This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
Earlier in the chapter some indication has been given of the customary method by which the promoter acquires his profits. The fundamental principle is that he is entitled to whatever remains of the capitalized value of the enterprise after the capital which it requires has been obtained. To make the practice entirely clear, let us take a simple hypothetical case. A promoter determines that a given manufacturing enterprise will ordinarily earn, after it has completed a two-year period of development, in excess of $100,000 per annum net profits. If he is conservative, he will perhaps figure on creating securities all of which will be salable at par on the following basis:
6% first mortgage bonds........
8% preferred stock.........
common stock yielding 10%......
We will assume that the corporation actually needs $1,000,000 cash, and that the expense of investigation, securing options, incorporation, and selling securities amounts in total to $150,000. Under these conditions, the promoter would probably enter a contract to turn over $1,000,000 in cash, or possibly property and total assets for which he would actually pay $1,000,000, in exchange for all the bonds, preferred stock, and common stock of the corporation. He would then be able to sell bonds, preferred stock, and $250,000 of the common stock, and would retain for himself $250,000, against which should be offset his expenses of $150,000. In other words, under all these estimates, his net profits would be $100,000, which would presumably be realized in common stock.
Naturally the situation is not quite so simple in practice; nevertheless, the same principle can be readily applied of capitalizing prospective income and selling or exchanging all of the securities necessary in order to put the corporation on its feet, the remainder of the securities being left as the profits of promotion. There is, however, another complication to be considered here, namely, the fact that a promoter very seldom works completely alone. It would, in all probability, prove essential for him to secure the co-operation of certain bankers and of men who have some special knowledge or prestige, and he will be compelled to divide his profits with them. Quite frequently the original promoter builds up a more or less formal promoters' syndicate, of which he is manager, and which shares in whatever gain he makes.
The principle that the promoter will accept as his compensation a portion of the final equity in the corporation is well established. Otherwise - in case, for instance, he insists upon receiving bonds or preferred stock - he reveals a lack of faith on his part in the success of the enterprise that would probably be fatal to his whole promotion scheme. This principle is applied in the United States freely, leaving to the promoter a block of the common stock. In English practice another arrangement, which is in some respects preferable, has been common. In addition to bonds, preference shares, and ordinary shares, the organizers of a new corporation frequently cause to be created a final claim on the property, ranking after ordinary or common shares, this final claim being represented by "founders'" shares. The founders' shares ordinarily are entitled to dividends only after certain dividends have been paid on ordinary shares, after which they are entitled to participation in additional dividends. A favorite arrangement is to give the ordinary shares, say, 6% as their preference above founders' shares, and then to divide additional profits equally between ordinary shares and founders' shares. The founders' shares are usually issued to a small nominal amount with a small par value to each share, often only one shilling. In a few instances where the companies have been phenomenally successful, the founders' shares have become extremely valuable, and there are even cases in which separate corporations have been formed in order to hold the total block of founders' shares and to sell interests in this block. The advantage of this English practice is that it defers promoters' profits until after those who have contributed cash have been fully protected.