Investments and Equity

Question

First, I apologize if this has been asked/answered before. Was not really sure how to search for the answer so I'm asking it here.

To me, it has always seemed like a business is a thing. A thing with value that someone, or a group of people can own. It makes a lot of sense, that I could sell you some percentage of that thing, for that percentage of that thing's value.

For example, say I have some business that we agree the value is $50,000. If I sell you 50% of it, I would expect you to pay me $25,000, and that all makes sense. In this example the money would be going directly to me.

Where I get confused, is that it seems the purpose of looking for investment, is to increase the capital of the business so that it can function, and achieve its goals more easily.

So let's amend our example. I give the business $25,000 and take 50% of the business. Well now the business is worth $75,000 so my $25,000 investment just bought a value of $37,500 which is unfair to the original owner of the business.

I ask this mainly, because this seems to be the scheme used on shows such as Dragon's Den. They need money for the business, but base the valuation of the business as whatever it was worth before sinking capital into it.

I suppose I don't have a clear cut thesis, but just wondering where I'm incorrect. Surely the investor doesn't make money immediately upon making the deal. That doesn't make sense to me.

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It might not be clear so let me try to summarize it succinctly, with a direct question.

When I invest in a business valued at $50,000, I pay $25,000 and receive 50% equity. Does that $25,000 go to the current owner of the business, or into the capital of the business itself?

Answer 1

You need to be clear about who gets your money:

1. If you pay the existing owner $25K and (s)he gives you half the business, then you now own half of a $50K business an the original owner has an extra $25K in spending cash. The value of the business has not changed.

2. If you contribute $25 to the company, new equity shares are created. Shares should be priced correctly, meaning you now own $25K worth of shares in a company worth $75k, so you should have 1/3 of the outstanding shares (counting both old and new shares). If you get more or less than this, then the transaction has happened in an unfair way. If this is a public company, that would most likely be illegal and the SEC may throw you in jail. If it was a private company and your friend created enough shares that you own half the company, then (s)he has given you a gift.

If you are contributing to the company at a fair price, you would need to contribute $50K in order to end up with half the equity of the new and now more valuable firm. In that case the firm would be worth $100K after your contribution.

Bottom line, this is a common and not complex transaction and should end up with a completely fair outcome. Any unfair situation you can imagine is probably based on false assumptions or a situation where a non-arms-length transaction is transferring wealth contrary to normal rules and procedures.

Answer 2

If you own 100% of the shares of a company, then you own those shares personally. They are not owned by the company. If you sell 50% of you shares to a third party, then you receive the proceeds of the sale, not the company. In this case, the company's net equity is unchanged but you have exchanged 50% of your equity for cash.

If you wish the company to receive the proceeds of the sale of shares, then you would have the company issue new shares in the company. In this case, your company's net equity would increase by the cash amount received and your personal equity would change accordingly.

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EDIT

In order to fairly sell 50% of equity by issuing new shares it would be necessary for the new investor to invest 50K. This is because the new equity would be the original 50K of equity plus the cash received for new shares. Thus :

cost of 50% of equity = 50% of (50K + cash recieved) = cash received.

Solving for cash received gives 50K, so that is the correct amount to charge the new investor.

Answer 3

There is a fundemental misunderstanding: the business and the owner are not the same entity. You said:

I give the business $25,000 and take 50% of the business.

No you can give the owner of the business 25K, and now he has 25K and 50% of a 50K business. That 25K sits in Mr. Smith's bank account, not Acme Widget's account.

A more simple example is when you buy a car. The money goes to the car dealership, it does not get put into the car's glove box.

You may be thinking of an investor in a business. He could pump $$ into the business as operating capital for a share of the business. In that case, it would be a bit unfair to get 50% of the business for a 25K. However, the owner may be interested in doing such a deal because value of the investor can add more than just $$ to the business. Having a celebrity investor might do more good for the business than the actual dollars.

Another situation is that the owner might be desperate. Without a influx of cash the whole business might end.

There are guidelines to business evaluation, but valuing them is not an easy thing.

Answer 4

When I invest in a business valued at $50,000, I pay $25,000 and receive 50% equity. Does that $25,000 go to the current owner of the business, or into the capital of the business itself?

Who receives the money depends on who is selling you the equity. There are a couple of different scenarios that can fit your question.

1. You could buy existing shares from the current owner(s) of the company. In this case, the current owner(s) would be receiving the funds from you, and in return giving you their stake in the company. So if you all agree that the value of the business is $50,000, and you give $25,000 to the current owner(s), they give you half of their shares. The value of the company has not changed.

2. The company could be issuing new shares. This is called stock dilution, or an increase in authorized share capital. Let's say that everyone agrees that the value of the business is $50,000. The company could create new shares and sell them to you for $25,000. In this case, the value of the company has jumped to $75,000; you now control one-third of the company, and the existing owner(s), who previously owned 100% of the company, now only own two-thirds. In order for you to end up with 50% of the company in this case, you would have to invest $50,000 instead, which would result in the company being valued at $100,000.

If you are wondering why the current owners would agree to this second scenario, there are two questions that address this:

• If a startup receives investment money, does the startup founder/owner actually gain anything?
• Why is stock dilution legal?