Since most institutional sources of money are constantly being pitched investment ideas, the entrepreneur should leverage his or her personal and professional networks to line up warm introductions to potential investors. If an entrepreneur is successful, he or she will receive an offer from an investor.
Typically, the investor will present the entrepreneur with a term sheet, which is a short document that covers the basic parameters of the deal including the amount to be invested, the pre-money valuation, the amount of equity the investor will receive and other big picture deal terms. The details will be ironed out by the attorneys after the term sheet is agreed upon.
At this stage, the entrepreneur has the opportunity to negotiate and to compare competing offers. Once the term sheet is signed, negotiation over major deal terms becomes substantially more difficult, and pulling out of a signed term sheet could damage the reputation of both the entrepreneur and the company. Many successful businesses will have multiple rounds of investment from investors. Ideally, these rounds should all be at a pre-money valuation that is higher than the post-money valuation of the previous round known as an "up round".
In the venture capital funding process, there is typically an initial "seed round," followed by lettered rounds Round A, Round B, etc.
A company will generally aim to raise enough capital to fund 12 to 18 months of operations and therefore will need to raise a new round at that frequency. Entrepreneurs should also be aware that each subsequent funding round will become more difficult, since investors in later rounds will want to see growth and momentum in order to justify the earlier investor's confidence.
While investors will give younger companies more leeway to figure out their business model, companies that have already been given this chance will need to show concrete results and achievements if they want to raise additional capital on attractive terms.
Some entrepreneurs may have the opportunity to cash out some of their equity when raising capital. The entrepreneur may want to diversify his or her personal wealth, or perhaps cash in on some of the success of his or her business. Many investors, however, may insist that the entrepreneur keep all or most of his or her equity rather than cashing out, since cashing out signals that the entrepreneur does not have full confidence in the future success of the company.
The later the stage of the company, the less pressure there will be on the entrepreneur to retain equity. If the company is successful and mature enough to be the target of a private equity investor, it may even be expected that the entrepreneur cashes out a substantial portion of his or her equity. In addition, as companies delay initial public offerings and other exits, a growing secondary market has developed for shareholders to sell their stock privately to accredited investors.
However, the entrepreneur and key shareholders may be reticent to sell any stock in these markets given the negative signal that the sale may send to other shareholders and investors. Different types of investors target companies at different stages of their growth cycle.
Here is a brief overview of the types of investors a company may consider raising capital from:. An entrepreneur's personal network is often the first source of funding for getting a company off the ground. These investors know the entrepreneur personally and are willing to invest in an idea that has long odds of success based on this personal knowledge.
Raising money from these non-institutional investors may require more legal work and regulatory monitoring. Because investment in a startup is inherently risky, the SEC has rules that limit how many non-accredited investors can participate in the investment. As a result, it is always a good idea for the company to hire an attorney experienced in raising capital.
These investments can be very lucrative. Many companies will also raise money from an angel investor, who may be the first investor that the entrepreneur does not personally know. Angel investors are typically wealthy individuals or even groups who invest in very early-stage startups, oftentimes in an industry that the angel investor is familiar with.
They are known as "angels" because they may invest at a time when the company has otherwise nearly run out of capital to continue operating.
Angel investors not only have substantial capital available to seed the business, they often have their own network of professionals and advisors that the entrepreneur can rely on to grow the business.
Some startup companies may opt to join a program known as an accelerator. These programs offer the company capital in exchange for equity, and the opportunity to participate in a several-month-long program aimed at accelerating the growth of the company alongside other startup companies.
Accelerators typically offer the advice of their staff who are successful entrepreneurs themselves , office space and access to networks of successful startups and advisors.
Competition to earn a spot at a startup accelerator can be stiff, and successful participation in a well-regarded startup accelerator can give a company a degree of legitimacy. Well-known accelerators include Y-Combinator, Techstars and Startups. Venture capitalists are perhaps the most well-known and revered institutional investors in private businesses. Venture capital funds are typically organized as limited partnerships, with outside institutional investors pension funds, endowments, insurance companies, ultra-high net worth investors investing as the limited partners and the venture capital firm acting as the general partner.
The venture capital fund will then invest in multiple startup companies. Venture capital is an important player in the institutional investor space, since venture capitalists typically have a mandate to take on more risk than most other institutional investors.
