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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.

yoozer8
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Dino
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    See https://en.wikipedia.org/wiki/Seed_money and https://en.wikipedia.org/wiki/Venture_capital. – ceejayoz Mar 25 '19 at 14:52
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    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 '19 at 17:42
  • You're asking whether accepting investment means you're necessarily selling them a (large) portion of equity, not just a fractional revenue-share. Generally, yes. Even with angel investors. – smci Mar 26 '19 at 01:26
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    Is this on-topic? – stannius Mar 26 '19 at 01:29
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    I was going to suggest to migrate the question to Startups, but apparently that one closed 5 years ago. – gerrit Mar 27 '19 at 08:31
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    They become either a shareholder or a creditor, on whatever terms you negotiate. Whether they participate in the upside depends entirely on that decision and those terms. – user207421 Mar 27 '19 at 09:41
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    @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. – JTP - Apologise to Monica Mar 27 '19 at 12:34

3 Answers3

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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.

Hart CO
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    Shark Tank seasons 1 through present summed up in 3 paragraphs. Brilliant, have my +1. – MonkeyZeus Mar 25 '19 at 16:49
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    One small nitpick (but definitely not a downvote): If you value a company at 4 million dollars, it doesn't mean you want to invest 1 million for 25%. It means that 1 million for 25% is your "break-even" point. Kind of like you wouldn't want to bet $1 on a $2-if-you-win coin flip. Not sure the best way to rephrase your answer to add that in, though. – Kevin Mar 25 '19 at 19:03
  • @Kevin I don't think that analogy works because the 25% here isn't a "chance of return". I think what you're trying to say is "if the company is valued at $4m, and an investor offers $1m, then they should expect to receive 25% equity". If they get less equity, then they're "overpaying". Or more precisely, "If the company were sold to someone else immediately after the investor receives their equity, then they would lose money" – Vlad274 Mar 25 '19 at 19:09
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    @Vlad274. If something has a value of $100, would you consider it "investing" if you bought it for $100? No - you'd just break even. If you think it has a value of $100, and you bought it for $80, then you're expecting to earn $20. Similarly, if you think 25% equity has a value of 1 million dollars, you wouldn't really want to actually pay $1 million for it - you're just breaking even. The reason investors invest is because they think the value of the company is more than 4 million, and the 25% equity is worth more than the 1 million they're paying. – Kevin Mar 25 '19 at 19:13
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    @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 '19 at 19:47
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    @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 '19 at 19:48
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    @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 '19 at 19:53
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    Isn't investing more like adding the money to the company? I mean, if one invests a million in a company that's already worth 4 million, he's added 20% (not 25%) out of total 5 millions? – Džuris Mar 25 '19 at 20:03
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    @Džuris If someone gifted the company $1M yes, but if I'm trading $1M cash for what is essentially $1M in equity then the company isn't necessarily worth more, they just have cash that they can hopefully use to increase the value of the company. – Hart CO Mar 25 '19 at 20:07
  • I mean if there are already 4000 shares (estimated value $1k each) owned by existing owners, how would investor get his equity for putting a million in the company. Wouldn't company issue additional 1000 shares for his million and make the total to 5000? – Džuris Mar 25 '19 at 20:18
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    If he just buys out 1000 shares from the existing owners, the money goes to previous owners not company. Of course, that's still an investment, but not one that gives the company any money to work with. – Džuris Mar 25 '19 at 20:20
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    @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 '19 at 20:27
  • @GrandOpener The "current market rate" already includes the expectation that it will go up (or down) in future. To beat the market, you have to make a correct judgement call that other investors' expectations are wrong, and then wait until events prove that you were right. – alephzero Mar 25 '19 at 20:44
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    @alephzero What you say is true, but most investing is not trying to "beat the market." Most investing is finding a rate of return and risk profile that is acceptable to you, and putting your money in. Beat the market whenever you can, but don't expect that you'll be able to do it consistently. – GrandOpener Mar 25 '19 at 20:48
  • @Džuris You're conflating a company's WORTH with paid up capital (and also maybe cash reserves). In investor lingo, the company you're talking about has 4 million in paid up capital but is worth 5 million (as estimated by a valuator, sometimes hired by the investor, sometimes IS the investor, sometimes hired or appointed by a bank or court). – slebetman Mar 26 '19 at 04:06
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    With giving money to a company, you expect the company actually needs the money and does something with it. You don't just sit on the money. It is the action of spending the money that changes the company's worth. – Nelson Mar 26 '19 at 06:41
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    Interestingly, someone DID give us a pile of money expecting nothing in return. Back in the day we referred to people like that as "angel investors" - which held the attitude that a ROI is optional. We held an unofficial number of 10% should we succeed. We never succeeded. He never complained. Still friends to this day. – Kai Qing Mar 26 '19 at 18:03
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    @KaiQing Angel investors typically do get equity, but it's true, some people have piles of money and feel good trying to help others. – Hart CO Mar 26 '19 at 18:43
  • You guys are getting deep in the weeds here. Read this: https://www.investopedia.com/articles/personal-finance/102015/series-b-c-funding-what-it-all-means-and-how-it-works.asp And here's a few quora answers: https://www.quora.com/What-is-the-usual-percentage-of-shares-that-go-to-seed-Series-A-and-Series-B-rounds – Buttle Butkus Mar 27 '19 at 05:09
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    Please read The Intent and Purpose of Comments - The whole comment thread is a candidate for being told to 'get a room' for future discussion. – JTP - Apologise to Monica Mar 27 '19 at 12:27
  • If the $1M are purchasing new shares, then the company will have exactly the same assets it had when valued at $4M, plus an additional $1M cash, making it worth $5M at that time. The investor should be expecting a number of shares equal to 25% of the then-outstanding shares, which will leave him with 20% of the new number of shares. – Monty Harder Mar 27 '19 at 16:51
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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.

Mohair
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    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 '19 at 01:18
  • 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 '19 at 01:19
  • 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 '19 at 01:33
  • @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 '19 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 '19 at 14:58
  • @Makyen My example was purposely kept simple to avoid unnecessary complexity to answer the question that was asked. You are focused on much larger things. I'm micro. You're macro. – Mohair Mar 26 '19 at 15:15
  • I don't think the terminology "shares" tends to be used in early rounds. – Acccumulation Mar 26 '19 at 21:21
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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.

Acccumulation
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