All of us must have at some point wondered as to why startups prefer to give stakes in their companies and getting investments instead of taking loans to grow the business. Why do they prefer to let go of a big chunk in exchange for funding when they can grow it at their own pace and still be its owners.
One major reason for founders to prefer a VC/ PE’s funding is that with an investment, you get partners who are deeply invested in your company’s success and growth. A VC only wants you to earn more and grow your business so that his equity in the business becomes more valuable and he gets a good return on his investment. A VC expects to multiply his investment by over 50 times in order to take this amount and reinvest it in another business and multiply it again. Investors do not have to repay the amount invested by a VC.
A bank’s loan will however have to be repaid – mostly in monthly instalments. These instalments may be difficult to repay for a company during its initial stages when it is still finding its feet. A VC/ PE helps out a founder with the parts of a business that he/ she is not comfortable with –ex: recruitment, analytics, etc.
A VC/ PE is one of the first investors who comes on board as his target is to multiply his investment by over 50 times. As an investor he also has the option of investing in the stock market, bond markets or the debt markets where he can easily make an investment on the basis of financial analysis. However, these investments rarely offer a 50 times return on investment. A VC/ PE has more risk appetite than the normal investor. He is willing to bet on businesses that are yet to mature, yet to turn profitable, yet to have anything significant.
The company could be like Google, Facebook, etc, .i.e. it may not have any competitors, it may be starting an all new industry. These companies are untested and are in completely untested waters. They may not just be starting a new company, but rather they are creating new industries. This is like shooting an arrow without knowing what you are aiming at.
Any person who invests knows this that with high risk there is a high reward. It is this that the VC is targeting. Another reason to invest in an untested startup is the fear of missing out (FOMO). VCs are usually afraid of missing out on the next big thing that could help them get a substantial payout. This risk of missing the bus and a huge payout is scary and this sometimes forces them to take risks that turn out to be big mistakes.
However, in the world of investing when you are in unknown territory, you win some you lose some. BSE Institute Ltd (BIL) offers multiple short term courses for investors to be better investors. You can know more here.
Venture Capitalists and Private Equity Investors are some of the toughest and the sharpest investors. Sometimes, they invest in the technology, sometimes they invest in the entrepreneurs, all the time knowing that only 1% of their investments are actually going to turn around and cover up for all the losses they make. Spotting the exact talent and opportunity is something that one can learn, but having the heart to invest knowing your money may be going down the drain, is something you have to develop.