Since we announced KeyStart a few weeks ago, I have had many people ask me about the terms of the investment agreement, and I recently heard an excellent analogy that will help explain it.
Betty is opening a restaurant in three months, but she needs cash now for a few things. So Betty sells a $100 restaurant gift card to Veronica for $80, which Veronica can redeem when the restaurant opens its doors to paying customers. Since Veronica prepaid Betty, Veronica will get $100 worth of food and drinks for the $80 she paid for the gift card.
The Analogy Explained
Betty = winning KeyStart contestant
Restaurant = winning contestant’s new business
Veronica = investment firm
$80 = $5000 cash investment
Gift card = purchase agreement
$100 = $6250 worth of future stock in winning contestant’s new business
Restaurant opening to paying customers = winning contestant getting larger investment in the future
Let’s assume you, the reader, are the winning KeyStart contestant. The following is what will happen next.
You will establish your business as a legal entity. Maybe you will name it Your Biz, LLC.
Your Biz will enter into an agreement with a real life Peoria investment firm named Attollo. The agreement states that Attollo will give Your Biz $5000 cash, then Your Biz will sign a purchase agreement with Attollo. At this point Your Biz is too new to place a value on it.
Let’s say that you’re a great entrepreneur and that Your Biz begins to grow and a year later it gets attention from an investment firm that could be called Hypothetical Ventures, who want to invest in Your Biz.
Hypothetical Ventures says they think Your Biz is worth $400,000 and they want to invest $100,000. You agree. So you take the $100,000 and now Your Biz is worth half a million bucks and you own 80%! But, wait.
Attollo’s original $5000 investment converts to $6250 worth of stock, according to the purchase agreement, so they get a piece of the action, too. So 6250/500,000 works out to Attollo owning 1.25% of Your Biz, LLC.
An Alternative Scenario
Suppose Your Biz, LLC, is making some really great sales and is able to grow steadily without raising investment money from Hypothetical Ventures or anyone else. That’s great!
As soon as the purchase agreement that Your Biz signed with Attollo turns two years old, their investment converts to $10,000 divided by the valuation of Your Biz.
The valuation of Your Biz is defined in the purchase agreement as the greater of annual sales or 5x the profit.
Let’s say Your Biz does $400,000 of revenue.
If the profit margin is less than 20% then the company valuation will be $400,000 according to the purchase agreement. So 10,000/400,000 works out to Attollo owning 2.5% of Your Biz, LLC.
If the profit margin is greater than 20% then the company valuation will be 5x profit. Let’s say it’s 27%. That means Your Biz made $108,000 in profit, so the company valuation will be $540,000. So 10,000/540,000 works out to 1.85%