Purchasing shares in startup companies was entirely different twenty years ago. Today, new startup funding options offer entrepreneurs numerous ways to turn their great ideas into reality. For an investor, the possibility of investing in the next big business can be an exciting venture. As crowdfunding becomes more mainstream, everyday people are beginning to support campaigns or projects in exchange for shares, product discounts, or early access.

How Startup Investing Works

Usually, a group of people will come together and brainstorm ways to find a creative solution to an everyday problem. Next, the idea is tested, possibly iterated, and then the results are finalized. Sometimes, the final results are so innovative that the creators decide to start a business from the concept. In order to fulfill their dreams, they may need advice or consolation from experienced entrepreneurs, as well as capital. In other words, they may need to work with some startup investors in order to bring their concept to fruition.

Young startups are able to raise capital by partnering with angel investors and Venture Capital (VC) firms. Investors looking to invest in young startups usually do so by:

  • Participating in a priced equity round: This is when investors buy shares in the business at an agreed upon price
  • Purchasing convertible securities: This is when investors purchase convertible bonds or preferred stocks that pay regular interest and can be converted into shares of common stock at a future date

Early-stage and seed investors will typically invest in a business by purchasing convertible securities and Y Combinator's SAFE documents. Y Combinator provides seed funding for startups. Seed funding is the earliest stage of venture funding. Generally, it pays for your expenses while you're getting started. SAFE stands for a “simple agreement for future equity,” and enables an investor and startup company to accomplish the same general goal as a convertible note, though a SAFE is not a debt instrument.

Priced equity rounds will usually attract investors that are more interested in more mature startups, usually considered Series A or later.

Why Raise Venture Capital?

VC is considered one of the best ways to financially structure a startup that needs large amounts of capital. Companies such as Google, Facebook, and Amazon were all venture-backed startups. Traditionally, startups have very little collateral that they can offer lenders to justify a large traditional loan. It's simply too risky.

Rather than taking on a massive loan, startups are able to raise money through VCs with no requirement to repay the funds. In return for the capital, VCs expect to receive a percentage of equity in the business. In other words, the founders are transferring a certain percentage of all future profits of the business to the VC firm in exchange for the startup capital.

Acquiring equity in an early-stage startup can be an extremely lucrative opportunity for VC investors because of the potential for outsized returns and astronomical growth. Besides the capital received, founders are also able to benefit from added:

  • Guidance
  • Support
  • Resources

VC financing is an excellent way for startups to obtain financing when "bootstrapping" doesn't seem to be working out. Bootstrapping occurs when an entrepreneur attempts to found and build a company from the operating revenues of the new company or their own personal finances. Bootstrapping usually doesn't work for business models that need massive amounts of up-front capital.

Why Care about Equity?

The concept of equity is important to understand because it will ultimately impact many decisions for the business including:

  • How decisions are made.
  • How the ownership of the business is allocated across shareholders.
  • How much equity employees may own.
  • How long the ownership vesting period for employees is.
  • What type and how much tax shareholders will need to pay for their shares.
  • What will happen if the company goes public or gets sold.

What is Equity Financing?

Equity financing is the process of raising capital through the sale of shares in a business. Equity financing essentially refers to the sale of an ownership interest to raise funds for business purposes. For investors, equity is the percentage of a business' shares that a startup is willing to sell to them for a fixed amount of capital. As the startup begins to progress and the likelihood of profitability increases, investors are eager to pay more money for each share of the business.

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