41

Lately I've been curious about how exactly investing in a product works, and I've been thinking about this scenario:

Let's say I'm creating some mobile application and I manage to get $1m of investment money. In the following year, the application turns out to be a huge success and I get an offer of $30m to sell it. If I decide to sell it, where is the investor involved in that process? Does the investor get a part of that $30m?

I would also appreciate some useful links that explain the process.

  • 5
  • 8
    Have you ever watched Shark Tank? It's over-simplified, but you do see how the investors "value" companies and ask for equity or royalties in exchange for their investment. Edit: Shark Tank is a US show, but there are similar shows in other countries. – JPhi1618 Mar 25 at 17:42
  • 5
    Is this on-topic? – stannius Mar 26 at 1:29
  • 2
    I was going to suggest to migrate the question to Startups, but apparently that one closed 5 years ago. – gerrit Mar 27 at 8:31
  • 2
    @stannius - One vote to close as 'unclear' another 'too broad'. And on Meta, we are tackling the issue of when to delete, with a member strongly feeling that a high voted question should remain indefinitely, even when closed. Here, I strongly suggest that the question is a candidate for an edit that will preserve the quality of the answer but tighten the question to the point of making it clearly on topic. – JoeTaxpayer Mar 27 at 12:34
128

Almost nobody would just give you a pile of money with no expectation of return. In most cases you exchange equity in the company for the investment. A simple example might be that I estimate your idea/company to be worth $4M currently, so for $1M I want 25% equity. When you sell for $30M, I get 25% of the proceeds. If you go belly up, I likely don't recoup my investment, but 25% of whatever assets can be sold.

There are other arrangements, too. My investment might earn a royalty on every sale you make, without me having any equity. The investment could just be a loan that you repay with interest. There are many options and nuances; that's why lawyers are usually involved.

How much power the investor has depends on how much you give them in exchange for their investment. There are plenty of stories of founders getting themselves ousted by investors after giving up too much control.

  • 31
    Shark Tank seasons 1 through present summed up in 3 paragraphs. Brilliant, have my +1. – MonkeyZeus Mar 25 at 16:49
  • 27
    @Kevin If I bought 25% for $1M I'm giving the company a $4M valuation. I expect the future value to be significantly higher, but if current value isn't $4M then one party got a better deal than the other. – Hart CO Mar 25 at 19:47
  • 53
    @Kevin ...I think that is investing. I'm buying something at the rate that it is right now on the assumption/guess/knowledge that it will increase in value. That's, like, the definition of investing. – John Doe Mar 25 at 19:48
  • 10
    @Kevin Generally investing involves paying the current market rate for something, with the expectation that it will go up in the future. Buying below market rate is awesome when possible, but the "go up in the future" part is generally more important. Buying something worth 100x for only 80x currency, when you don't have a strong expectation of the thing increasing in value, is actually not a very good investment unless you can easily resell it immediately. – GrandOpener Mar 25 at 19:53
  • 6
    @Džuris They are effectively issuing additional shares, but the company is also growing by $1 mil in value (which, at first, they own in cash). If someone invests $1 mil in a company for 25% equity they are effectively valuing the rest of the company at $3 mil, or at least, the total of "company+new $1 mil" = $4 mil. Often with the expectation that this new cash influx gives the company advantages that allow it to grow further - that's the point of this arrangement in the first place – Bryan Krause Mar 25 at 20:27
13

Typically, if you create a business that wants investors, you will issue stock in the company. One unit of stock is called a share. You decide how many shares there will be and how much each share is worth. The total value of all the shares represents the market value of your business.

Say you issue 1 million shares in your company, and you value each share at $4. That makes the market value of your company $4 million. If someone comes along and wants to invest $1 million in your company, it's a simple matter of selling them 250,000 shares.

At some point in the future, your company is doing really well and someone offers you $30 million for it. There are 1 million shares, so that means each share is now worth $30. Your investor owns 250,000 shares, so their $1 million investment is now worth $7.5 million. You still own the other 750,000 shares, so you get the other $22.5 million.

That's a really simple example, but it illustrates the basic idea of investing in stock of a company.

  • 2
    Note that it's not a simple matter of selling 250k shares of 1M. If you are selling shares, then the shares have to come from somewhere. Either they are being sold by someone who already owns them, which results in the money not actually going to the company, or the company creates/sells shares that are not owned by anyone other than the company (this latter is the usual intent for raising capital). Doing the latter dilutes the ownership share represented by the current outstanding shares. This can be that new shares are created, resulting in 333,333 new shares, for 1,333,333 shares total. – Makyen Mar 26 at 1:18
  • Alternately, the shares could already exist, or be authorized, but be owned by the company/not issued. In which case, only 750,000 shares are owned by others. However, their effective ownership percentage is reduced when the additional shares are sold by the company. In other words, in that scenario 750k shares represented 100% ownership of the company, but once the additional 250k shares are sold, the 750k shares represent 75% ownership. – Makyen Mar 26 at 1:19
  • Doesn't the investment dilute ownership in (theoretically) exact proportion to how much money the investor invests? Per the comments on the other answer - investor pays $1 million for 25% of a company now valued at $4m. The company just got $1m cash on the books, so, more or less they were worth $3m before the investment. They might have a smaller share but it's of a pie that's exactly embiggened enough that they break even. In fact the newly capitalized company could potentially be worth more than it was before (like, maybe it was only worth $2m) because now it can sieze opportunity! – stannius Mar 26 at 1:33
  • @Makyen In my simple example, yes, it is that simple. There is one owner of the company who owns all 1 million shares. He sells 25% of his shares to someone else. True, the proceeds of that sale go to the person who owns them, not the company, but in my example, the owner is effectively the company, so they are one and the same. – Mohair Mar 26 at 13:28
  • @Mohair The company and owners of the stock are definitely not one and the same. One major point of having a corporation is to establish a separate legal entity from the person or persons who own the stock. Sometimes, that's the entire point of the corporation (obviously, if you're seeking investment, it's not the entire point for this company). However, strictly maintaining that legal separation is critical. While someone might be willing to purchase stock that's privately held, that's not what's normally considered investing in the company. It's generally considered investing in the stock. – Makyen Mar 26 at 14:58
2

There's a distinction between selling the company and selling your stake in the company. Let's say you gave the initial investor a 10% state in exchange for the $1m. Then you have a 90% stake in the company.

If you sell this stake, then the new buyer will now have a 90% stake, and the original investor will still have a 10%, but no money. However, if the new investor is willing to buy your stake, then they're likely willing to buy the other 10%, in which case the original investor would have the option of giving up their 10% in exchange for what the new buyer is offering.

If you sell the company, then the original investor would lose their stake, but get 10% of the sale price; they would in essence be forced to sell their stake. The original agreement will likely have terms spelled out as to under what conditions this is allowed. Many agreements give the original investor veto power, or give a minimum price the company can't be sold less than.

protected by JoeTaxpayer Mar 26 at 20:01

Thank you for your interest in this question. Because it has attracted low-quality or spam answers that had to be removed, posting an answer now requires 10 reputation on this site (the association bonus does not count).

Would you like to answer one of these unanswered questions instead?

Not the answer you're looking for? Browse other questions tagged or ask your own question.