My friend told me that her startup just raised a million dollars from a group of investors and that it means her business is now worth 15 million. What does all that mean and how does a company just have money appear without having an actual product yet?
You ask one of the most fundamental business questions, one that’s at the heart of a massive number of startups and business enterprises: how do you fund development and growth? Whether it’s a coffee shop that needs to buy tables and chairs, invest in great coffee brewing gear and hire a staff or a game developer that needs to pay its programmers, just about all companies need some money in the bank account.
Often, the very first investment comes from the founders themselves, the people whose passion and zeal fuels the creation of the new business. A food truck might be purchased by the two women who want to create a mobile restaurant, for example, or a massage therapist might need a table and money for a basic ad campaign that they fund with credit cards and a prayer.
The second wave of money can show up as a startup demonstrates that there’s a real business opportunity, that it’s not just a good idea. How? By gaining customers and generating at least a little bit of income. This small investment typically comes from friends and family. These investments can be tricky, however, because these [financially] unsophisticated investors need to realize that their investment could vanish completely if the company fails and that it’s much higher risk than a savings account at the bank.
These investors, even if it’s just Grandma, are buying something tangible too: ownership in the company. This is typically done through stock (or the option to buy stock in the future at a discounted rate). To issue stock means that the company needs to be assigned a value. That is, if I invest $1,000 in your business, do I own 1% of the company? 10%? or 0.0001%? Every entrepreneur is sure their business is worth millions, but that’s something they have to prove to appropriately skeptical investors.
The next wave of investors are experienced professionals who have the savvy to assess business grown and opportunities, not just be pulled in by an exciting pitch. This might start with so-called angel investors (who invest small amounts at an early stage) or go straight to venture capitalists (who can invest millions, but wait until they know that there’s a proven opportunity and actual revenue stream). Either way, they bring lots more money and the experience to know how to help the company grow.
Which brings us to your friend’s company. You shared that they raised $1 million in outside investment, which placed the valuation at $15 million. You can calculate that the investor now owns 1/15th of the company’s stock or about 6.6%. If the firm goes on to be publicly traded or is acquired by another firm, that 6.6% could be worth much more than the initial investment as the overall company value skyrockets. That’s the goal of all investors; to multiply their money.
Just as a theoretical, let’s say her company is acquired by another firm in 2022 for $25 million. That 6.6% ownership stake that cost $1 million would then be worth a sweet $1.6 million. That’s a profit of $666,667 in two years! Then again, in 2021 the company could go bankrupt and the stock value plummets to zero. Risk, reward.
Hope that helps you understand how all this fits together on a growing business. The key, of course, are paying customers. But that might be old school business analysis… 🙂
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