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How do Start-up Businesses Raise Money?

When someone invents a new “must-have” piece of technology, writes some ground-breaking software, or devises a brilliant solution to a world-wide need, it is incredibly exciting.

  • 7 February 2010
  • Author: Geoff Hardy
  • Number of views: 2145

When someone invents a new “must-have” piece of technology, writes some ground-breaking software, or devises a brilliant solution to a world-wide need, it is incredibly exciting. Visions of celebrity status or an early retirement on the super yacht surrounded by Playboy bunnies or toy boys come flooding in. All they have to do is tell the world about their product or service, and the world will beat a path to their door. Or so they think. 

The reality, as most entrepreneurs will tell you, is quite different. Most great inventions don’t ever get to market, much to the frustration of their inventors. The reason for that is that inventors, in their optimism and enthusiasm, tend to underestimate the obstacles they are going to encounter, and simply run out of resources before they emerge from “Death Valley”. Some get through of course, due to a combination of a great idea, dogged determination, and luck. And thank goodness inventors do underestimate the obstacles, because most would give up prematurely if they knew what was ahead of them. 

Apart from the above factors, the secret ingredient that gets them to the finish line is money. Why is money so important? Because it pays for their travel, accommodation and nourishment when they go door knocking to their potential funders, customers, suppliers, manufacturers and distributors, whether here or overseas. It pays their staff and contractors who won’t work for love alone. It pays for dies, molds and prototypes to be built, raw materials to be procured, samples to be manufactured, promotional materials to be produced, and professional advice and regulatory consents obtained. And most importantly, it keeps them alive throughout the lengthy journey. 

Where do entrepreneurs get this money? Understandably they would like to think that people would be falling over themselves to fund them, such is the brilliance of their offering and the certainty that it will prove a success. But rightly or wrongly, the outside world won’t see it that way. They are sceptical, often for good reason. So money is scarce, and there are essentially four sources of it, depending on how far down the road the entrepreneur has gone. 

The first is colloquially known as “friends, family and fools”. They believe in the entrepreneur, and they don’t tend to do a lot of critical analysis of the business plan, even if they had the expertise. They are generally the only people who will back the entrepreneur in the early development stages of the business. They go “where angels fear to tread”. 

The second source of finance is angel investors. These are usually high wealth individuals who are prepared to take a punt, in the hope that their business will be the next Microsoft. Angel investors are different from venture capitalists. They invest less money, but they get involved at a much earlier stage, and in that sense they take bigger risks. Angel investors will diversify their investments across a large number of start-up businesses. They expect eight out of ten to fail, with the complete loss of their capital. But they bank on the remaining two compensating for those losses by producing outstanding returns. 

Because of the risk, they will insist on a high price for their investment – 40% of their share capital is typical, with considerable say in the strategic direction of the business, and the right to get their share capital out ahead of the founder, friends and family in certain defined circumstances or on the achievement of certain thresholds. They will be very selective about who they invest in, and will be looking for people with the “x factor” and a very sophisticated business plan. Their ultimate objective is to cash up immediately before the growth in their business peaks or plateaus out. In a boom market that may be as soon as two years, but in normal times it could take as long as 10-15 years. 

Venture capital is something growth businesses tap into when they need more money to expand and they have a bit of a proven track record – some market acceptance of their offering, some brand recognition, and a discernable trend in expenses and revenues. So venture capitalists tend to invest more money than angel investors, but they get involved at a later stage, and take less of a risk. They are just as selective about who they invest in, they extract almost as high a price for their financial backing, and they have the same focus on an early exit for the best possible return. 

They have more money to invest than angel investors because they invest money belonging to members of the public rather than their own. The public investors are attracted by the prospect of a higher than normal return, commensurate with the risk. The venture capital fund managers make their returns in two main ways. First, they charge an administration fee based on a percentage of the funds invested. Secondly, they generally have their own substantial equity stake in the companies the fund invests in as well. 

Their plan will be to sell the shareholding in 3-5 years, if the conditions are favourable. Right from the outset they will groom the business for sale, and they will want to be bought out in one of two ways. First, by a merger with, or an acquisition by, another organisation – either one of the existing competitors of the business, or a company that wants to break into the market. Alternatively, through an IPO, in which the venture capital fund’s shareholding in the business as well as a large number of newly-created shares are offered to the public with an investment statement and a prospectus. In that case the shares are generally traded on a stock exchange. 

Once that is done, the business will be well established and it can be funded out of more traditional (and risk-averse) sources such as bank finance, share or bond issues, or even self-generated cash flow. If entrepreneurs get that far, they deserve their super yacht.

Geoff Hardy

Geoff HardyGeoff Hardy

Geoff’s academic qualifications and his background as a former partner in New Zealand national law firm Simpson Grierson, means that we can confidently handle any commercial law matter, no matter how complex.

This newsletter is not intended to be relied upon as legal advice.

Other posts by Geoff Hardy

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