal 50%. If an investor asks for them, you should question how aligned their Interests are with yours. How much you’d like to spend on administration? Are maintaining enough flexibility for the future?
Focus on reality when raising capital. From an estimated peak net worth of $4.5 billion, Holmes is now serving over 11 years in prison after being convicted and sentenced to investor fraud. To find out how to avoid going broke like Elizabeth Holmes, check out our article, Elizabeth Holmes and Theranos: 5 Lessons for A Founder.
If you have any questions on how to set up your business or raise capital, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 1300 544 755 or visit our membership page.
Preference shares gives shareholders preferential treatment over the ordinary shareholders. One key difference is priority.
Ordinary shares carry no preferential rights. Similar to preference shares, they possess voting rights and rights to dividends. However, in the event a company goes into liquidation, preference will be given to preference shareholders over ordinary share holders.
We appreciate your feedback – your submission has been successfully received.
