A useful way to look at it is the difference between current value and potential value.
When an investor puts money into a company in exchange for an ownership stake, mathematics means that the amount of ownership the investor receives for the amount of the investment determines the “value” being assigned to the existing company before the investment.
As an example, let’s say that I invest $100,000 into Company X and receive 10% of the company’s stock in exchange for my investment. Simple math tells me that if 10% is worth $100,000, then 100% of the company must be worth $1 million.
Now, since Company X has $100,000 in its bank account following my investment, we need to back that out to determine how much the company was worth beforemy investment. So we subtract the $100,000 and find that the terms under which I invested mean that I valued the company at $900,000 before I appeared in the picture.
So it would seem on the surface that I contributed $100,000 and you as the founder contributed $900,000, so we should therefore both just get a proportionate number of shares of the same kind of stock, right? That certainly makes sense, except for one thing: there is a substantial difference in the form of the two contributions.
My $100,000 is a suitcase full of dollar bills (or the equivalent) that can be exchanged for anything at all. My late grandmother called them “universal gift certificates”. They are the same dollars that can buy me a vacation, or a Rolex or a trip to the Superbowl, all of which I have passed up on in order to invest in you.
Your $900,000, however, is made up of your ownership in a brand new company that likely doesn’t have revenue yet, let alone profits. So what I am doing by putting in my investment is betting on the future value the company could be worth, after you become successfully profitable.
If everything works out as planned, that’s just what happens! The company is successful and a bigger company comes along and buys it for a lot more cash. We split the sale proceeds 90/10, and we were retroactively proven correct in the value we had originally assigned to the company.
The problem, however, is that with a majority of investments, it does not work out that way.
Let’s say that despite everyone’s best efforts, the company does not succeed, and it is eventually acquired by a bigger company for only $500,000. If we both owned the same type of shares and divided the cash in the same 90/10 manner, I (who had put in cold, hard cash) would only get back $50,000 of my money. You, however, who had put in little or no real money, would be walking away with $450,000 in cash as your reward for running a failed business and losing $50,000 of MY money!
While that might seem like a nice result for you, that’s certainly not what *I* would consider to be fair. So if that is the only way you would be willing to take my investment, I’ll say “thank you, but I’m going to pass on this particular investment, and instead spend my money on that vacation, watch or football tickets.”
Because THAT isn’t an outcome that either of us really wants, we come to a compromise: instead of us owning the same type of stock, we’ll create another kind (technically called “Convertible Preferred” stock). The primary feature of this new class of stock is that in the first case (the good one) it converts into exactly the same kind of stock you have, we split 90/10, and everyone is happy.
HOWEVER, if the bad case happens, then it works a little differently: we agree that the first money that comes in should go to fully pay off the cash that I invested (the $100,000). THEN, anything left over (in this case it would be $400,000) goes to you (who own what is called “Common” stock). The effect of this is to retroactively adjust the nominal value we had assigned to your contribution, to match what it turns out to have really been after all.
And that, in a very simplified way, is an explanation as to why there are different classes of ownership in startup companies.
*original post can be found on Quora @ http://www.quora.com/David-S-Rose/answers *