What Selling 20% of Your Company to a Private Investor Really Costs

Key takeaways

• The price follows the pre-money valuation: $500,000 at a $2.0 million pre-money valuation buys 20% of a $2.5 million company.
• The real cost of equity is set at exit: 20% is $1 million at a $5 million sale, $2 million at $10 million and $4 million at $20 million.
• Later rounds dilute everyone - a $1.5 million second raise plus a 10% option pool takes a founder from 80% to 56%.
• Debt of the same size has a known cost - $130,056 of interest in the example - but needs cash flow and usually a director's guarantee.
• Terms can cost more than the percentage: a liquidation preference, vetoes and anti-dilution clauses all shift value to the investor.
• New shares issued by the company and shares you sell yourself are taxed differently, so bring your accountant in before the term sheet.

How is the price of a 20% stake worked out?

The investor's percentage is their money divided by the company's value after the money goes in. If the business is valued at $2.0 million before the deal (the pre-money valuation) and a private investor puts in $500,000, the company is worth $2.5 million afterwards (post-money) and the investor owns $500,000 divided by $2.5 million, or 20%.

So the valuation is the whole negotiation. business.gov.au's guide to valuing your business says there is no single method and lists the common ones: current market values, return on investment, the value of business assets, the cost of starting from scratch, and future profit. It calls future profit the biggest value of most businesses and suggests professional advice, because goodwill is hard to measure.

The return-on-investment method is the one investors reach for first. If the business makes $400,000 of net profit and the investor wants a 20% return on the price, they will value it at $400,000 divided by 0.20, or $2.0 million. A few hundred thousand dollars either way on the valuation changes the stake sharply.

Proving the forecast before you raise - a signed contract, a year of growth in the accounts - is often worth more than any negotiating tactic, because it moves you down this table.

What does the 20% cost you if the business grows?

The cost of equity is not paid on the day you sign. It is paid at exit, and in dividends along the way, and it rises with your success. The same 20% stake is worth very different amounts depending on what the business eventually sells for.

Dividends add to it. If the company pays $300,000 a year in dividends from year three, the investor collects $60,000 a year of it.

Compare a loan of the same size. At an illustrative 9.5% over five years, principal and interest, $500,000 costs $10,501 a month and $130,056 of interest in total. At an assumed 25% company tax rate (check yours with your accountant), the after-tax interest cost is about $97,542. That is the whole cost, and it ends in year five whatever the business becomes. At any sale value above about $3.15 million, the 20% stake is worth more than the $630,056 of principal and interest the loan would cost in total - before counting dividends or tax.

How do later rounds dilute you further?

Few companies raise once. Each new raise issues more shares, so every existing holder's percentage falls. Suppose that three years later the company raises $1.5 million at a $6.0 million pre-money valuation. The new investor takes 20% of the $7.5 million post-money company. The new investor also asks for a 10% employee option pool, created before the round so that it dilutes the existing holders, not the newcomer.

With the pool, the existing holders share 70% in the old 80:20 ratio: 0.8 times 70% is 56%, and 0.2 times 70% is 14%. If the company then sells for $10 million, the founder receives $5.6 million. Had the founder borrowed the first $500,000 instead and done the same second round, they would hold 70% and receive $7.0 million. At that sale price, the first 20% cost $1.4 million.

Watch for anti-dilution clauses. If a later round is priced lower than the first, a weighted-average or full-ratchet clause gives the early investor extra shares, and the founder absorbs the whole adjustment.

Is a loan really cheaper, and what does it need?

A loan is cheaper only if the business can service it. On the illustrative $500,000 at 9.5% over five years, repayments are $126,011 a year. Lenders test that against cash earnings with a debt service cover ratio: if a lender wants 1.25x to 1.5x (an indicative range that varies by lender), the business needs roughly $157,500 to $189,000 a year of EBITDA. The ICR and DSCR calculator shows the largest loan your earnings support.

A lender will also want security - a general security interest over business assets, often a mortgage - and usually a director's guarantee, which makes the debt personal if the business fails. A private investor asks for none of that.

Repayment shape matters as much as rate. A five-year principal-and-interest loan drains cash hard in a growth phase; a longer term or a balloon lowers the monthly cost but leaves a lump to refinance. Our guide to amortisation versus balloon payments works through the trade-off. If the business has no property to offer, read our piece on finance without property security before you assume equity is the only door.

