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Question: My friend told me that his company just raised two million dollars from investors and that it means his business is worth $15 million. What does all that mean and how does a company just have money appear without having an actual product yet?

Dave Taylor

Answer: You ask a fundamental business question, one that’s at the heart of a massive number of startups: How do you pay for development and growth? Whether it’s a restaurant that needs to buy tables and chairs, print menus and hire a staff or a software firm that needs to pay its programmers, all companies need some money in the bank.

Often, the very first investment comes from the founders, the people whose passion and zeal fuels the new business. A food truck might be purchased by the two women who want to create a mobile restaurant, for example.

The second wave of money can show up as a company demonstrates that there’s a real business opportunity, not just a good idea. This small amount typically comes from friends and family. These investments can be tricky, however, because these [financially] unsophisticated investors need to realize that their investment could yield big rewards or vanish completely if the company fails.

These investors, even if it’s your mom, are buying something tangible too: ownership in the company. This is typically done through stock, or the option to buy stock in the future at a discounted rate. This means that the company needs to be assigned a value. That is, if I invest $1,000 in your business, do I own 1% of the company? 10%? or 0.0001%? Every entrepreneur is sure their business is worth billions, but that’s something they have to prove to skeptical investors.

The next wave of investors are professional and more experienced with business grown and opportunities. It might start with so-called angel investors — who invest small amounts at an early stage — or venture capitalists — who can invest millions, but wait until they know that there’s a proven opportunity and actual revenue stream.

Which brings us to your friend’s company. You shared that they raised $2 million in outside investment, which placed the valuation at $15 million. You can calculate that the investor now owns 13.3% of the company’s stock. If the firm goes on to be publicly traded or is acquired by another firm, that 13.3% could be worth much more than the initial investment as the overall company value skyrockets. That’s the goal of investors; to multiply their money.

Just as a theoretical, let’s say the company is acquired in 2022 for $50 million. That 13.3% ownership stake that cost $2 million would then be worth a sweet $6.6 million. Then again, in 2021 the company could go bankrupt and that’s that. Risk, reward.

Hope that helps you understand how all this fits together on a growing business.

Note: This is my 200th column for the Boulder Daily Camera! Thanks for reading, and don’t forget to reach out with your technical or business questions!

Dave Taylor has been involved with the online world since before the launch of the Internet and runs the popular tech help site. You can also find AskDaveTaylor on Facebook and check out the AskDaveTaylor YouTube channel, too.

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