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Studying for a test? Prepare with these 10 lessons on Stocks and bonds.
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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.