Learn the Basics of How Equity Investors Plan to Make the Money Back and Hopefully a Large Profit.
Whether you are considering creating your own startup or investing in one, you might wonder how equity investors get paid. Regardless of which situation you are in, it is essential to understand how investors recoup their investment and its length of time this could take. Keep on reading for the answer to this question and more information about equity investing.
Question – How Do Equity Investors Get Paid?
There are only two ways an equity investor gets paid. They either make money off of dividends, or they can sell their shares. That is it. They can make dividends while the company is profitable or sell their stocks for money – this may be for a profit or not, depending upon when they choose to sell.
What Exactly are Dividends?
A dividend is simply a distribution of a companies earnings or profit to shareholders. The amount and frequency of dividends are decided upon by the companies board of directors.
Typically, most companies give out dividends quarterly, but sometimes this could be more or less depending on the company. Some examples of this are companies that give out dividends monthly, yearly or semi-yearly.
Usually, dividends are distributed in a cash payment. However, sometimes the dividends are issued in stock or other types of property. How much the dividend is, depends on the board of directors. They could either choose to do it on a specific percentage of profit or the dividend yield – which is a percentage of the current stock price.
Let’s look at an example to understand how this would work. For this example, we will pretend you are the investor.
You invested $50,000 into a startup. At the time of the investment, or as soon as the company could get a valuation – it was determined each share of stock was worth $1.00. This has given you 50,000 shares of stock for this startup.
Now let’s say that once the company started turning a profit, you decided for the time being that you would hold onto all the stock because the popularity of the company keeps going up. This is a solid business and a fantastic investment. They also give out dividends quarterly with a 2% yield of the stock price.
In addition, they do one special dividend Mid-February to represent 5% of December and January’s profits as they are a company that makes a large portion of their sales before and after Christmas. A special dividend would be divided between all shareholders evenly. For easy math, we will assume you will always own precisely 20% of all shares.
Let’s look at some hypothetical numbers to see how you could make money on a successful company throughout the years.
Year 3 is when companies are usually just breaking even or beginning to see a profit.
- Stock Price: $1.50
- Dec/Jan Profit: $18,000
2% of a share would cost 3 cents. You have 50,000 shares, so that is $1500.00 per quarter – $6000.00 for the year.
The two-month profit was $18,000. So 5% of that is 900.00. So 20% of that is $225.00. So your special bonus is worth $225.
In year 3, you made $6225.00 on dividends.
Year 5, a company can usually tell which way the market is going for them. They may be doing the best than they have so far, but there is still a lot of fun for growth.
- Stock Price: $3.50
- Dec/Jan Profit: $52,000
2% of a share would cost 7 cents. You have 50,000 shares, so that is $3500.00 per quarter – $14,000.00 for the year.
The two-month profit was $52,000. 5% of that is $2600.00. 20% of that is $520.00. So your special bonus is worth $520.
In year 5, you made $14,520.00 on dividends.
If a business makes it to year 7 and is doing more than just hanging on, they may start to see some real success now!
- Stock Price: $16.00
- Dec/Jan Profit: $188,000
2% of a share would cost 32 cents. You have 50,000 shares, so that is $16,000 per quarter – $64,000.00 for the year.
The two-month profit was $188,000. 5% of that is 9,400.00. 20% of that is $225.00. So your special bonus is worth $225.
In year 7, you made $65,880.00 on dividends. Congratulations – you made more in dividends alone this year than you put into the company 7 years ago. Bonus – you still own the stock. You can continue to hold, sell some or sell it all. Your current stock is worth $800,000, and it is only year 7. If the company keeps going in the direction it is, it can someday be worth more.
Now, this is the dream – to invest in a company, watch it succeed, and watch your profits climb right alongside the company’s success.
However, with every fantastic success story, there will be unsuccessful hundreds. So, even though you can make money back through dividends, this can not happen if there is no profit.
When a startup is trying to woo an investor, the investor is looking for how they will eventually be paid. Getting common stocks known as shares is what they are usually looking for.
Often, an investor will not settle for common stock but want preferred stock, which comes with extra benefits. Some of these benefits could include becoming a member of the company’s board of directors or even having veto power on that board.
The investor might ask for other things as well. One thing an investor may want is a specific share of the company forever. For instance, in our example above, we assumed that the investor owned 20% of all shares.
Now, if the company ever puts additional shares up, they would be the investors. The initial contract would cover whether:
- those were a perk for being the primary principal investor in the beginning or
- whether the investor would have to buy them but get a discount or
- if the investor had the option to buy at full price but could decline, in effect deciding not to continue to hold 20% of the company shares.
