What will happen to the investments of the "Friends-and-Family" during a seed round?


6

Let's say a certain startup is currently in the Friends-and-Family stage.

What will happen to the investments of those people during a seed round or when someone invests bigger?

Seed Funding

asked Sep 23 '13 at 18:48
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Abel Melquiades Callejo
47 points
  • They will likely be diluted to(wards) zero, but it depends on the wording of the contracts involved. – Steve Jones 8 years ago
  • @SteveJones let's say there are 3 investors with 1,000 usd each and all of them summed up will have a total share of 30%. What will happen to those investments if someone will invest 50,000 usd? – Abel Melquiades Callejo 8 years ago

2 Answers


4

The more of your company you are obliged to give away, the less your friends/family will be left with. In the end, it all depends on whether the seed investor thinks that the percentage of your company they are being offered e.g. 10% for $50,000 is worth the price. Investors I have spoken to have talked about a minimum of 10x return on investment after 5 years if all goes well.

This is in order that the high failure rate of startups is compensated for. If an investor backs 10 startups and 8 fail, then the remaining two need to be on a roughly 10x return to pay for the failures and make some profit.

Lets say your seed investor does get 10% of the company for $50,000 (that values the whole company at $500,000 post-money & $450,000 pre-money). They therefore need their $50,000 to become worth at least $500,000 after 5 years in order for it to be worth it. That means that your whole company needs to be worth $5,000,000 for the 10% to be worth that much. How you do that valuation depends on what industry you're in and what your business model looks like, but lets say your investor is looking to sell to a different investor who values companies like yours at 8x net profits. Working backwards, that means that your company must make $5,000,000 / 8 = $625,000 net profit per annum.

If your current financial projections can reasonably support that sort of profitability after 5 years, then you're in a good position to offer 10% of your company for $50,000. If not, you'll have to change the deal or change your business model.

If you were successful in persuading an investor to buy 10% from you at $50,000, that would mean that the 30% stake that your friends/family have is now 30% x 450,000/500,000 = 27% of the $500,000 total. However, if you are obliged to part with 50% of your company for the same price, then the pre/post money valuations would be $50,000 and $100,000 meaning that they end up with 30% x 50,000/100,000 = 15% of the $100,000 total.

Bottom line: the more valuable you can make your company to an investor, the less your friends and family will get diluted. Hold off for as long as you can!

answered Sep 25 '13 at 02:01
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Matt Gibson
318 points

1

The missing parameter is the valuation of each round. In your example, if $3,000 resulted in 30% of the company, it means the company was deemed worth $10,000.

Later on, your new investor brings $50,000. You negotiate a valuation (which is really the same as a percentage). The company issues new shares. Now you can compute how many shares each person has, and therefore the new percentage for the original friends-and-family. Excel is your friend to figure out the details.

answered Sep 24 '13 at 12:14
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Alain Raynaud
10,927 points
  • Mr Alain, is that what @SteveJones said about 'likely be diluted to zero'? Would it be possible to just make the friends and family a total of 10%, 25% share then will be given to the new investor while reducing the founders with 5% (-5%)? – Abel Melquiades Callejo 8 years ago
  • Everything is possible. As the CEO, you could sell some of your shares, so that doesn't dilute your friends and family. It's just that healthy startups don't do it that way. – Alain Raynaud 8 years ago

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