This section presents the basic terms with which companies raising capital need to be familiar. A more detailed discussion of the valuation of startup companies and various calculations in connection with these terms is given in Chapter 9.
Sale of Shares by Shareholders Versus Investments
The main difference between the sale of shares by shareholders (a "secondary offering") a transaction to which the company is not a party and raising capital for the company (i.e., importing money into the company) is that in the latter case the company allots new shares to investors (i.e., adds shares to the company's allotted share capital), against which it receives an investment, usually in cash which it can use for its business.
For example: Speed Ltd. has 3,000,000 shares that are equally divided between its two entrepreneurs. In other words, each entrepreneur holds 50% of the company's equity. If a certain entity were to buy 1,500,000 shares from one entrepreneur, the other entrepreneur would still hold 1,500,000 shares out of the 3,000,000 (50% of the company) and will not have been diluted at all. Ostensibly, the company's financial condition has not changed at all either, since no new funds were infused into the company. If, on the other hand, an investor invests money in the company, in consideration for which the company allots to him or her 1,500,000 shares, then, although each entrepreneur still retains 1,500,000 shares, these shares now constitute only one third of the company's equity. In other words, they were diluted by approximately 17%, or one third of their holdings (for an accurate calculation of the number of shares allotted in investments and the rate of dilution, see Chapter 9). However, in this case the company receives funds or other resources which it can use for its activities. This type of issuance is the most prevalent in early-stage equity private placements, since the main reason for raising capital is the need to infuse money into the company and not the entrepreneurs' desire to realize their investment.
Terms for Describing the Value of a Company
It should be noted that the price of the share just before and after the investment remains unchanged. Speed Ltd., for example, has 3,000,000 shares before the investment. Since its pre-money value was estimated at $3 million, the price of each share was $1. The company has now received an investment of $1 million in consideration for shares. Since the share price is $1, one million additional shares were bought and allotted. The total amount of allotted shares is now 4,000,000, i.e., the new investor holds 25% of the shares: 1,000,000 out of a total of 4,000,000, with the price of each share remaining $1.