What else does a private investor's 20% usually come with?

The percentage is the headline. The term sheet decides what it is really worth.

• Liquidation preference. A 1x non-participating preference lets the investor take their money back before anyone else on a sale, or their percentage if that is larger. Sell for $2 million and 20% is $400,000, so the investor takes their $500,000 instead and the founder receives $1.5 million, not $1.6 million.
• Board seat and reserved matters. Major decisions such as new share issues, large borrowings and asset sales need the investor's consent.
• Pre-emptive rights. The right to take up new shares before outsiders, so they can hold their percentage.
• Drag-along and tag-along. Rules that decide who can force, or join, a sale.
• Founder vesting and leaver clauses. If you leave early, you may have to sell shares back at a discount.
• Warranties. Promises about the accounts and the business that you personally may have to stand behind.

Two offers at the same valuation can be worlds apart once these are priced in. Have a lawyer read the term sheet before you accept the number.

How is selling equity taxed?

This is general information, not tax advice - speak to your accountant before you sign. The broad shape differs by how the investor gets their shares.

Most growth raises issue new shares, because the business needs the money. When a founder does sell part of their own holding, the ATO's small business CGT concessions may be relevant, and the conditions are detailed. Employee option pools carry their own tax rules too.

Which rules govern selling shares to a private investor?

Offering shares is fundraising under Chapter 6D of the Corporations Act. ASIC's fundraising overview notes a proprietary company can have no more than 50 non-employee shareholders, and can raise from the general public only where the offer does not need a disclosure document.

ASIC's page on when a disclosure document is needed sets out exemptions such as personal offers to fewer than 20 persons in 12 months raising no more than $2 million, which must not be advertised, and offers to people presumed not to need disclosure, such as sophisticated investors. A lawyer should confirm which exemption you rely on before the money moves.

How do you decide, and what are the alternatives to selling 20%?

1. Model the stake at three sale values, as in the table above, and compare it with the dollar cost of debt.
2. Test whether cash flow can carry a loan at a buffer above the repayments.
3. Price the terms, not just the percentage: preference, vetoes, vesting and anti-dilution.
4. Consider partial answers: borrow for the asset and raise less equity; use a convertible note; or raise later at a higher valuation once the growth is visible.

If debt covers some or all of the plan, compare it with private investor money by posting one loan request on ADS, and 200+ verified lenders and brokers can ask about it.

Frequently asked questions

How much is 20% of my company worth?

At the deal, 20% is worth what the investor pays: $500,000 at a $2.0 million pre-money valuation in the example. Its real cost to you is set later, when the company is sold or pays dividends. At a $10 million sale, that 20% is $2 million. Value it at several possible exit prices, not just the price on the term sheet.

What is the difference between pre-money and post-money valuation?

Pre-money is the agreed value of the company before the investment; post-money is that value plus the new money. The investor's stake is their investment divided by the post-money figure. $500,000 into a $2.0 million pre-money company gives a $2.5 million post-money value and a 20% stake.

Is it better to give up equity or take a loan?

If the business can comfortably service the repayments, a loan usually costs less, because its cost is fixed and ends. In the example, $500,000 of debt cost $130,056 of interest while 20% of a $10 million exit was $2 million. Equity suits a business that cannot carry repayments yet, or an investor who brings more than money.

What is dilution?

Dilution is the fall in your percentage when the company issues new shares. Your shares do not disappear; the total grows. In the example, a second raise of $1.5 million and a 10% option pool take the founder from 80% to 56%, and the first investor from 20% to 14%.

Do I pay tax when a private investor buys new shares in my company?

Generally, when the company issues new shares, the money is share capital of the company and the founder has sold nothing, so no capital gain arises for the founder at that point. Selling your own existing shares is different and can trigger capital gains tax. This is general information only; confirm your position with your accountant.

Related reading

• Business Loan Amortisation vs Balloon Payments
• Startup Finance Without Property Security
• Directors' Guarantees: What You Sign

Sources

• Value your business — business.gov.au
• Fundraising (Chapter 6D, proprietary companies) — Australian Securities and Investments Commission
• Disclosure documents to be provided to potential investors when raising funds — Australian Securities and Investments Commission
• Small business CGT concessions: eligibility overview — Australian Taxation Office