How Startup Investing Works on TV
A panel of investors lean back in large leather chairs. Enter: the startup founder, dressed in Silicon Valley chic-casual (jeans, t-shirt, hoodie, flip-flops).
The startup founder delivers an enthusiastic, if somewhat shaky pitch, ending with the figure he needs to keep his company afloat: $500,000 for 10% of his startup. The investors nod approvingly at the bags under the founder’s eyes and his or her rumpled attire, noting the signs of sleep deprivation and lack of self-care as devotion to the business.
They ask a few questions, confer with one another, and make a counteroffer: 55% of the business for a $500,000 investment. The founder tries to negotiate to no avail, paces back and forth a little, steps outside to phone a trusted friend for advice. Eventually, the founder decides that he or she needs to take the deal, even if it means giving up majority control of the company. If the founder doesn’t take it, the business will go under.
This stereotypical display of the hopeless founder and money-hungry, rich investors is highly dramatic and an example of poorly negotiated equity investing.
How Startup Investing Really Works
A few people get together and come up with an innovative solution to a common problem. They test out their new solution, iterate a little, and find something that works and that a sizable group of people actually want to use.
Inspired, this band of innovative thinkers decide to turn that early idea into a company. But to fulfill that dream, they’ll need advice from seasoned entrepreneurs who have built successful companies before. And money.
This is where startup investors come in.
In Silicon Valley and beyond, early-stage startups can raise venture capital from VC firms and angel investors in various ways (and, in reality, they happen very differently than in the theatrical scene above).
We’re going to explore the different types of early-stage investments that give promising startups the cash flow they need to start chugging toward that IPO, and when investors are likely to encounter each investment type.
Equity investments and convertible investments are both securities, or non-tangible assets; for example, shares of stock in Apple or a government bond. (Tangible assets refer to physical investments, like diamonds or real-estate.)
There are two main ways to invest in early-stage startups:
Seed and early-stage investors often invest in startups via convertible securities, such as convertible notes and Y Combinator’s SAFE documents. Investors in later-stage startups (Series A or later) will more commonly invest in priced equity rounds.
Why do startups raise venture capital?
Venture capital is an ideal financing structure for startups that need capital to scale and will likely spend a significant amount of time in the red to build their business into an extraordinarily profitable company. Big name companies like Amazon, Facebook, and Google were once venture-backed startups.
Unlike car dealerships and airlines – companies with valuable physical assets and more predictable cash flows – startups typically have little collateral to offer against a traditional loan. Therefore, if an investor were to issue a loan to a startup, there’s no way to guarantee that the investors could recoup the amount they’ve lent out if the startup were to fail.
By raising venture capital rather than taking out a loan, startups can raise money that they are under no obligation to repay. However, the potential cost of accepting that money is higher – while traditional loans have fixed interest rates, startup equity investors are buying a percentage of the company from the founders. This means that the founders are giving investors rights to a percentage of the company profits in perpetuity, which could amount to a lot of money.
Early-stage startup investing offers potential for astronomical growth and outsized returns (relative to larger, more mature companies). This potential makes acquiring startup equity an attractive investment opportunity to prospective investors, despite the additional risk.
For the Founders, taking VC money can also come with huge benefits – startup investors can offer valuable support, guidance, and resources to new founders that can help to shape their company and increase its chances of success.
Venture Capital financing is also ideal for startups that can’t get very far by bootstrapping. Although many founders self-fund their startups while operating out of a cramped apartment until they’ve reached profitability, bootstrapping doesn’t work for companies that require a lot of capital up-front just to build and test their MVP (minimum viable product).
What is equity?
Equity essentially means ownership.
Equity represents one’s percentage of ownership interest in a given company. For startup investors, this means the percentage of the company’s shares that a startup is willing to sell to investors for a specific amount of money. As a company makes business progress, new investors are typically willing to pay a larger price per share in subsequent rounds of funding, as the startup has already demonstrated its potential for success.
When venture capital investors invest in a startup, they are putting down capital in exchange for a portion of ownership in the company and rights to its potential future profits. By doing so, investors are forming a partnership with the startups they choose to invest in – if the company turns a profit, investors make returns proportionate to their amount of equity in the startup; if the startup fails, the investors lose the money they’ve invested.
What is the difference between stock, shares, and equity?
The terms stock and equity are often used interchangeably. Stock is a general term that refers to an unspecified amount of ownership interest in a company. Shares represent the way that a company’s stock is divided. A company’s stock can be divided into a potentially limitless number of shares, each worth exactly the same value.
In a priced equity round, shares in the startup have a fixed price, and investors can purchase equity in the company by buying shares at the price during that round.