13. Importance of the prospectus.—Whether the stock is sold to large investors or to small ones, to outsiders or to employees, a prospectus will be needed in any event. The prospectus may be an informal document, printed or typewritten, but whatever the form, it should be neat, clear, concise and well ar ranged. A well-worded typewritten letter is often as good a prospectus as may be had. The lack of a good prospectus is a frequent cause of failure in the promotion of small companies. As a rule, no one but an experienced financier can properly draw such a prospectus. Practical psychology plays a large part in it. It is a matter of salesmanship of a special kind which knows the mind of the investor and the prac tices of finance.
One instance is recalled in which two entire days were spent writing and rewriting one three-page let ter. But the time was well spent, for this letter sold $140,000 worth of seven per cent preferred stock to one who had no personal knowledge whatever of the business or of the circumstances surrounding its pro motion.
14. Sale of bonds and mortgages.—Bonds and mortgages are not commonly issued by small com panies unless the assets consist largely of real estate. Established earning power is the usual basis of such loans. These the new company cannot show until it has operated for several years. Consequently, it can sell bonds or mortgages only to a very conserva tive percentage value of its real estate. The mar ket for such bonds is limited, since large bond houses will not bother with these small issues and they are not ordinarily considered first class invest ments.
Often, it is possible to induce the owner of a factory site or vacant plant producing little or no revenue, to exchange it for bonds or stock of the new company, or part bonds and part stock. In this case, the bonds are secured by a first mortgage on the property, and improvements tend to increase the security constantly. The inducement held out to the owner is the regular return upon the securities, which he did not receive before from the idle plant. If the business fails, the worst that can happen to him is to get the property back again with improvements.
It is frequently necessary for wealthy directors or stockholders to guarantee the bonds, or at least to guarantee the interest for a period of years, if they are to be sold locally. Stocks will frequently sell where bonds will not, because of the opportunity for large profits attached to stock.
15. Capital investment.—One of the most frequent causes of disaster to small new companies is the in vestment of a large part of their capital in plant and other permanent equipment. Frequently, the small enterprise can be initiated with half the capital, and less than half the risk, by renting small quarters the first few years, during the experimental stage, instead of jumping right into a large plant investment. This leaves the capital free for current operation, and any loss occasioned by the high rent paid is usually more than recouped by the experience gained, by the mis takes prevented, and by the better basis upon which the plant may be financed when it is finally acquired.
The original plant may prove inadequate, incapable of expansion to meet the growing needs of the busi ness, may be in the wrong location, may depreciate in value or in other ways become unsatisfactory and en tail loss upon the new concern.
The great reason, however, for withholding capi tal investment in the beginning, is to preserve the assets in liquid form and insure adequate working capital. The shortage of working capital is a cause of chronic complaint of small new companies, and should be carefully guarded against. The use of a big plant and a fine office should be foregone until the business has been thoroly established.
16. Advances by stockholders and directors.— When a shortage of capital becomes evident, and credit at the bank and with the trade is weakened, it frequently becomes necessary for prominent directors, stockholders, or others to indorse the company's obli gations. This is always a danger signal, for it means that those who indorse will demand concessions in re turn, such as control of the business, high salaries or bonuses that will seriously cripple the finances of the company.
From the standpoint of the indorser, these special concessions seem justified, for he is assuming a risk beyond his mere liability as a stockholder, for which compensation may reasonably be expected. Very few men familiar with finance are willing to indorse the notes of a company or of a friend. They realize the hazard involved. Such indorsements at best should be only temporary, and not renewed by pay ing one obligation and indorsing another in its place. Continuance of such practice is usually a death blow to common or minority stockholders, as the bonuses demanded eat up the profits at the expense of divi dends. The indorser, to protect himself, sometimes finds drastic measures necessary. Very often these include squeezing out his associates by foreclosing and buying in the business.
We shall illustrate by referring again to the small tool company which the rich man's son had financed upon the reputation of his father, and then misman aged. The company had accepted much aid, includ ing generous loans from the bank of which the man ager's father was director. Observing the impending failure, the father now advanced his son's company a few thousand dollars more, taking first mortgage bonds as security. The new funds sufficed to carry the company over the four months' period, so that the preference created by the bonds could not be set aside under the Bankruptcy Act.
As soon as these four months had passed, the com pany was thrown into bankruptcy and bought in at 25 per cent of its original cost to satisfy these bonds. Practically nothing was paid to the other creditors, not even to the bank of which the father was a direc tor. Of course, the business was reorganized and be came successful on the assets which creditors had donated. The capitalist remained until his death a director of the bank which he and his son had virtually defrauded.