As a result, they fill a void for raising capital that would exist between traditional institutional investors who cannot take on the risk of investing in an unproven company and individual investors who don't have sufficient capital or expertise to grow an early-stage company. Venture capital not only can provide startup companies with substantial capital, they also offer a very sophisticated network of resources and expertise from their portfolio companies.
Venture capitalists typically participate in formal fundraising rounds, although recently they have begun participating in smaller seed rounds which are now also larger than they historically have been. While venture capital is a subset of private equity, traditional private equity firms are a relatively new class of investors in startup companies.
They have historically invested in more established companies, but with big-name startups deciding to delay initial public offerings, there have been more late-stage startups raising substantial sums of money from traditional private equity firms.
When owners of a business choose sources of financial capital, they also choose how to pay for them. Firms that are just beginning often have an idea or a prototype for a product or service to sell, but few customers, or even no customers at all, and thus are not earning profits.
Such firms face a difficult problem when it comes to raising financial capital: How can a firm that has not yet demonstrated any ability to earn profits pay a rate of return to financial investors? For many small businesses, the original source of money is the owner of the business. Someone who decides to start a restaurant or a gas station, for instance, might cover the startup costs by dipping into his or her own bank account, or by borrowing money perhaps using a home as collateral.
Venture capital firms make financial investments in new companies that are still relatively small in size, but that have potential to grow substantially.
These firms gather money from a variety of individual or institutional investors, including banks, institutions like college endowments, insurance companies that hold financial reserves, and corporate pension funds. Venture capital firms do more than just supply money to small startups. They also provide advice on potential products, customers, and key employees.
Typically, a venture capital fund invests in a number of firms, and then investors in that fund receive returns according to how the fund as a whole performs. All early-stage investors realize that the majority of small startup businesses will never hit it big; indeed, many of them will go out of business within a few months or years.
They also know that getting in on the ground floor of a few huge successes like a Netflix or an Amazon. Early-stage investors are therefore willing to take large risks in order to be in a position to gain substantial returns on their investment. If firms are earning profits their revenues are greater than costs , they can choose to reinvest some of these profits in equipment, structures, and research and development.
For many established companies, reinvesting their own profits is one primary source of financial capital. Companies and firms just getting started may have numerous attractive investment opportunities, but few current profits to invest. Even large firms can experience a year or two of earning low profits or even suffering losses, but unless the firm can find a steady and reliable source of financial capital so that it can continue making real investments in tough times, the firm may not survive until better times arrive.
Firms often need to find sources of financial capital other than profits. When a firm has a record of at least earning significant revenues, and better still of earning profits, the firm can make a credible promise to pay interest, and so it becomes possible for the firm to borrow money.
Firms have two main methods of borrowing: banks and bonds. A bank loan for a firm works in much the same way as a loan for an individual who is buying a car or a house. The firm borrows an amount of money and then promises to repay it, including some rate of interest, over a predetermined period of time. If the firm fails to make its loan payments, the bank or banks can often take the firm to court and require it to sell its buildings or equipment to make the loan payments.
Another source of financial capital is a bond. A bond is a financial contract: a borrower agrees to repay the amount that was borrowed and also a rate of interest over a period of time in the future. A corporate bond is issued by firms, but bonds are also issued by various levels of government. For example, a municipal bond is issued by cities, a state bond by U. Department of the Treasury.
A bond specifies an amount that will be borrowed, the interest rate that will be paid, and the time until repayment. When a firm issues bonds, the total amount that is borrowed is divided up. Anyone who owns a bond and receives the interest payments is called a bondholder.
If a firm issues bonds and fails to make the promised interest payments, the bondholders can take the firm to court and require it to pay, even if the firm needs to raise the money by selling buildings or equipment. However, there is no guarantee the firm will have sufficient assets to pay off the bonds. The bondholders may get back only a portion of what they loaned the firm. Bank borrowing is more customized than issuing bonds, so it often works better for relatively small firms.
The bank can get to know the firm extremely well—often because the bank can monitor sales and expenses quite accurately by looking at deposits and withdrawals.
Relatively large and well-known firms often issue bonds instead. They use bonds to raise new financial capital that pays for investments, or to raise capital to pay off old bonds, or to buy other firms.
