Question about how much equity to give away to an investor...

[bigfish44]

I am starting a website, and I have invested $4000 of my own money, and a friend has agreed to invest $5000. I will be doing all the work and my friend will play no role in managing the business. The website is going to be launched in just a few days so I have no cash flow yet.

I have the projected revenue numbers for a similar website... $300,000 this year, $2.5 million next year, and $10 million the year after that. These seem like optimistic numbers to me.

Would anyone be able to help me come up with a fair number for how much equity to give away to my friend which reflects the amount of time that I already have and will put in, as well as the amount of cash we're investing?

Thanks so much, I really appreciate it.

Jeff

[B.Sheehan]

This can sometimes be a very awkward situation but it does not neccesarily have to be. Just be very blunt. I went through a similar thing with my new company Kontinuum. I have two people joining my team that act as if the business was thier own. In the beginning this is great - extra help and extra resources. But is important to always plan using the worst case scenario. I.e. 3-5 years later and your relationship has had a meltdown.

Some things to consider:
- who is enduring Director's Liability (you, him, both of you)?
- is either of you leaving a full time position to do this full time?
- would one of you be considered the "founder" or was it mutual?

There are a couple of tools such as debentures, convertable debt, stock options and multiple classes of stock. I personally prefer to use multiple classes of stock. Get a good lawer and have them write in 2-3 classes. The important class is the Class A voting level. This is the one that will increase in market value and the one that controls the company. Other classes are a way to secure a person's investment (either time or money) but do not increase in value. They do receive dividends though and in most cases on a higher level than the Class A stock (reward for the non-voting status).

[akula]

I am starting a website, and I have invested $4000 of my own money, and a friend has agreed to invest $5000. I will be doing all the work and my friend will play no role in managing the business. The website is going to be launched in just a few days so I have no cash flow yet.

I have the projected revenue numbers for a similar website... $300,000 this year, $2.5 million next year, and $10 million the year after that. These seem like optimistic numbers to me.

Would anyone be able to help me come up with a fair number for how much equity to give away to my friend which reflects the amount of time that I already have and will put in, as well as the amount of cash we're investing?

Thanks so much, I really appreciate it.

Jeff

good good

right, this issue has been covered in Allocating shares in a new start up

Basically, in order to "come up with a fair number for how much equity to give away to my friend which reflects the amount of time that I already have and will put in, as well as the amount of cash we're investing" you have to decide on a premoney valuation

Ok? If you have problems I'll walk you through it but only if you take a few minuets to read up on the subject

[akula]

This can sometimes be a very awkward situation but it does not neccesarily have to be. Just be very blunt. I went through a similar thing with my new company Kontinuum. I have two people joining my team that act as if the business was thier own. In the beginning this is great - extra help and extra resources. But is important to always plan using the worst case scenario. I.e. 3-5 years later and your relationship has had a meltdown.

Some things to consider:
- who is enduring Director's Liability (you, him, both of you)?
- is either of you leaving a full time position to do this full time?
- would one of you be considered the "founder" or was it mutual?

There are a couple of tools such as debentures, convertable debt, stock options and multiple classes of stock. I personally prefer to use multiple classes of stock. Get a good lawer and have them write in 2-3 classes. The important class is the Class A voting level. This is the one that will increase in market value and the one that controls the company. Other classes are a way to secure a person's investment (either time or money) but do not increase in value. They do receive dividends though and in most cases on a higher level than the Class A stock (reward for the non-voting status).

very good points

having decided on a premoney valuation, there are many ways to provide consideration for people's sweat equity, cash or in-kind investment

common stock is one way, but there are other kinds of securities

[bigfish44]

Thank you so much for the timely and extremely helpful responses!

Doing the "premoney valuation" by looking at other similar businesses and finding the present value of future cash flow scenarios I came up with a very rough estimation of...

good outcome.... (20% chance)= $2.5 million business value
fair outcome... (50% chance)= $130,000
worst case... (30% chance)= 0

By weighting these values I came up with a company value of $565,000. The $5000 that my friend is contributing amounts to less than 1% (.009) of this amount! Offering him 1% of the company for his $5000 contribution this early in the game seems extremely low to me. Did I do something wrong? Any suggestions? Thanks so much.

