Investment fundingI received this question in an email:

What is the average return for a business investor and what are the typical terms of the return? For example, if a complete stranger wants to invest $50,000 in our company (at start up), what would most investors ask in return?

The question reminds me that most of the web buzz around investment is about what happens with high-tech and high-growth angel and venture capital investment. That, however, is a very small subset at the very top of the investment pyramid. There’s not enough information floating around about what investment looks like for the rest of the world.
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So here’s a simple primer on the basics of business investment for startups:

  1. Everything in startups is on a case-by-case basis. The things I discuss in this post are generally true, but there are always exceptions.
  2. Investment normally implies ownership. The hypothetical $50K investment would buy a percentage of ownership in your company.
  3. How much ownership the investment is worth is determined by dividing the amount of the investment by the value of the company. A $50K investment buys 50 percent ownership of a company worth $100K, 20 percent ownership of a company worth $250K, and 5 percent ownership of a company worth $1 million.
  4. There are laws governing who can invest and how you can seek investment in your company. Make sure you check with an attorney on this. The terms “friends and family” and “angel investment” are legally significant.
  5. Standard startup investment gets a return only when the startup company generates actual liquid money for its owners by selling its shares. Since it’s all case-by-case, you could offer investors dividends or some other drip compensation, but that’s not the standard. The standard is that the investors make their money when they can sell their ownership shares for a whole lot more than the $50K that they originally invested. Angel investors want to believe that their investment can grow 10x or even 100x in 3-5 years, because investing in startups is very risky and therefore angel investors must get a very high rate of return on a successful investment to make up for the losses they incur with startup failures.
  6. Return relates to risk. If you have a low-tech, low-growth business, maybe you can attract friend and family investors who will be satisfied with an annual dividend or something similar (and small). That’s unusual.
  7. Always compare the investment in your company to what the investor would get with much less risky investments like certificates of deposit or mutual funds. All startups are risky. Investors should expect a higher payoff.
  8. Sometimes people invest in a startup for non-monetary reasons, like family support.

So what is the answer to that specific question about the $50K investment? I can’t answer without knowing what the company is, to evaluate its growth prospects, chance of eventual exit, and so forth. But it starts with the assumption that the investment will mean selling a share of your company.

Tim BerryTim Berry

Tim Berry is the founder and chairman of Palo Alto Software and Follow him on Twitter @Timberry.