Authentic voices. Remarkable stories. AOL On Originals showcase the passions that make the world a more interesting place.
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Let’s say I am hanging out with my buddies one night and we realized that there is a huge opportunity in selling socks online. And so, we decided 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 are five of us friends.
So, the first thing we want to do is we want to start a—well you know, you could do it in different orders. You could write up a business plan or you can start the corporation but let us assume that we start a corporation. I am going to indicate the corporation by kind of creating a balance sheet right from the get-go. So, what are the assets of the corporation? What are the debts? What are the liabilities? And we could talk a little bit about what a corporation even is.
So, its asset to begin with is essentially just an idea. I mean you could say, it takes physical form into some degree in the business plan but it’s just an idea at first and then there are no immediate liabilities. It doesn’t owe anybody any money and we learned that in the balance sheet videos. 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, we have no liabilities and these are the 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’re very intangible at this point, unique skills. These are the assets that our five buddies have together and we have no liabilities. We do not sound like we borrowed money or anything. So everything we have, the assets are equal to our equity. So, there are no liabilities and we just have equity.
Equity is essentially what the owners of the company have the rights to. I haven’t assigned any numbers here and that I did that for a reason. For example, 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 four buddies, we just had worthy 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 $1 million shares. So, each of us has $200,000.00 shares in the company; that’s a bit of an arbitrary notion. And you normally do assign some value. They’ll share as initially at some pennies per share but I wont’ get into the technicalities of that, just fair enough to say that we each have $200,000.00 shares in this company. Some of them go to me and then the rest of them go to buddy one, buddy two, buddy three and buddy four and this is the equity right here. And there are a total of $1 million shares outstanding.
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. And really, we’re going to have to quit our jobs so that we can work on this fulltime. 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, etc. So, where do we get our money from?
So, this is where the whole venture capital world comes into the picture and if you’ve heard the word before. I think you had some sense of what it is. The venture capital world, it’s kind of separated into different people who invested different stages. So, you’ll have people that are called angel investors and sometimes these people won’t even call themselves venture angel investors. These are the guys that are kind of these—I don’t want a 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 uncles. 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 they will talk to the people after that, the other types of venture capital. Let’s put in general, venture capital can mean 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 it gives 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. Socks or something people run out of every week. We can even do some scriptions for socks. You get 10 pairs a month, etc. You can give them as gifts.” And the first nine guys slam their doors at our face and think our business plan is stupid but the 10th guy says, “Hey! You know that’s interesting.” So, we entered to negotiations and he’s like, “You know what? I am going to invest but we have to figure out what I am going to get in exchange for investing in your company. How much of your company am I going to get?” And so this leads to a process of valuation. So, let’s say we need $5 million from the angel investor to get started. We need $5 million dollars; 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 sometime, we can hire a bunch of people. We can rent office spaces and do everything you need to do to start a company and $5 million will support that a year or 2, depending on how many expenses we have.
Question is, “What does he get for that $5 million?” So, in order to come to that conclusion, you have to determine what we have before he came to the picture worth. When I did this balance sheet, notice that I didn’t even write what these assets are worth. What is this worth? And this value, 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 we and this angel investor agree that our assets before we go to him are worth $5 million, so if we agree that they’re worth $5 million—so, essentially this is just an idea. And then we have these shares, $1 million shares of that million. I have $200,000.00. The rest, other $800,000.00 is with my friends. These are $1 million shares total or shares outstanding.
So, if this idea we agree with the angel investor, if we agree that 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. 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 and how does that work out? Well, if you think about it, this is the post-money company. So, let’s think about it a couple of ways. If this is $5 million, that’s the idea. What is the $5 million worth? That’s not a trick question. 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. 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 you 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 a debt. So, you’re not going to even be able to raise debt until the company’s more mature or until you—maybe you could post some collateral. 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’re talking about. What is the post-money valuation? We said before any of these 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 he believed that this was worth $5 million, it would now be $10 million 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, me and my buddies, we’ve contributed half of the value of the company and this rich guy, he has 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 a way any of my shares and either any of my friends. They’re all going to keep their shares. So, let’s see. We had five chunks of $200,000.00 shares that went to each of us. That was buddy one, two, three and four. What we’ll do is, we’ll actually issue another million shares and give it to this rich dude. So, this is another $1 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 $1 million shares, you have $2 million shares.
So, something interesting here and some people will often talk about the notion of dilution because before I had $200,000.00 out of a $1 million shares. So, before I had 20% of the company and now, what do I have? Well, we’ve essentially doubled the share counts and 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 these 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. I now own 10% of $10 million which in theory it should be $1 million, before I owned 20% of 5 million which was also worth $1 million. So, if he believes these valuations, I’m neutral and we’re going to put this $5 million to work.
I just realized I am out of time. Let me continue this in the next video.