Wolfman
Chief Solipsistic, Autosycophant
For the past year, I've been working very hard on starting up a new, very lucrative business in China. Now, I should clarify here that I have almost zero business training or education, everything I've learned has been learned hands on, through experience. Prior to this current effort, one area in which I was completely and absolutely ignorant was getting investment for a business.
I needed around $US 80,000 to get my new business started; but was under the impression that if I got that much investment from someone else, I'd have to give away the lion's share of the company (ie. I could invest $20,000 of my own money, they were investing $80,000; this is four times more than my investment, so they should have four times as much equity in the company).
It turns out that this was quite far from the truth; and I thought it might be handy to have a kind of 'idiot's guide' to discuss this, to help others from similar backgrounds to actually understand what is involved in getting investment, particularly Venture Capital (VC). I'm quite confident that there will be those here who have significantly stronger business backgrounds that will be able to shed much more light on the subject, but this is being written from the perspective of a complete VC newbie, for the other VC newbies who may be out there.
First thing you need to realize is that the amount of equity you give to an outside investor has nothing to do with a comparison to how much money you're putting in. It is based on calculations that determine how much profit the investor can expect to receive over a certain time period.
For example, let us say that a small company is looking for $100,000 in VC in order to expand their business. The company has a solid, proven track record, and can make reasonable predictions as to their profits over the next 3-5 years. The investor looks at this as relatively low risk; their expectation in return for investing is that they will have a 400% return on investment within 4 years. In other words, they invest $100,000 now...and expect that after 4 years, they should have made $500,000 (recovering the initial investment, plus $400,000 in profit).
Now, let us say that the company predicts that over the next four years, they will make a total of $10,000,000 in profits. The investor expects to receive $500,000, so their share (or equity) in the company would be 5%. On the other hand, if the company predicts that over the next four years, they will make a total of $1,500,000 in profits, then the investor would expect to get 1/3 equity in the business.
Let us take another case...a brand new company that is just being started up. In this situation, there are no reliable financial figures, no proven track record. Any conclusions are based on hypothetical values and assumptions. Even if it seems like a really good idea, there is still a larger perceived risk for the investor. So they're still willing to invest...but now they expect a 1000% return on investment over four years. Now, if we have a company that expects $1,500,000 in profits over four years, the investor will want 2/3 equity in the business.
Please note the difference -- this is very important if you are seeking VC. You can have two companies that seek the same initial investment ($500,000), and expect the same profits ($1,500,000), but investors will expect completely different levels of equity in return for their investment. If your business is already established, and you can provide reliable financial info, they want 1/3 of your company's equity; if you're just getting started up, they want 2/3 of your company's equity.
Obviously, the more equity you give away, the less you have remaining for yourself. And this is where a bootstrap strategy can be very useful.
Don't go for the big bucks the first time around. Figure out what is the cheapest, simplest way you can get the business started. Perhaps you can get a small, simple operation started for $50,000, and you have to give 10% equity to get that money. After a year of business, you have more accurate financial data, and you've (hopefully) proven your ability to make the business work. Now you can go to investors to get $500,000 to build your company up, but give away much less equity to get that investment.
This is, in fact, the strategy I've employed with my own business. I plan three rounds of investment. For the first round (just completed), I had to give away 12% equity. The second and third rounds will be looking for significantly more money (second round expands my business across China; third round expands to other Asian countries such as Korea, Japan, Singapore, etc.) I expect to give a total of around 45% equity by the end, keeping 55% for myself.
Now keep in mind that the values above are highly flexible, and are used for illustrative purposes only. For example, investors in new internet companies often have expectations of 2000% return on investment or higher. Other investors are interested only in very established, proven businesses, and will expect only a 300% or 400$ ROI in return for relative stability.
Next: What the Investors Want To Hear
I needed around $US 80,000 to get my new business started; but was under the impression that if I got that much investment from someone else, I'd have to give away the lion's share of the company (ie. I could invest $20,000 of my own money, they were investing $80,000; this is four times more than my investment, so they should have four times as much equity in the company).
It turns out that this was quite far from the truth; and I thought it might be handy to have a kind of 'idiot's guide' to discuss this, to help others from similar backgrounds to actually understand what is involved in getting investment, particularly Venture Capital (VC). I'm quite confident that there will be those here who have significantly stronger business backgrounds that will be able to shed much more light on the subject, but this is being written from the perspective of a complete VC newbie, for the other VC newbies who may be out there.
First thing you need to realize is that the amount of equity you give to an outside investor has nothing to do with a comparison to how much money you're putting in. It is based on calculations that determine how much profit the investor can expect to receive over a certain time period.
For example, let us say that a small company is looking for $100,000 in VC in order to expand their business. The company has a solid, proven track record, and can make reasonable predictions as to their profits over the next 3-5 years. The investor looks at this as relatively low risk; their expectation in return for investing is that they will have a 400% return on investment within 4 years. In other words, they invest $100,000 now...and expect that after 4 years, they should have made $500,000 (recovering the initial investment, plus $400,000 in profit).
Now, let us say that the company predicts that over the next four years, they will make a total of $10,000,000 in profits. The investor expects to receive $500,000, so their share (or equity) in the company would be 5%. On the other hand, if the company predicts that over the next four years, they will make a total of $1,500,000 in profits, then the investor would expect to get 1/3 equity in the business.
Let us take another case...a brand new company that is just being started up. In this situation, there are no reliable financial figures, no proven track record. Any conclusions are based on hypothetical values and assumptions. Even if it seems like a really good idea, there is still a larger perceived risk for the investor. So they're still willing to invest...but now they expect a 1000% return on investment over four years. Now, if we have a company that expects $1,500,000 in profits over four years, the investor will want 2/3 equity in the business.
Please note the difference -- this is very important if you are seeking VC. You can have two companies that seek the same initial investment ($500,000), and expect the same profits ($1,500,000), but investors will expect completely different levels of equity in return for their investment. If your business is already established, and you can provide reliable financial info, they want 1/3 of your company's equity; if you're just getting started up, they want 2/3 of your company's equity.
Obviously, the more equity you give away, the less you have remaining for yourself. And this is where a bootstrap strategy can be very useful.
Don't go for the big bucks the first time around. Figure out what is the cheapest, simplest way you can get the business started. Perhaps you can get a small, simple operation started for $50,000, and you have to give 10% equity to get that money. After a year of business, you have more accurate financial data, and you've (hopefully) proven your ability to make the business work. Now you can go to investors to get $500,000 to build your company up, but give away much less equity to get that investment.
This is, in fact, the strategy I've employed with my own business. I plan three rounds of investment. For the first round (just completed), I had to give away 12% equity. The second and third rounds will be looking for significantly more money (second round expands my business across China; third round expands to other Asian countries such as Korea, Japan, Singapore, etc.) I expect to give a total of around 45% equity by the end, keeping 55% for myself.
Now keep in mind that the values above are highly flexible, and are used for illustrative purposes only. For example, investors in new internet companies often have expectations of 2000% return on investment or higher. Other investors are interested only in very established, proven businesses, and will expect only a 300% or 400$ ROI in return for relative stability.
Next: What the Investors Want To Hear
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