BLOG: How startups introduce investor capital, without founders losing value
By Daniel Williams. Posted 4 May, 2015
So you’re a fledgling startup looking to raise some capital; or maybe you’re an investor and you’ve been approached to invest in a new startup. You hear all the time about tech companies raising squillions of dollars; but how exactly does it work and how do the founders, who have no money, retain a significant share of their baby?

It can be quite a hard concept to grasp, and typically you might think of it this way…
Founder 1 and Founder 2 start a business. After twelve months they determine the value of their startup to be $100,000 (We won’t go into the method with which they arrived at this value.)

There are 1,000 shares, so each share is worth $100.

They decide they need more capital to grow the business and since the bank won’t loan them the money (that is way too high-stakes for most lenders!), and they don’t have access to any other sources (friends, family etc.) they decide to go out and find an investor.

Given their inexperience in this field, they ask an investor to “buy” half of the business for $50,000, which they will invest into the business for growth. Now the ownership looks like this…
The problem with this method is that the founders have had their shareholdings diluted to half, while the investor now owns half of the company.

The $50,000 value of their shares has now also halved to $25,000. Clearly this is a flawed approach!What we actually need to do is treat the investor’s cash as separate from the company’s valuation.

Let’s take the investor’s $50,000 of cash and add it to the company’s valuation.
$100,000 valuation
+ $50,000 investor cash
$150,000 new valuation
Now we are valuing the company at $150,000, so the value of the 1,000 shares has increased to $150 per share.

The investor’s share of the 1,000 shares will be calculated as:
$50,000 investor cash
/ $150 per share
Now the two founders have diluted their shareholdings from 500 shares each to 333, but the value of their shares remains the same at the original $50,000 each. They simply own a smaller piece of the company now.

Note: yes, there is one share missing from the equation, but for the sake of the example, we’re ignoring it.

The key point to always remember is that the investor’s contribution is addedto the company’s current valuation to give a new valuation.

So that’s how we work out changes to shareholdings upon investors entering the business (in other cases, new shares are introduced to eliminate dilution, but that is for another time.)

Now, go forth and raise capital!

Disclaimer: this is a very basic explanation of investment and share dilution. Please seek professional advice before engaging an investor!

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