Q: “While I’m looking for investors, I’m also a little leery because I don’t know what I should be offering in return. Whether it’s a part of my company or money, I’m so confused about that. I was told some investors will invest money for a percentage return, but not sure what that really means and how much is the percentage, etc.”
A: Great question. We need money for our startups but it comes with a price. The price is often that the investor gets a piece of your company or a piece of your company’s profits. By the way, there are so many other things you can trade for investor dollars, like board positions, pride, naming rights, passion, mentoring opportunities, etc.
Investors are motivated by many things and some of those things are easy to give up and don’t cost you much. Even the differences between Equity and Profit rights can be complicated and designed to accomplish a wide variety of end results for you and the investor. I get into these options very deeply in our full Get Startup Investors course. To keep this article relatively concise, I will focus on simple Equity vs Profit.
Equity typically comes with a few main components. These components are often measured by a percentage of the equity, or portion of the company, purchased by the investor in exchange for the startup capital.
- Control in the form of voting rights.
- Return of the investor’s original investment and any growth in the event of a positive exit event like the sale of the company.
- Ongoing revenue if the company starts to pay periodic dividends to shareholders (this is what most call “Profit” or a “percentage of return.”)
In the simplest form, an example of this type of Investment Capital for Equity exchange would be as follows.
The Founder of the business would arrive at a REASONABLE value for their young company. Let’s say the company is worth $1,000,000. The Founder would then offer the investor a percentage of the company equity in exchange for startup funding. So, if the Founder needs $250,000 to continue moving forward, she would offer 25% of the company equity in exchange for the $250,000. If the offer was accepted, the Founder would have $250,000 to fund the company’s growth and the investor would have 25% of the control, 25% of the payout if the company ever sells, and 25% of the ongoing profits if the company pays dividends to the shareholders.
In this scenario, the Founder still has 75% of the equity. Apart from the obvious financial benefits of getting paid if the company sells or distributes profits to shareholders, it is important to note that the Founder still controls the company. If difficult decisions ever come to a vote, the Founder, holding the majority of the voting rights, will win any contest. Control isn’t everything, but it is a big deal.
Flip this scenario around and note that if the Founder was asking for $750,000 in exchange for 75% of the equity and the Investor accepted, the Founder would have lost control. Again, keeping it simple, this would basically make the Founder the Investor’s employee with a 25% share of the equity.
Many Founders find themselves in this position. They now have the cash they need to get started but they don’t have the lion’s share of the company they started. This is not necessarily bad. As many have said, 25% of a successful business is better than 100% of an idea that isn’t going anywhere.
Profits or “Percentage of Return” are often considered a combination of component 2 and 3 from the above Equity explanation. Buying a percentage of the profits in exchange for startup capital is simply buying the rights to a percentage of the winnings if the company sells or starts generating ongoing profits that can be paid out to investors. It’s a simple form of trading money today for the hopes of more money in the future. The big difference is that the investor is not gaining control over your business.
Note that as with any negotiation, the value of an item is exactly that which the buyer and seller agree. So again, keeping things simple, if you are selling Profit only, you may need to give up a little more profit because the investor is not getting any control in the deal. For instance, if the Investor was going to get 25% of the equity for $250,000, they may need to get 35% of the profit for the same $250,000 investment. The Investor may want more profit because they are giving up some control.
I know there are probably at least a thousand questions and sub questions that come up when using such simple examples and terms. However, I hope this gives you a place to start as you learn about selling Investor Equity vs Profit.