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Raising money for a startup

Raising money from an angel investor. Pre-money and post-money valuation. Created by Sal Khan.

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  • blobby green style avatar for user Kirk Fraser
    What about dilution of control? Since the angel now owns 50%, can he vote you out and keep your idea?
    (17 votes)
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    • blobby green style avatar for user JoelAlanAdams
      50% doesn't equal control in the same way 51% does, so even for decisions requiring only a simple majority, the investor would need to convince someone else of the value of the decision in order to make it happen. Further, operating agreements can define the rules for decisions. It may require a two-third's majority of shareholders for major decisions like selling the company, etc. Finally, even with 51% and all decisions based on a simple majority, no one can vote away your equity. You own it, and any reasonable operating agreement will protect that. You can certainly be diluted over time, and in the long run many things are possible.

      Ask questions, get to know your investor and his or her reputation, and deal with people that both add value and share your vision for the company. Then open yourself to trusting that others might just know better than you do, and trust that investors want the company to succeed just like you do. After all, if it doesn't they lose out too. All that said, first things first, get an attorney who will watch your back, and run all major decisions through that feedback loop. Just my two cents.
      (28 votes)
  • blobby green style avatar for user garyknott
    So, the big hurdle gets the least (essentially epsilon) time - how
    does one get face-time with a VC?
    (4 votes)
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    • blobby green style avatar for user Tarlton Parsons
      The short answer is: go knock on their door. There are several ways to do this, but going to their website is the best starting point if you don't have contacts that can introduce you. Most VCs have websites. But don't just approach everyone you find. Do your homework, find VCs that focus on the kind of business you want to build. VCs get hit on more than a pretty girl-- everybody wants money--so they filter aggressively. You will get one short chance to get their attention, so you need to have a clear,concise and SHORT pitch ready, and you need to be ready for hard questions. Put yourself in their shoes, what would make you invest money you worked hard for? It isn't hard to find VCs, but it is hard to get their attention. You must convince them of three basic things: Your idea is something the market wants, you can make money with it and you have the ability and commitment to make it successful. They will often test this last by seeing if you are easily discouraged. So no matter how hard they are on you, don't let it dampen your enthusiasm. A final piece of advice: if you haven't done this before, don't start with your best prospects, start with your worst so you can learn on them. And always remember, you can get a thousand no's, you only need one yes.
      (45 votes)
  • blobby green style avatar for user Jaime G Sada
    But how do you agree that the "socks" idea has a $5M value? That's the really the key issue.
    You have to make an assumption on the amount of capital needed to get to the point where income starts flowing in, as well as the volume and profit margins, at that capitalization level, and set some capital return ratio for the angel investor, related to his perceived risk.
    (11 votes)
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    • blobby green style avatar for user dave
      To arrive at a valuation, you must bring together all assets (often a patent is required which costs $5-10K and will account for $1M), existing clients (minimum 5 paying clients will get you 500K valuation added) and people's skills which may get you another 500K. Angels typically only invest from $250K-$2M range. VC's start at $5M and typically want 65-80%. Use resources like SCORM and SBA but save your money - a decent business plan will cost $2-4K and the process will take 6 months on average to review and there is no guarantees. The best advice I can offer is figure out how to generate money and get 5 clients, then proceed to the next step.
      (13 votes)
  • blobby green style avatar for user Blake Murray
    I'm 13 and I want to start a game and software development company. How can I do this?
    (4 votes)
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  • male robot hal style avatar for user rahul
    Why do they call angel investors "angel"
    (4 votes)
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    • piceratops seedling style avatar for user Travis Bagley
      An angel investor injects seed money to help get a business off the ground or to provide support for an ongoing and struggling business they want to see succeed. The term 'angel' simply means that the investors goals are not only monetary in nature. Their focus is to help the entrepreneur or the business to succeed, not to only make a large profit.
      (7 votes)
  • purple pi purple style avatar for user Arcbound Ravager
    What is an NDA?
