In popular media when a startup receives funding it’s hugely celebrated, and most people think it to be a sign of success. However, people and founders do not understand what’s really happening behind the scenes. Who’s losing control and who’s gaining control, and what happens to a company’s valuation.
When a startup receives investment from an external firm, the ownership and structure of the company changes. Here’s how it typically works:
- Pre-investment structure:
- Let’s assume there are two founders, and each owns 50% of the startup.
- Issuing new shares:
- When the investment firm buys a stake in the company, it usually does this by purchasing newly issued shares from the company rather than from the founders’ personal shares.
- The company issues new shares that dilute the ownership of the existing shareholders (founders). So, after the investment, each founder will own less than 50%.
- Who receives the money?
- In most cases, the company itself receives the money from the investment firm. This money is added to the company’s balance sheet and used for growth, expansion, or other business activities.
- The founders do not personally receive money unless they are selling a portion of their shares, which is less common in early-stage investments.
- Post-investment structure:
- The new ownership percentage will depend on the amount invested and the valuation agreed upon during the investment round.
- For example, if an investment firm invests Rs 1 Crore for 25% ownership, the company is valued at Rs 4 Crore post-investment. The two founders’ combined ownership will drop from 100% to 75% (37.5% each if equal).
Example Breakdown:
- Before Investment:
- Founder A: 50%
- Founder B: 50%
- Total company value: Rs 2 Crore (hypothetical pre-money valuation)
- Investment:
- An investment firm invests Rs 1 Crore for a 25% stake.
- After Investment:
- Founder A: 37.5%
- Founder B: 37.5%
- Investment firm: 25%
- Total company value: Rs 4 Crore (post-money valuation)
- The company now has Rs 1 Crore in funds to operate, expand, or invest in its growth.
The key point is that the company gets the money from the investment, while the founders’ percentage of ownership is reduced but they retain their shares unless they also sell a portion directly.
Abhishek Sareen is a sales & marketing professional with over 16 years of experience. He started his career as a management consultant at Kurt Salmon Associates and has worked in marketing & brand management, international business in sectors like precision steel tubes for automotive industry, consumer goods and retail.
He’s is a passionate cyclist and participated in several endurance competitive events. His interests are in behavioral psychology, economics and chess. He is a graduate in Computer Science and an MBA in Marketing. He completed his executive education from IIM-A in 2016 focusing on business strategy.