When you start a new business, you need money to get it off the ground. You
need the money to rent or purchase space for the business, furniture and equipment,
supplies, etc. You also need money to pay employees. There are several
places where you can get the money that a new business needs:
* Personal savings -- you can fund the business yourself from savings
or by getting a second mortgage on your home.
* Bootstrapping -- In some simple businesses, you can bootstrap
the business. That means that, with a very small investment, you get the business
going and then use the profits from each sale to grow the business. This approach
works well in the service industry where start-up expenses are sometimes low and
you don't need employees initially.
* Bank loan -- You can borrow money from a bank.
All three of these techniques have limitations unless you are already a wealthy
individual. A fourth way to get money to start a business is called Venture
Capital - with venture capital you can sometimes obtain large quantities of money,
and this money can help businesses with big start-up expenses or businesses that
want to grow very quickly.
Venture Capital Firms and Funds
You often hear about Venture Capitalists (VCs) funding Dot Com companies, and they
fund all sorts of other businesses as well. The classic approach is for a
venture capital firm to open a fund. A fund is a pool of money that the VC
firm will invest. The firm gathers money from wealthy individuals and from
companies, pension funds, etc. that have money they wish to invest. The firm
will raise a fixed amount of money in the fund - for example, $100 million.
The VC firm will then invest the $100 million fund in some number of companies -
for example, 10 to 20 companies. Each firm and fund has an investment profile.
For example, a fund might invest in biotech startups. Or the fund might invest
in Dot Coms seeking their second round of financing. Or the fund might try
a mix of companies that are all preparing to do an IPO (Initial Public Offering)
in the next 6 months. The profile that the fund chooses has certain risks
and rewards that the investors know about when they invest the money.
Typically the Venture Capital firm will invest the entire fund and then anticipate
that all of the investments it made will liquidate in 3 to 7 years. That is,
the VC firm expects each of the companies it invested in to either "go public" (meaning
that the company sells shares on a stock exchange) or to be bought (acquired) by
another company. In either case, the cash that flows in from the sale of stock
to the public or to an acquirer lets the VC firm cash out and place the proceeds
back into the fund. When the whole process is done, the goal is to have made
more money than the $100 million originally invested. The fund is then distributed
back to the investors based on the amount each one originally contributed.
Let's say that a VC fund invests $100 million in 10 companies ($10 million each).
Some of those companies will fail. Some will not really go anywhere.
But some will actually go public. When a company goes public, it is often
worth hundreds of millions of dollars. So the VC fund makes a very good return.
For one $10 million investment, the fund might receive back $50 million over a
5 year period. So the VC fund is playing the law of averages, hoping that
the big wins (the companies that make it and go public) overshadow the failures
and provide a great return on the $100 million originally collected by the fund.
The skill of the firm in picking its investments and timing those investments is
a big factor in the fund's return. Investors are typically looking for something
like a 20% per year return on investment for the fund.
Venture Capital in a New Company
From a company's standpoint, here is how the whole transaction looks. The
company starts up and needs money to grow. The company seeks venture capital
firms to invest in the company. The founders of the company create a business
plan that shows what they plan to do and what they think will happen to the company
over time (how fast it will grow, how much money it will make, etc.). The
VCs look at the plan, and if they like what they see they invest money in the company.
The first round of money is called a seed round. Over time a company will
typically receive 3 or 4 rounds of funding before going public or getting acquired.
In return for the money it receives, the company gives the VCs stock in the company
as well as some control over the decisions the company makes. The company,
for example, might give the VC firm a seat on its board of directors. The
company might agree not to spend more than $X without the VC's approval. The
VCs might also need to approve certain people who are hired, loans, etc.
In many cases, a VC firm offers more than just money. For example, it might
have good contacts in the industry or it might have a lot of experience it can provide
to the company.
One big negotiating point that is discussed when a VC invests money in a company
is, "How much stock should the VC firm get in return for the money it invests?"
This question is answered by choosing a valuation for the company. The VC
firm and the people in the company have to agree how much the company is worth.
This is the pre-money valuation of the company. Then the VC firm invests the
money and this creates a post-money valuation. The percentage increase in
the value determines how much stock the VC firm receives. A VC firm might
typically receive anywhere from 10% to 50% of the company in return for its investment.
More or less is possible, but that's a typical range. The original shareholders
are diluted in the process. The shareholders own 100% of the company prior to the
VC's investment. If the VC firm gets 50% of the company, then the original shareholders
own the remaining 50%.
Dot Coms typically use Venture Capital to start up because they need lots of cash
for advertising, equipment, and employees. They need to advertise in order to attract
visitors, and they need equipment and employees to create the site. The amount of
advertising money needed and the speed of change in the Internet can make bootstrapping
impossible. For example, many of the eCommerce Dot Coms typically consume $50 million
to $100 million to get to the point where they can go public. Up to half of
that money can be spent on advertising!