Raising capital

Companies need money to survive. And yet, when Instagram was acquired by Facebook for close to $1B in 2012, they famously had no revenue. How did they fund their growth and ongoing operations? They raised money, or capital, from investors.

What’s in it for the investors? Beyond any potential bragging rights, they receive equity, or a share of ownership, in the companies they invest in. If the company is successful and “exits” (is acquired or listed on the stock market) as Instagram did, it should make a positive return on its investment.

A company that self-funds its growth (the founders use their own money until the company can pay for itself) is said to be bootstrapped. Self-funding allows the founders to maintain full ownership and control of their company, but unless they also have very deep pockets, there will be a limit to how much they can afford to spend, which can lower the speed at which the company can grow.

If a company’s primary goal is to grow quickly or have high startup capital costs, it usually turns to outside investors. The first group are the so-called “Angel” investors, individuals with money looking to make relatively small personal investments in startup companies. Angels may also have industry experience or a network that can be useful to the startup. Angel investors usually invest at the “pre-seed” or “seed” stage of the company’s lifecycle, where the product or service offered may only be an idea.

Early-stage startups may also apply to join startup accelerators, organisations that provide a structured period of guidance, mentorship and (usually) money in return for a small percentage of company equity.

The most famous accelerator is Ycombinator, founded in 2005 and has helped companies like Airbnb, DoorDash, and Coinbase, which now have a combined value of more than $400B. The top accelerators like Ycombinator are very popular and, therefore, very selective in the startups they agree to take on, with current acceptance rates at less than 5%.

Venture Capital

Growth-focused startups will usually try to raise money from venture capitalists, or ‘VCs’.

Venture capital is a form of private equity that raises money from limited partners or LPs and invests the money into high-risk startups. VCs will generally specialise in industries or sectors where they have an advantage, like marketplaces or SaaS.

Many VC firms will focus their investing on specific stages within a company life cycle so that early-stage VCs might look for seed and Series A _level companies (companies that are still trying to find product/market fit), while later-stage funds will invest in the _growth rounds, series B, C, D etc.

The VC investment process

Startups will “pitch” (give a presentation explaining their product) to VCs, who will decide whether they want to make an investment.

If the VCs are interested, they will offer the startup a term sheet, a non-binding agreement outlining the terms and conditions for the investment, like the amount of money to be invested and the equity to be given in return. After agreeing to terms, there will usually be a short period to work out the administrative details, and the money will be transferred.

As a VC-backed company grows, it will normally reach the point where it needs another round _of funding before it runs out of _runway (the amount of time before it runs out of money). The startup will give up equity with each round of funding, so by the time a startup has raised multiple rounds of funding, it is common for the founders to have significantly less than 50% equity (and control) of the company.

In return for investing their LP’s money, VCs will usually take “2 and 20” – a 2% annual management fee and 20% “carried interest”, their share of any of the eventual profits from the investment. And where do these profits come from? An exit or liquidation event; is a transaction where the startup’s shareholders can realise the value of their investment. The most common exits are:

• Acquisition: another company buys the startup
• Acqui-hire:(a combination of “acquisition” and “hiring”) The startup is acquired mainly as a way to recruit the existing employees into the acquiring company
• Merger:two companies combine into a separate new legal entity
• Initial Public Offering (IPO):the company “goes public”, is listed on the stock market and can sell shares to public investors

As most startups will either fail or fail to make a large financial return, VCs will try to create a portfolio of investments in companies with high-risk / high-return potential. An early-stage VC will be placing many small bets on companies with a very high probability of failure, with the hope that a small number will pay off with extremely high (100x or more) returns that are enough to “return the fund”.

A growth stage VC on the other hand, is investing in companies that are further along in the startup lifecycle, so their investments should have less risk (in theory at least) as the companies they invest in should have strong products, revenue and so on, but this will result in lower returns on their investment.

Why should you care?

You might be asking why any of this matters if you have no intention of working in the investing side of the industry, and that is a fair question!

How a company funds its growth will greatly impact its day-to-day operations, its long-term goals and the expectations it will need to meet. If you’re interested in working in a startup, your choice of funding can greatly impact the next few years of your work life.

If you choose to work with a bootstrapped company, they will probably not have as much money to spend as a venture-backed startup, which could play out in the form of lower salaries and fewer benefits or perks. Bootstrapped companies are less likely to reach sky-high valuations and exits than you’ll read about on Techcrunch, so if you do receive equity or options in the company, then they are not likely to be worth much.

But it’s not all negative – once a bootstrapped company has reached a breakeven point and can support itself financially, it will be free to grow at a rate they feel comfortable. This can result in more relaxed working environments and a good work/life balance.

On the flip side, venture-backed startups have the money and resources to fuel growth, but that’s what they must do – GROW. The money they get from VCs isn’t supposed to sit in their bank accounts, it needs to be spent on costly expenses like recruiting staff and paid advertising.

And the VCs are not interested in companies that are simply “good enough”; they need the 100x outliers that will give them the returns they need to please their LPs and raise their next fund. This can place a huge amount of stress on a startup’s founders and employees – the company may be growing revenue or user count at a steady state (along with their expenses), but if they aren’t hitting their monthly growth targets, they may struggle to raise the next round of funding, which can result in an otherwise promising company running out of cash and dying.

This growth-at-all-costs pressure can lead to higher stress and longer work hours, but the rewards can be equally high in terms of potential for career growth and large financial payoffs (the startup lottery has very low odds, but people do win).

By this stage, you might be tempted to skip startups and work at an established technology company instead, but they have their potential drawbacks. It’s a little out of scope for our current topic, but if you’re interested, check out our guide to working in startups vs established technology companies to learn more.