By Tim Chaves, founder and CEO of ZipBooks.
As founder of an accounting software startup, I've raised over $2 million in venture capital funding to get my company off the ground. And that's not unique: If you're selling goods, you need inventory; if you're selling software, you have to build it. But doing that costs money -- there's usually some period of losses long before you begin to see profits. Someone has to be willing to take those losses, but who would be willing to throw money at a project that's intentionally losing money?
Obviously, investors aren't interested in losing money: They want it back, and then some. Keep in mind that some could be a better fit for your business than others. Here are a few types of investors, and what drives them.
The easiest way to fund your business is from your own pocket: No pitches or lengthy agreements are involved, and you understand the vision. But businesses are hungry: They eat up both capital and time very quickly. For entrepreneurs who figure out a way to manage this, bootstrapping can yield long-term benefits for ownership, lifestyle and negotiating leverage.
Friends and Family
Many entrepreneurs choose to raise money from friends and family when they're first starting out. While common, in my experience, this can be a challenge, especially if the friends and family investing can't afford to lose their investment. If you're both okay with taking on this risk, great. If not, be mindful here.
Banks and Debt
Usually, banks and debt providers need you to already have revenue or collateral before they'll provide funds. That's because they're in a low-risk, low-return game. Even if your company takes off, they're limited to the agreed-upon interest rate. This is often a better path for more established businesses.
Despite their name, "angel" investors don't provide funds without strings attached. Because these investors are paying their own money, 25 percent returns are usually a win for them. There are only so many places to put capital; public equities and other less-risky investments don't yield the same type of returns angels can get with good startup investments.
Angels invest across industries and stages, and can be a great fit for entrepreneurs who need money early, but aren't yet ready for (or don't want) venture capital.
Many early entrepreneurs don't realize that venture capitalists aren't investing their own money. VCs raise money themselves in order to allocate that capital in startups. Their investors (called limited partners or LPs) pay fees on behalf of VCs, but the way VCs can really make money is through what's called carried interest, or "carry."
Understanding carry is key to understanding VC incentives. Usually, the carried interest rate is somewhere around 20 percent. That means 20 percent of the profits from the fund (the carried interest) goes to the VCs. Eighty percent of the profits go to the LPs. For that to be life-changing for the partners, they have to generate huge profits.
They also know that some of their investments will end up failing. To compensate, they're aiming for an equity stake in at least a few companies that could strike it big (think billion-dollar business with an IPO).
There are many different ways to fund a business, and each has its set of pros and cons. Not all investors are created equal: Keep this in mind as you examine their motivations, and understand how those dynamics can determine what type of investor fits your case best.
Tim Chaves is the founder and CEO of ZipBooks, a free accounting tool with built-in invoice financing, time tracking and payment processing.