If I lend ten people $10,000, but only ONE of them pays it back, then they have to pay back $100,000 for me just to break even loaning out the money. So, if 90% of start-up businesses fail, how can there be business loans below 900% interest rate?
The same question goes for equity investors (i.e. people who pay money for partial ownership of the company); if 9 out of 10 of their investments will fail, then how could they be happy just doubling their money on the 1 in 10 that succeed? Shouldn’t they need a return of ten times what they put into it, from the one company who’s successful?
Obviously I’m oversimplifying, but if you had to attack this logic, how would you say it’s flawed?
Failed loans doesn’t equal a total write-off - if they paid back 80-90% of principal (plus recovery after default) plus a high interest rate back, you may have already made more than you are paying out to your depositors.
But for new businesses, they often won’t give you a business loan. You’ll have to co-sign personally and put your personal assets at risk as well. Or get Angel investors, and they want equity and essentially do charge the investors 900%+ interest as they lose on most investments but win big on a few.
Banks typically don’t back startups for the reasons you give. Investors require equity for startups which means that if the company becomes massively profitable then there investment goes up a commensurate amount.
If you default on your business loan, the bank will take whatever you offered up as collateral - your house, your business’s equipment, etc.
Second, you’re assuming that VC investors fund every single startup out there, which is almost certainly not true. 90% of all startups may fail, but I don’t think 90% of startups that are funded by VC investors (as opposed to being funded only by the founders) fail.
VC investors don’t make loans, they trade funding for a stake in the company. They do expect to sell that stake for 900% or more what they paid for it later if the startup succeeds.
It isn’t uncommon for the founders of a startup to take out a home equity loan (so the bank gets the house when it fails) and to max out their credit cards (so that loan is unsecured, the bank is banking on historical data and the average person with good credit isn’t going to found a startup).
And, like you said, most startups are going to fail for any number of reasons.
As others have noted, most start-ups are funded by either equity-based funding, or by loans backed by collateral more secure than the company itself.
I would as a slight aside, that the outsize returns that venture capitalists can get if the company is successful can skew perspectives. I have a brother who is one of these wheeler-dealer types and is very familiar with such matters. He says it’s extremely common for the managing partners of successful businesses to rip off the limited partners (i.e. the investors/venture capitalists) via things like kickbacks or self-dealing. He says even if the managing partners are generally honest people, they tend to justify it to themselves by pointing to the fact that even after being ripped off the investors are still getting a very good return on their money. But that’s because these people are focused on their own business. The bigger picture is that the return on high-risk investments needs to be high enough to absorb the inevitable losses from the less successful ones.
I’ve heard that venture capital is like playing the lottery. One Facebook or Google makes up for hundreds of losing bets. Most venture backed startups fail. Some make a modest return. Some rare few become huge and change the world. Those last few are the ones all venture capitalists are chasing.
And they’re not loans. Startups don’t pay back the loan plus interest. They’re investments in return for part ownership in the company. If you give $100k to 20 startups in return for 5% ownership, and in five years 15 of them fail, four just break even, and one gets valued at a billion dollars, you just made 50 million dollars on an investment of $2 million. Those numbers may not be accurate, but that’s the general idea of how investors make money off of startups even though most startups fail.
Remember, “Startup” isn’t the same as “new small business”. Banks make business loans all the time. If the business fails, they still get their money in collateral and/or bankruptcy. Your uncle’s new motorcycle repair shop is not a startup. “Startup” refers to the sector of new tech businesses that are trying to “shoot the moon” or make sweeping changes to society through technology. These are the lottery tickets, the high risk, high reward investments that make venture capital (and startups in general) such a unique corner of the market.
Have you ever watched TV shows where people try to attract investors, like “Shark Tank” and “The Profit”? Although they’re entertainment, they’ll give you an idea of the criteria an investor might use when deciding to invest in a company. They also show some of the mistakes the companies make, typically with mismanagement of capital or not understanding their target market.
The investor needs to believe that they will get an appropriate return on their money. Either they believe in the team or they can see the company has produced results that indicate the chance for future success. If you don’t have that right now, you will likely have to raise money by yourself through friends and family.