    (2 votes)
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  • blobby green style avatar for user brain.talking
    I am wondering where 1 million shares come from? Does it from those 5 people who start the business? Thanks (Refer to of this video)
    (2 votes)
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    • blobby green style avatar for user Tarlton Parsons
      Shares of company are like slices of a pie. If you and two friends buy a pie together and slice it into three slices, one for each of you, then you each have a "share" of the pie. If one of you paid half the cost of the pie, then the four of you might agree to cut the pie into four slices and the person who paid half the cost would get two slices (half the pie--two of the four shares) and the other two of you would each get one slice (one share). If you decide to share your pie with more people (maybe because they give you some money) you can cut the pie into more pieces (make more shares). Of course, you can't actually "re-cut" a pie, but we are pretending you can for this example. The important thing to understand is that cutting the pie into more pieces doen't make the pie any bigger, it makes the pieces smaller. Shares work the same way. A company can make as many shares as it wants, it just means each share is a smaller piece of the company. This process is called "dilution". Hope that helps.
      (7 votes)
  • How do you determine what the initial idea is worth? The number seemed to come from nowhere. Is it someones opinion?
    (3 votes)
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    • Mr.Attorney, absolutely empty answer "fair market value!"
      Josefgaskill, the best option to value an ideia or a concept is to reverse calculate the returns that an investor would get. You should establish a timeframe, an exit valuation (benchmark with market value (and here it makes sense because in theory the concept will be more mature), estimate the final % stake in the company, assume something between 5x and 10x, cash-on-cash, and finally you get the entry price. So the question is not how much is it worth today, but instead is how much will it be worth in the future. Hope it helps.
      (4 votes)
  • blobby green style avatar for user Gustavo Sandoval
    At the end you mention there's no dilution. But I think that's a little misleading, don't u think ? There's no dilution money wise but there's dilution in ownership. You now own only 10% instead of the 20% pre money
    (3 votes)
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    • You are very much correct. He is diluted and this could be worth millions or billions down the road, even know his value of the asset (his shares) are the same. When ever you issue shares it is the Boards responsibility to add value for the shares issued to justify ownership dilution. The new shares issued should also promise to increase value even more with time without the issuance of more shares. i.e. terh $5 million in cash will allow us to grwon and increase the valuatin of the company 5 fold becuase we have the cash to implement the business plan.
      (3 votes)
  • blobby green style avatar for user JohnQL
    My partner and i created a company that is basically a website. We each own 50% of the company and came to a conclusion that we need funds. We each invested over 25k in the project thus far. We need roughly 2-500k in order to proceed with marketing/mobile app/advertising. We don’t want to give up more than 30% of the company, this way we stay majority holders at 35% each. The website has no value because it isn’t up and running yet. We want to launch the website in 6-8 weeks. Once we launch we want to toss the funds into marketing and advertising. Only problem is we don’t have a value for the company. The company will bring money in by selling real estate ads on each page for a small daily/weekly/monthly fee. How can I go up to an investor (people I actually know) and tell them to invest in my company without having any real value? I want to give 15% to one investor strictly for funds, and then give the other 15% to an investor that can give us a service as well as funds (ex owns a television channel so he can advertise for us for free if he hops onboard with us). Do I create a formula with the value I think my company has? How do I go about doing this. PS I already have the two investors ready to hear me out, I just don’t know how to go about doing it since I have no real value.
