When making an investment in a startup (or any company), an investor will demand to receive an ownership percentage in the startup. How does that work?
There are many potential reasons why an investor might make an investment in a company, including: financial return, a love of the industry, the company's impact on the investor's other holdings, or a range of other strategic reasons. Of these, the financial return of her investment will likely have the greatest impact on the investor.
Financially, the investment is centered on the basic exchange:
The investor puts $$ into the company
-- In exchange for --
A share of the company's stock.
For example, if the investor puts $100 into the company, she would expect to receive an ownership percentage which would entitle her to that same percentage share of profits produced by the company (as well as the other "traditional" rights of stock ownership...such as voting on company matters).
What is the ownership percentage received for the investment?...20%, 50%, 100%?? It depends entirely on the value of the company!
If the company had a value of $100, then in exchange for the investment of $100, the investor would expect to receive 100% of the company's stock. Alternatively, if the company had a value of $200, then the investor would expect to receive an ownership share of 50% for her investment, and 20% if the company were to have a value of $500.
What is the value of the company? That is determined, in large part, by the company's future earnings. (More here).
So, if an entrepreneur believes his company has a value of $250, then he would offer 40% of his company to the investor in exchange for the investment of $100.
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