However, the idea that banks are usually used for relatively smaller loans and bonds for larger loans is not an ironclad rule: sometimes groups of banks make large loans and sometimes relatively small and lesser-known firms issue bonds. Corporations may be private or public, and may or may not have stock that is publicly traded. They may raise funds to finance their operations or new investments by raising capital through the sale of stock or the issuance of bonds.
Those who buy the stock become the owners, or shareholders , of the firm. The stock of a company is divided into shares. In most large and well-known firms, no individual owns a majority of the shares of the stock. Instead, large numbers of shareholders—even those who hold thousands of shares—each have only a small slice of the overall ownership of the firm.
When a company is owned by a large number of shareholders, there are three questions to ask:. First, a firm receives money from the sale of its stock only when the company sells its own stock to the public the public includes individuals, mutual funds, insurance companies, and pension funds.
The IPO is important for two reasons. For one, the IPO, and any stock issued thereafter, such as stock held as treasury stock shares that a company keeps in their own treasury or new stock issued later as a secondary offering, provides the funds to repay the early-stage investors, like the angel investors and the venture capital firms. When the firm sells stock, the venture capital firm sells its part ownership of the firm to the public.
A second reason for the importance of the IPO is that it provides the established company with financial capital for a substantial expansion of its operations. Most of the time when corporate stock is bought and sold, however, the firm receives no financial return at all. A venture capital firm may have a 40 percent ownership in the firm.
When the firm sells stock, the venture capital firm sells its part ownership of the firm to the public. A second reason for the importance of the IPO is that it provides the established company with financial capital for a substantial expansion of its operations. Most of the time when corporate stock is bought and sold, however, the firm receives no financial return at all. If you buy shares of stock in General Motors, you almost certainly buy them from the current owner of those shares, and General Motors does not receive any of your money.
This pattern should not seem particularly odd. After all, if you buy a house, the current owner gets your money, not the original builder of the house. Similarly, when you buy shares of stock, you are buying a small slice of ownership of the firm from the existing owner—and the firm that originally issued the stock is not a part of this transaction.
Second, when a firm decides to issue stock, it must recognize that investors will expect to receive a rate of return. That rate of return can come in two forms. A firm can make a direct payment to its shareholders, called a dividend. The increase in the value of the stock or of any asset between when it is bought and when it is sold is called a capital gain. Third: Who makes the decisions about when a firm will issue stock, or pay dividends, or reinvest profits?
To understand the answers to these questions, it is useful to separate firms into two groups: private and public. A private company is owned by the people who run it on a day-to-day basis.
A private company can be run by individuals, in which case it is called a sole proprietorship , or it can be run by a group, in which case it is a partnership. A private company can also be a corporation, but the stock is not sold to the public. A small law firm run by one person, even if it employs some other lawyers, would be a sole proprietorship.
A larger law firm may be owned jointly by its partners. Most private companies are relatively small, but there are some large private corporations, with tens of billions of dollars in annual sales, that do not have publicly issued stock, such as farm-products dealer Cargill, the Mars candy company, and the Bechtel engineering and construction firm. When a firm decides to sell stock, which in turn can be bought and sold by financial investors, it is called a public company.
Shareholders own a public company. Since the shareholders are a very broad group, often consisting of thousands or even millions of investors, the shareholders vote for a board of directors, who in turn hire top executives to run the firm on a day-to-day basis.
In theory, the board of directors helps to ensure that the firm is run in the interests of the true owners—the shareholders. However, the top executives who run the firm have a strong voice in choosing the candidates who will be on their board of directors.
After all, few shareholders are knowledgeable enough or have enough of a personal incentive to spend energy and money nominating alternative members of the board. There are clear patterns in how businesses raise financial capital. These patterns can be explained partly by the fact that buyers and sellers in a market do not both have complete and identical information. Those who are actually running a firm will almost always have more information about whether the firm is likely to earn profits in the future than outside investors who provide financial capital.
Any young start-up firm is a risk; indeed, some start-up firms are only a little more than an idea on paper.
When the founders put their own money into the firm, they demonstrate a belief in its prospects. At this early stage, angel investors and venture capitalists try to get all the information they need, partly by getting to know the managers and their business plan personally and by giving them advice.
As a result, other outside investors who do not know the managers personally, like bondholders and shareholders, are more willing to provide financial capital to the firm.
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