    (2 votes)
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Video transcript

Let's say I'm hanging out with my buddies one night and we realize that there's a huge opportunity in selling socks online. And so we decide to start a company. So the first thing we would do is we would write a business plan. And say, you know what? In this business plan writing process, this is all we've all contributed to it individually. So we'll all be equal shareholders. Let's say there's five of us friends. So the first thing we want to do is we want to start a-- well you know, you could do in different orders, you could just write up a business plan, or you can start the corporation. But we'll just assume we start a corporation. And I'm going to indicate the corporation by creating a balance sheet right from the get-go. So, what are the assets of the corporation, and what are the debt-- and what are the liabilities-- and we could talk a little bit about what a corporation even is. So it's asset to begin with. It's essentially just an idea. I mean, you could say it takes physical form to some degree in the business plan, but it's just an idea first. And then, there are no immediate liabilities, it doesn't owe anybody any money. And we learned in the balance sheet videos-- and you might want to watch the balance sheet videos as a prerequisite to this one-- but in general, assets are equal to liabilities plus equity. So this is assets. The only asset we have right now is our idea. Maybe you want to add the potential talent that we have, maybe unique skills. They are very intangible at this point. These are the assets that our five buddies have together. And we have no liabilities. It doesn't sound like we borrowed money or anything. So everything we have-- so the assets are equal to our equity-- and I'll do that in a brown color-- so there's no liabilities and we just have equity. And equity is essentially what the owners of the company have the rights to. For example, if-- I haven't assigned any numbers here and I did that for a reason-- but if the assets were $10 million and liability was $5 million, if we had owed $5 million to someone else, then you would have $5 million left for the equity. And that's what the owners of the company would have. Me and my five buddies, or I guess my four buddies, we decide we're the owners of the company, so we'll be equal shareholders. So we would split the equity between us five ways. So we just pick an arbitrary number. Let's say to begin with we have a million shares, so each of us have 200,000 shares in the company. And that's a bit of an arbitrary notion. And you normally do assign some value to those shares initially, it's some pennies per share, but I won't get into the technicalities of that. Just fair enough to say that we each have 200,000 shares in this company. And some of them go to me and then the rest of them go to buddy one, buddy two, buddy three, and buddy four. This is the equity right here. And there's a total of one million shares outstanding. Good enough. Well, just an idea and some paper and some well intentioned individuals alone isn't enough to start a company. We're going to have to create some type of an online presence, and do some programming, and maybe have a warehouse, and do some marketing. So we're going to have to-- and really we're going to have to quit our jobs so that we can work on this full time. So we're going to have to raise some money. Money to hire some engineers, so that we can quit our jobs. To hire some marketing people, et cetera, et cetera. So where do we get our money from? So this is where the whole venture capital world comes into the picture. You've heard the word before. I think you have some sense of what it is. And the venture capital world, it's kind of separated into different people who invest in different stages. So you'll have people, they're called angel investors. And sometimes these people won't even call themselves venture-- angel investors. And these are the guys that are kind of these, I don't want to stereotype it, but they'll be kind of like the old guys who made it big in the `80s and now they're sitting on billions of dollars. And they want to participate in the neat, fun ideas that young guys like me and my friends think of. And so they're kind of like your rich uncle who says, oh that's a great idea, I'll throw some money behind that. They usually invest at a very early stage. So those are probably the people we would go to initially. And then we'll talk to the people after that, the other types of venture capitalists. But in general, venture capital can meet a lot of things. But it means someone who's going to give you money. They're going to take a stake in your company and hope that your-- they give you enough money to kind of get your venture going. To kind of start your business. So let's say we go to an angel investor, and we say hey, angel investor, don't you think this is a great idea? We're going to sell socks online. You know, socks are something people run out of every week, we can even do subscriptions for socks. You get 10 pairs of month, et cetera, et cetera. You can give them as gifts. All of these lovely things. And the first nine guys slam their doors on our face. They think our business is stupid. But the tenth guy says, hey you know, that's interesting. So we enter into negotiations. And he's like, you know what? I'm going to invest. But we have to figure out what I'm going to get in exchange for investing in your company. How much of your company I'm going to get. And so this leads to a process of valuation. So let's say we say need $5 million from the angel investor to get started. We need $5 