In terms of expected value, it makes total sense to bet a chunk of money you can afford to lose on a pool of startups. Betting on a pool reduces the variance and if the typical outcome is hugely positive (with a certain chance that you bet right before a bubble crash and you’ll lose most of your stake) it’s definitely the way to go.
As I understand it, however, these type of gambles are not available to the average investor. Don’t you need over a million dollars in assets and they can’t advertise to you about the opportunity?
In general, equity offerings in privately-held companies are open only to accredited investors (there are a few ways to qualify, but one is to halve a net worth of a megabuck or more.)
But that’s not to say startup investments are out of reach of non-accredited investors; after all, every poor college kid who has started a company in their dorm room is an equity owner. As long as you’re not offering a round of financing for sale on the open market and actively trying to recruit investors, you can sell a stake in your company to pretty much anyone.
Most startups that seek venture capital do so by putting together a prospectus and going out to pitch a multitude of VC firms. Those funding rounds (if successful) are often underwritten by a handful of firms each kicking in a certain amount. Those firms generally don’t want people bogarting their equity and will be highly reluctant to make carve-outs for civilians, even if they are accredited investors.
But if you want to be an angel investor, all you need is a dollar and a dream.
I’m not hearing a way to buy a smaller stake in 100 or 1000 startups that professional investors think look promising instead of betting it all on the one you hear about.
Because the odds are dismal for any single startup.
It used to be that you couldn’t advertise private placements of securities, but Congress and the SEC have changed those rules. Now you can advertise to anyone you want but you can still only sell the securities to accredited investors or qualified institutional buyers (depending on the exemption from registration you are relying on). https://www.sec.gov/info/smallbus/secg/general-solicitation-small-entity-compliance-guide.htm
There are also separate exemptions from registration for Crowdfunding offerings, which can be advertised and sold to anyone. No one would argue that it makes any sense to invest a chunk of money in those.
The term you are looking for is “venture capital fund.” The number of companies in a fund is more likely to be around a dozen to some number of dozens but the concept of diversifying your risk is there. Some investors have made billions on them. These are still sold only to accredited investors.
I’m not quite sure what you’re asking, but if you want exposure to diversified venture capital investments, the way to do that is to become a limited partner in a venture capital firm. Bring money.
Yeah, that’s what I was saying. You can’t make these excellent bets if you only have a mere 10k or 100k or whatever of money you can afford to lose. This is for the already wealthy only, and it sounds like most of the time it has made the already rich even richer. (fore example if you had bet 10k every year over the last 20 years, some of those 10k stakes would have been lost completely in the last couple crashes, but all the rest would have returned much more than you put in)
Granted, but keep in mind, even the best VC funds are no guarantee to great riches. VC funds, even well-diversified ones, fail spectacularly, too. Others chug along and basically break even or slowly bleed capital. Others might have one big win that just ends up supporting dozens and dozens of losing investments for years.
Venture capital is insanely high-risk, and if you don’t have the kind of money for insanely high-risk investing, you’re much better off with S&P index funds and corporate bonds, anyway.
Of course they aren’t. But if the* expected value* of the bet is 30% interest, even if individual bets on VC funds sometimes bust and sometimes give you a stake in facebook, if you have enough time to play the game you’re going to be hugely ahead. Sort of like gambling where you’re the house. Individual days you can actually lose money but the math says you’re going to be ahead.
The irony, of course, is that if regular mom and pop and institutional investors (I assume that large pension funds and banks can’t invest in VC funds, either, right?) could invest in VC funds, the returns would average much lower. This is because many more startups would be funded that offer lower chances of success.
Finite VC money means that only the startups with higher success chances/higher upsides get funded.
That’s the profit margin of a pharmaceutical company. I figured that silicon valley startups must do that well or better or nobody would invest in them.
A bit of googling suggests that Y combinator earns more like 45%.
What pharmaceutical company? You understand that cash profits are not the same as equity valuation growth, right? You can’t just look at random numbers and start comparing them, that’s not how it works.