How does selling equity to raise capital really work?

Question

hello there..i run a sole proprietorship..i am looking to incorporate my business so that i can get investors in..but i have no idea how equity works..i have had no experience with a pte ltd so i dont understand how the concept of selling equity to investors,angels work..

let stay i incorporate my new business and put in a thousand dollars worth of capital.i am willing to give up to 50 percent of my ownership of the business to bring in $500,000 worth of investment dollars.but how does it work?would my 1000 dollars worth of capital be worth 50 percent and their $500,000 be worth 50 percent as well?

i just dont know how this whole concept works,and i have tried to look for answers online without much help..any advice would be appreciated..thank you very much in advance..

Answer 1

Okay this can be complicated so I am first going to look at financing in general and then look to your specific question.

There are two types of financing debt financing and equity financing.

Debt is as simple as bank loans, loans from friends, leases, and lines of credit.

Equity financing is selling off pieces of the business. So if you have $100 shares that are worth $100 each then the value of the company is $10,000. In the real world you will have x number of shares and you need to have an idea of what they are worth. If your comapny is public, the market prices your stock for you. If you are private you have to figure it out.

Now the key here is valuing the company. What is your company worth. There are branches of finance dedicated to this. One basic and accepted way is to do discounted cash flows. Basically the value of a business is the value of the expected cash flows that the business will generate, discounted to present (you need to look up NPV) Essentially, since your business has been around for a while, you have historical cash flows and should also be able to project your cash flows outward. Without this, your business cannot be valued at all. Another valuation method is the multiples method. So if there is a company that is similar to yous in size that is publicly listed, you can work out a value for your company. You still need sales projections for this one as well. I think the DCF and multiples methods are the two main valuation techniques.

So if you are looking to get equity by angels or VC. You first need a business plan and financial projections. If you plan to incorporate first, then there are a number of things you can do. You can incorporate a separate entity and then buy the sole proprietorship, or you can do it as part of the deal you strike with investors.

In terms of your specific question, if you had $1000 dollars of equity and 100% of the stock, then this would be a "pre money" valuation of the company at $1000. If you were looking for a $500,000 dollar investment for 49% (50% is bad as no one has control) the the total value would be $501,000, with you having 51% of that post money valuation. meaning that your post money value would be around $255K.

In order for that to happen the individuals would have to see that the value was worth it. Also sophisticated investors will add a zillion covenants to the Term Sheet and depending on the quality of your plan may ask for a greater than 50% share. Also you may find that your stock value gets diluted as there are several series of financing, the investors have the right to oust you as CEO, they will want an exit strategy which is usually buyout or IPO.

Hope that helps somewhat, this is a huge topic.