Stocks or shares are just a percentage of the company an investor holds. Typically, when an investor gets these stocks, they are at a low value, and if the company finds success, the value of the stock will rise over time. So the key for an equity investor making their money back is the company they invest in must make a profit and find some degree of success.
Equity investors are investing in a company or a person; this is not a loan. If a company fails, the investment also fails. This is a bet, usually long-term that the company will do well and you will make more money than you put over time, but there is certainly no guarantee.
This is why many investors, especially people who choose to invest in new businesses and startups, invest in multiple companies hoping that one or two will turn a profit. But, unfortunately, about 70% of startups will not make it to the 10-year mark, and even if they do, there is no guarantee they are turning a profit.
However, once a startup does make it that long, there is more of a change of overall success and larger profits. If they managed to keep afloat against huge competition, which is invariably changing as new startups flood the market yearly, they do something right. Most likely, they have a good business model, a good product, or an excellent management team.
How Does the Investor Get Stock From a Startup Before Valuation?
The most common way people make money with stocks is by buying low and selling high. This is no different for an equity investor. When they receive stocks for a new company in which they invest, the initial price is usually low. This is probably before the company going public.
Sometimes investors and startups make a deal on how many stocks and how much each stock will be worth right away, but this is rare. For example, to give someone says 20% of your company.
As in the earlier example, 50,000 stocks at $1.00 apiece, you would have to know that your company is currently valued at $250.000.00. However, when your company is just starting, it is difficult to get an accurate value assigned as there is not enough data.
Often, an equity investor will actually get convertible notes as a form of investment. This is a form of short-term debt that will be transferred to equity at a later time.
For instance, If a company gets on or more investors initially, those investors will get convertible notes before their company has a set value. Then, later on, they may realize they have run out of all their initial capital, and they will do another round of financing.
By the time the new round of financing comes into play, there is enough data regarding the company, which allows the company to be assigned a value. Once a value is given, your convertible notes will be converted to equity either in the form of common stocks or preferred stocks, depending upon the original agreement.
At this point, the investor can decide if they want to keep this investment or look into selling their stock.
How Can an Investor Make Money from Stocks?
So, now that you understand how an investor gets the preferred or common stocks from a new business or a startup, you may still wonder how to make money off these stocks. We already discussed in this article the role of dividends.
Dividends can either make you a small amount of money or, in cases where the stock has exploded in price since you originally bought it, a large amount of money. But, of course, if the company is not posting a profit, you will not make any money.
Dividends are only an option if you hold on to the stock. It is like a bonus or an incentive not to sell. It is excellent if you are looking for long-term small amounts. But what if you are more interested in the short term?
If the stock is live, you can always just sell it. You can sell all your shares, or you could choose to just sell a portion. Selling a part will allow you to continue to receive dividends (although a smaller amount as you will have fewer shares) but to get a one-time, more considerable amount by selling for the stock price today.
If the stock is not live yet and is not being publicly traded. Still, for whatever reason you want to sell, you can sell your interest in this company to another investor. Again, depending on what stage the company is in, this may still be for a profit, but perhaps not a large one.
Sometimes a company either merges into another or is purchased by another company. When this happens, your profit could occur quicker. For instance, if the company had not been assigned a valuation yet, it will now with new owners. Therefore, it could be merged into a new company or be considered a division of that company.
This could raise the value considerably, or the new company could buy out all the stockholders at the time of the sale.
Another good time to sell is when the company goes public. Early investors get stock at a discounted rate in the early stages of the company. At this point, no one in public has stock. Once a company is about to go public with an IPO – Initial Public Offering – The stock is usually opening with a higher price per share than the investor paid in the beginning. If you do not want to hold onto your stock, this is usually an excellent time to make your investment and more back.
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So, how do investors get paid? Typically they earn money in 2 ways – selling their shares of the company (all at once or a little at a time) or holding the shares and collecting dividends. This is a pretty straightforward system that depends heavily on investors being able to choose companies with a high chance of success.
Although all investors would love to have the magic answer to always choose companies that succeed, this is not really actionable. So, to better their odds, most investors have a diverse portfolio and invest in many companies increasing the odds that some of their investments will pay off in the long run.
Bijay is an entrepreneur and start-up founder having more than 14 years of IT industry experience. He is the co-founder of TSInfo Technologies, a SharePoint development company.
A dedicated professional and very passionate about public speaking and also wrote thousands of technical blogs in various technologies. He also wrote a lots of blogs on entrepreneurship, investment, startup, business, manage money tips, etc.