million-- let me write that down-- that's what we say we need. And that's what the angel investor says that he's willing to give us, because he agrees. $5 million, that's enough for us to quit our jobs, and then we could all take salaries for some time. We could hire a bunch of people. We can rent office spaces. Do everything you need to do to start a company. And $5 million will support that for, I don't know, a year or two. I don't know, depending on how many expenses we have. But the question is, what does he get for that $5 million. So in order to come to that conclusion, you have to determine what is what we had before he came to the picture worth, right? Notice, when I did this balance sheet I didn't even write what these assets are worth. What is this worth? And this value, this is called a-- well in general, whenever you're valuing anything, it's called a valuation. And since we want to know what this is worth-- this is before we got any kind of money from investors-- this would be called a pre-money valuation. And I'll show you why that matters in a second. Because, if us and this angel investor agree that this-- our assets before we go to them-- are worth $5 million. So if we agree that they're worth $5 million-- let me draw that so, what color was I doing that in? It was in yellow-- so if we agree-- let me draw it a little bit smaller-- essentially it's just an idea, and then we have the shares, a million shares. Of that million, I have 200,000. The other 800,000 are with my friends. These are one million shares total, or shares outstanding. So if this idea-- we agree with the angel investor-- if we agree this is worth $5 million. So everything we have today is worth $5 million. Then when he gives us another $5 million, that's an asset, right? We'll have $5 million in cash. So he'll give us another $5 million. He'll essentially get 50% of the company. He'll get all of these shares up here. Now how does that work out? Well if you think about it, this is the post-money company, right? So let's think about it a couple ways. This is $5 million. That's the idea. What is the $5 million worth? That's not a trick question. That's worth $5 million, right? It's worth $5 million. So what is the post-money valuation? When we talk about valuation we're talking about the value of the assets, especially because we're not dealing with any debt right now. Everything on the right-hand side is equity, so this is all equity. Let me write that, no liabilities yet. And in general, when you're doing a startup company, if I want to start socksonline.com, and I go into my local bank and say, hey give me a loan, they're just going to turn me away. Because if you have a venture that really doesn't exist yet and has no cash flow, they know that you're not going to pay the interest on the debt, so you're not going to even be able to raise debt until you are a more mature company. Or until you-- maybe you could post some collateral. And I'll talk more about that. Maybe you could say hey, I'll use my house. If I don't pay the debt, you can take my house, or something like that. But for the most part we don't want to do that. So the only way to raise money at this early stage is by issuing equity. So going back to what we were talking about, what is the post-money valuation? We said before any of this stuff on the top existed, the pre-money valuation of just our idea was $5 million. Now, the angel investor, if we value this at $5 million, he'll give us $5 million more. What is the total value of all of the assets now? Well if we said this was $5 million, that's just something we agreed with. This is worth $5 million. So the combined assets, if you believe that this is worth $5 million, is now $10 million, right? And this would be the post-money valuation. And if you think about it, if you think about the company in this form right now, we-- me and my buddies-- we've contributed half of the value of the company. And this rich guy, he's contributed the other half of the company. So it makes sense that he has 50% of the company. So how is that going to work? Well, I don't give away any of my shares, and neither are any of my friends. They're all going to keep their shares. So we had five chunks of $200,000 that went-- 200,000 shares that went to each of us. All right, that was buddy one, two, three, four. So what we'll do is, we'll actually issue another million shares and give it to this rich dude. So this is another one million shares. So as the company board, you can actually authorize to create shares. And that's what we did, and we essentially sold those shares for $5 million. So now instead of having one million shares, you have two million shares. So something interesting here, and some people often talk about the notion of dilution, right? Because before, I had 200,000 out of a million shares. So before, I had 20% of the company. And now what do I have? Well we've essentially doubled the share count, so now I only have 10% of the company. So some people say, oh you know what, my share of the company got diluted. But it really isn't the case, because the company has gotten all this cash. I now own 10% of something that's twice as valuable, as opposed to 20% of something that's half as valuable. If you really believe that, then this was no change, right? I now own 10% of ten million, which in theory should be worth a million dollars. Before I owned 20% of five million, which was also worth a million dollars. So if you believe these valuations, I probably-- I'm neutral. And we're going to put this $5 million to work. And actually let me take a step-- actually no, I just realized I'm out of time. Let me continue this in the next video.