Weakon 313 talked bout private equity (PE). In it I mentioned venture capital (VC) as a type of private equity investment. It’s so big these days I found it merited its own post, or at least half of one, shared with angel investing. We’ll start with venture capital.
Venture Capital
Google, YouTube, Apple, and Twitter. Aside from all being interrelated technology companies you can find on your iPhone, they were all started by venture capital. Venture capital is a type of private equity investment that is usually invested in the early stages of company development. Google got VC funding in 1999, before they went public. YouTube was running on VC funding before Google purchased them. VC funding seeks to provide growing companies with the money they need to operate before they start turning a profit. The best way to illustrate this is with an example.
Let’s say I want to take Weakonomics far beyond just a blog. I want to turn it into a Web2.0 media company. We’ll have videos, pundits, blogs, podcasts and all other types of things that would attract visitors to my site. It would be impossible for The Weakonomist to do this on his own. I would need servers, IT guys, programmers, writers, personalities, and a sales team among many other employees and assets to get this project going. I don’t have that kind of money. However if my business idea is appealing to a VC firm, they might provide the seed money I need to get started. Let’s just say it’s $5 million. The VC firm gets the money they need by raising it from private investors and institutional investors. The firm employs analysts that decide whether a business venture is a good use of their clients’ money or not.
If things work out from there I may go through additional rounds of funding with that VC firm or a collection of others. We can just say I need $50 million to get to the growth numbers I need to start turning a profit. If I get all that funding and things work out, what do the VC firms that gave me all that money get in return? They get a share of the profits, or more specifically, partial ownership in the company. There would be a board of directors and the VC guys would have chairs there. If CNN approached us with an offer to buy us for $150 million we would decide whether or not to sell ourselves or keep going.
VC can be a very profitable investment for both the entrepreneur and the investors. But at the same time Weakonomics could be a massive failure and they’d lose all their money. Unlike borrowing money, you don’t have to pay back VC funding because it is an equity investment.
Angel Investing
Long before I need $5 million to get going I might need $100,000 just to hire a part time programmer and buy some camara equipment. Venture capitalists aren’t interested in making such a small investment. This is where Angel Investing comes in.
Unlike PE and VC, angel investors are almost always some rich people with some money. It isn’t a team of Stanford MBAs you’re pitching your business to, it’s some local business contact that happens to have some money he doesn’t want to invest in the stock market. It could be because he likes to support local entrepreneurs (because he likely is one) or he thinks he can get a better return with you than in the S&P 500. Regardless, if you pitch well he may decide to give you the $100,000 you need to get your feet off the ground.
Angel investing is kind of the “filler” between just a budding entrepreneur that has borrowed from his “FFF” (friends, family, and fools) and venture capital. You could find Angel investors willing to part with as little as $10,000, or as much as a few million. Sometimes angels pool their money into angel investor networks. The best way to find out about these is to find the nearest university with an entrepreneurship center. Here you get access to experienced entrepreneurs who know all the local people with angel money.
Angels don’t expect some measly 15% annual return. Because you are a growing company and they expect many of their funded companies to fail, you’d better have a good argument with a 20-30x return over 5-7 years. Many angels also want a defined exit strategy for their money. Whether that is taking the company public, cashing out with VC funding, or simply selling to another company, they do want their money back.
Remember unlike VC funding you’re actually going to talk to the guy with the money, which has its pros and cons. However because most banks won’t loan a business with a huge growth strategy and no income any money, you almost always have to come here to get your start-up money.
VC, PE, and Angel Investing are all sources of capital for a growing business without going to “the public” which is what is called an IPO (initial public offering). The process is expensive and most times people don’t bother with that until they absolutely have to, or need millions more in funding after VC dries up. It’s a fascinating and lucrative business, but it isn’t for the faint-hearted. You can lose millions. For every Google, there’s another 100 failures you’ve never heard of.
Photo: aussigal
 By The Weakonomist |
The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics. Also keep in mind that nothing I say can be construed as financial advice. |
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Good summary. With all VC (and f&f for that matter), remember they’re an also extra complication that’ll take up time to manage and keep on side — even the nice ones who give you help and support in turn. Debt may be hard to service – and even harder to get – but at least it doesn’t demand a five-year pie-in-the-sky exit strategy when you’re only just getting off the ground.