Q:
I'm writing my business plan for a company that would sell computer books
and software titles and include a gourmet coffee cafe. Can I sell stock
in order to obtain money for my startup? If so, how?
--H.A., Lancaster, Pa.
A:
In the formal sense -- offering equity ownership to the public within
securities regulations -- the answer is generally no. But in the less formal
sense -- selling a percent of ownership in your startup to friends and family -- the practice is common. During the very early "seed" round to fund a new company, the risk and uncertainty are high, so your investors are likely to receive a substantial stake in the company for a relatively small amount of capital.
To get started, you'll need to form a legal entity -- a partnership, a
corporation, limited liability company (LLC), etc., so that you have something formal to share. At this point, you -- as the entrepreneur -- will own shares of stock representing 100% of the company. Each time you issue additional stock to an investor, your percentage will decline. Get experienced legal counsel to draw up investor agreements and a formal proposal for how you would use and repay the funds. Make sure you include a backup plan for repaying your investors if things don't work out as you expect they will.
If you plan to raise more than $1 million within a 12-month period, you may
need to write a private-placement memorandum as well. This is essentially your
business plan, plus more complete documentation describing the securities,
the risks, and the uncertainties in the business investment.
PICK A P-E. How do you value your company at this early stage? Investors typically multiply third-year projected earnings by comparable price-to-earnings ratios (how much the company's stock commands for each dollar of earnings) of similar companies. "Traditionally, p-e ratios have been in the 10 to 12 range," says John B. Vinturella, a New Orleans management and technology consultant, "but Internet ventures now command two or three times that." If your projected
third-year earnings are $250,000 and you use a p-e of 12, your company's
estimated worth in three years is $3 million.
Next, value the investment after three years, based on expected rate of
return. With a risky startup, an investor may expect close to a 60% annual
return, so an investor's $150,000 investment will be worth roughly $600,000 in three years, and his percentage ownership in your $3 million company will be 20%. "Remember that these are only projections, and they must be realistic, based on documented market research," Vinturella says.
Since startups usually don't pay dividends (profits are reinvested), your
initial backers are going to be with you until your company is either sold or
goes public, says Lori King, a financier based in Bellevue, Wash. Have an exit
strategy mapped out up-front for savvy investors, King says, or they won't
put much stock in your business idea.
Have a question about running your business? Ask our small-business experts. Send us an E-mail at smartanswers@businessweek.com, or write to Smart Answers, BW Online,
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