[BioSpherical]

It doesn't look like you've done anything wrong.
Yet putting a $565,000 on a company before its even started trading seems optimistic. Obviously I know nothing about the website, its market potential, or, perhaps most importantly, your business acumen.
To be honest if I was investing $5000 in a new website I would want at least 10% equity. BUT as I say it depends on the afore mentioned variables. If you'd had more successful businesses in the past perhaps 1% is fair.

[akula]

Thank you so much for the timely and extremely helpful responses!

Doing the "premoney valuation" by looking at other similar businesses and finding the present value of future cash flow scenarios I came up with a very rough estimation of...

good outcome.... (20% chance)= $2.5 million business value
fair outcome... (50% chance)= $130,000
worst case... (30% chance)= 0

By weighting these values I came up with a company value of $565,000. The $5000 that my friend is contributing amounts to less than 1% (.009) of this amount! Offering him 1% of the company for his $5000 contribution this early in the game seems extremely low to me. Did I do something wrong? Any suggestions? Thanks so much.

Ok good, so you see the problem. Nothing went wrong, it's just that you have a mismatch between the valuation and the investor.

Let me put things in perspective...when youtube went to sequoia they got a 8mill premoney valuation, and they were the fastest growing website in the history of the internet. so, in comparison to youtube...it may be your premoney val is unrealistically high

now...let's say your premoney is not too high. then, you have a problem because the investors you're dealing with are not wealthy enough to substantially contribute to this kind of venture. if you plan on growing into a multimillion dollar company virtually overnight, your equity needs to be owned by people who have the capital to get you through the J curve. In other words....if your valuation is not too high, it's the investment from your friend which is too low.

I can tell you from experience that for a premoney val >500k, seed rounds have to be >100k for the IRR figures to make sense. If you're telling someone that they can invest $5k and see it turn into $500k within a few years - you're not being realistic. Sure...you think you're being realistic, but anyone who invests in private equity will tell you that you're not...investors have a hurdle rate of 30%...5k invested for 5 years should be worth about 15k. The chances of 5k turning into 500k within 2 years (900% annual return!) are a lot lower than 20%. If you adjust the probability to <1%, you'll have a more realistic valuation. Anyone who comes into my office saying they are 20% sure they can give you a 900% return two years in a row, is very...hmmmmm...enthusiastic....if they asked for 100k and promised 500k within 5 years, that would be more realistic.

the point: to get the deal to make sense, either lower lower your premoney val (by decreasing best scenario value and probability) to a point where it makes sense for small time investors to do the deal with you (i.e. their 5k can buy them at least 10% of the shop), or, keep your premoney val high, but then you're gonna need a different caliber of investors.

keep in mind: a venture like youtube got valued at 8mill and got sold for 1650mill. that's a discount of 99.54% on the best case scenario (i.e. they put a probability of 0.5% on the best case scenario). in your case, if you discount 2.5mill by 99.54%, your premoney val is $12k. At $12k, a 5K investment, and the resulting 17k postmoney val - your friend gets (5/17)*100 = 30%

finally: do you understand what I'm saying? you can't put a $565,000 val on a startup with 10k in cash. If you do this, the IRR numbers won't work. So, to get the numbers to work, either lower the val by lowering probabilities, or seek more cash. There's nothing wrong with putting a $565,000 val on a startup if you're pitching for 100k in cash....that kind of capital reserve can (optimistically) get to that kind of valuation...but not at 10k.

[akula]

errr....yeah

reflection: for everybody who is pitching "We're gonna make untold millions, and all we need is 10k" kind of deals, keep in mind that you're setting your self up to be a victim of your own enthusiasm.

if the valuation is too high, the company will need much higher cash injections to justify the valuation (it’s not realistic for a startup to turn 10k into 1000k), but if the valuation is too low, the company may not be attractive for its lack of prospects (no one wants to invest in a shop which has 99&#37; chance of losing everything and 1% chance of making millions)

so...when doing deals, so as to avoid conflict over valuations, stay in the investor's sweet spot. all investors have an idea for how much money they want to invest, how much equity they want to buy, and the kind of returns they expect. if you are to successfully market your securities, you'll have to be agreeable to these parameters.

[mxer210]

Wow akula nice posts! Very insightful

[akula]

at least here I don't get metallic fixtures thrown at my head (hi amy!)

[bigfish44]

Thanks guys, I appreciate the help.

[Paint and Air Sportz]

if you think your site will really grow, ask them to loan you the money with intrest and tthey onw nothing. You will be happier in the long run.