My strategy professor in business school had an amusing phrase to describe companies who take on too much external funding. He said they had an “OPM” problem: Other People’s Money.
The issue with taking Other People’s Money is that, usually, they want it back. With interest. It’s basically how the entire system of capitalism works.
This is particularly interesting in the context of startups and venture capital, and after some pokes from people on Twitter (@jdgreen in particular) I want to step through why I dislike the celebration of massive funding rounds as if it’s some kind of success.
Debt or Equity?
Companies need money to operate, and startups are no different. You need to pay people to do things for you, somehow, otherwise it’s charity and volunteering. So where do you get this money?
One option is organically which means the old-fashioned idea of selling a product or service for more than it costs you to make, and then re-investing the profits into the business to fund growth. The issue with that is that you need a product or service to sell (which, as a startup, you don’t have yet) and it’s slow because you’re limited by how much excess cash you make in profits.
To start things off, you need some up-front capital. One option is a bank loan, i.e. debt. Banks are tricky for a startup, because startups, by their very nature, are very risky relative to other investments. Most banks don’t want to lend money to people who may never pay it back (such as when your startup fails and declares bankruptcy), so it may not even be an option. You might be able to get Friends, Family, and Fools to lend you some money, but they might want something more than a promise to pay it back. They might want a slice of the company, hoping that it might succeed and be worth a lot of money.
That’s called equity. Shares in a company is called equity and it’s how a company is technically formed right at the beginning for reasons I won’t go into. When someone gives you money in exchange for a part-share of the company, what they actually get in return is a claim on the residual assets of the company. They don’t actually own it, except in a lazy shorthand sense. The shareholders come dead last in any claims on the company’s assets if it dies. Literally everyone else gets paid first.
Why on earth would anyone take equity? We come back to interest and risk. Interest is compensation for taking a risk with your money. Loaning money to someone else (as debt or equity) is riskier than holding onto it yourself. You need to be compensated for investing the money with this company instead of something else, like government bonds or a bank deposit. In fact, you need to be compensated more than that, because this investment is riskier than government bonds. It’s called a risk premium.
How much extra you need to get paid depends on how much extra risk you’re taking. Since most startups fail, they are very risky indeed, so you need to be paid a lot of interest.
Venture Capital Payback Ratios
The rule of thumb in venture capital is you expect to be paid between 10 and 20 times what you invest in any given company. Why? Because out of 20 investments, 16 will die completely paying you zero, 2 to 3 will probably do ok and you’ll get your money back, and hopefully one will do really well and pay for all the others. You have no idea ahead of time which one will succeed, which is why you invest in a portfolio of companies.
If you invest, say, $1m in 20 companies, and only get a 10x return from the one that succeeds, you just lost $10m. That’s why the returns need to be so high, and why an exit at only about 10x the money invested can be considered a ‘failure’.
Getting Your Money Back
But what is an ‘exit’? It’s industry jargon for “getting your money back” and there are only two ways for equity investors to get their money back:
- Sell their shares back to the company.
- Sell their shares to someone else.
If the company buys the shares, the cash paid to the investor has to come from the company. This is usually called a share buyback and is one way to return cash to investors. This only happens when the company decides that they can’t do anything with the cash that would be better than what investors themselves could do with the money. In a growing startup that needs cash to fund that growth, this won’t ever happen.
Which leaves you with option two: selling your shares to someone else.
Aside from selling your shares to an existing shareholder (one of the other investors), you only have two options here: a trade sale (another company buys this one by buying your shares) or via an IPO: Initial Public Offering.
One company buying another is a pretty easy thing to understand. Company A offers the shareholders of company B some sort of valuable stuff to exchange for their shares in company B. It could be cash, shiny beads, coal, or even stock in company A. It could be a mix. If the shareholders of company B agree to sell, then company A takes control of company B and effectively owns it. The shareholders get cash and shiny beads, hopefully enough to pay back their initial investment plus the risk premium, and they all go home for tea and medals.
An IPO is a way of listing your shares on a stock exchange so that pretty much anyone can buy them. There are all kinds of complex rules governing how shares in companies can change hands (ostensibly to stop people from getting ripped off too egregiously) but having a listed stock means the potential demand for your shares is much higher. With higher demand, and a limited supply of shares, the price should go up. After the company lists on the exchange, you sell your shares on the open market to whoever will take them for the price you’re willing to sell at. And then it’s tea and medals time.
I’ve glossed over a lot of the detail here, but this is the essence of how things work. And this gives you the required background to understand my next post on why taking too much money is a bad idea.