Why do entrepreneurs go to VC and private investors instead of banks? originally appeared on Quora - the place to gain and share knowledge, empowering people to learn from others and better understand the world.

Answer by David S. Rose, Managing Partner, Rose Tech Ventures; CEO, Gust, on Quora:

Startups are risky, and banks are not in the risk business. Banks are in the "renting money" business. They will only lend money to people or businesses when they are sure (or at least as sure as they can be) that they will get the money back. They make sure by having collateral, which means that if the borrower doesn't repay the loan on time, the bank can seize the collateral, sell it, and get back their money that way. Examples of collateral that banks require before they give a loan might be your house (that's what a mortgage is), your car (that's what an auto loan is), or, for someone with a demonstrated history of good credit, your signature (which is where you promise to pay back the loan and agree that if you don't, the bank can come and take everything you own, if necessary, in order to get repaid.)

In contrast, startups are pretty close to the riskiest thing around...even more risky than gambling at a casino. The majority of all startup fail, which means that there would be no money or other assets available to repay a loan.

Because of that, entrepreneurs looking to finance a new venture first have to put in their own money (because no one else in the world would risk money if the entrepreneur him or herself is not prepared to risk it). Then maybe, if the entrepreneur has family or good friends with faith, they might be willing to invest a few dollars into the new business--as much as a show of support and friendship as it is a business decision.

Then, if the entrepreneur has shown at least a bit of success with that early money, a private angel investor might be willing to take a very, very big risk and invest some additional money to help the business take off. But angel investors are fully aware of how risky this is, so instead of just lending money to the entrepreneur, they invest money by purchasing a part ownership of the business, and thus become the entrepreneur's partner. For the startup founder, this has a good side and a bad side.

The good side is that if the business fails, the investor's money goes with it, and does not have to be paid back by the entrepreneur! But the flip side is that if the business succeeds, the investor now owns part of it (often a lot of it), and benefits accordingly. This is a perfect example of the trade-off between risk and reward: the bigger the risk being taken, the bigger the reward needs to be if things go well.

Banks want no risk, and are therefore prepared to forego the reward of owning a piece of a very successful company; VC and angel investors want to profit from the growth of wildly successful, innovative startups and are therefore willing to take a lot of risk. They do this because they know that out of 10,000 entrepreneurial startups, there will be 1,000 that look really promising, of which 100 will be successful, of which 10 will be really, really profitable, and of which one might, if they're lucky, be Facebook.

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Published on: Mar 9, 2017