Entrepreneurs and investors alike are often puzzled by this basic question: How much of the company should the investor get?
One approach is through financial analysis and calculations. If you like numbers you will definitely find this approach satisfying.
Suppose you’re raising $500,000. To calculate how much your investor should receive:
- Step 1: Look at your business plan and see how much annual EBITDA (earnings) your business will be generating in five years from now. Let’s say $800,000 per year.
- Step 2: Look at the market and see at what multiples companies in your industry sell for. Say the right multiple is 8x earnings.
- Step 3: Look at the market and see what annual returns investors expect to receive for a company like yours. Say the required rate of return is 30% per year.
- Step 4: Based on Step 2, your company can be sold at the end of Year 5 for $6,400,000 (eight times $800,000).
- Step 5: Based on Step 3, your investor will expect to receive $1,856,465 at the end of Year 5 ($500,000 compounded at 30% per year for five years).
- Step 6: This means your investor should own about 29% of your company ($1,856,465 divided by $6,400,000).
Very elegant and simple.
But also very inexact. At virtually every step, you’re really making educated guesses: how much you will be earning five years (an eternity) from now, the right sales multiple, the return your investor expects to receive. Change any of the inputs and you can get a very different output.
That’s why in the real world the investor’s ownership percentage is more often the subject of negotiation. The investor wants X, the entrepreneur wants Y, and you try to reach a compromise, depending who has more negotiating power.
The process doesn’t have to involve just horse-trading. For example, if the investor wants 30% because she thinks the company will be worth $5 million in Year 5 and the entrepreneur is willing to give up only 20% because he thinks the company will be worth $7.5 million, there’s an obvious compromise: the investor gets 30% up front, but the entrepreneur can “claw back” part or all of the extra 10% if the company turns out to worth more than $5 million.
In practice, determining how much stock the investor receives is a function of both art and science, although probably more of the former than the latter.
Questions? Let me know.