Lesson: Incorporating Your Venture with Augie Rakow

Step #9 Money: Investment types

So you've got this product or service, you've got maybe a customer or potential customer, and you need some money to build the product so that you can actually deliver it to that customer so you can get money from them, get their payment. Now, you can bootstrap a company which means you build your product, you sell it, you get some money, you use that money to build your next product, sell it, bring in money, and use that money.

Bootstrapping means you're growing the company from the revenues of the company, just growing it from its own revenues. Now, maybe you want to grow faster than that. You make a product, it costs you $9 to make it, you sell it for $10, you make $1, that's not enough to make your next product. You needed $9 to make it, right? It costs $9 to make it, you sell it for $10, you get $1, and you need $8 more. Hopefully, you made a big enough profit. You made it for $9, you sold it for $20, and you got $11. Take that $11, $9 to make your next product. Hopefully, you can do that. But even then you sell one product, you're only getting enough to make one more product. So bootstrapping can be a slow, painful process.

If you have come up with a product that people think is going to sell very quickly, if you're getting so much demand but you don't have the finances to make the product, you want to get some additional investments so you can make more of the product and make more money. Okay, that's what the venture world is based on, identifying those high growth areas of business where the more money you pour into the company, the more it can make. Don't confuse that with having a product that nobody wants and you can't generate any revenues, you can't generate any sales, and so you need investment because it's not a viable business. Keep that distinction in mind.

So when someone gives you money and someone invests in your company, there are a few different ways they can do it. You can have debt where someone just loans you money. Here's an advance, I'll give you a million dollars, pay it back over 5 years or whatever. That helps you make more of your product and sell more, and then you can pay off the debt. Or someone can say, "Here's a million dollars. I want 25% of your company. You don't need to pay back my money. I just want 25% of your company. That's what we call an equity investment. So debt versus equity, that's a spectrum, debt versus equity. And there's a lot of points along that spectrum. But in simplistic terms, debt versus equity.

Now, debt is what we call cheap money. It can be expensive, too. But assuming you get a reasonable interest rate, assuming the repayment terms are reasonable, assuming you can repay it, it's good. You get the money temporarily, you give it back, and you still own 100% of your company. The downside with debt is you have to pay it back. And if you can't pay it back, you could go bankrupt, various different problems.

On the equity end, that's very expensive money. Sure, short term it feels kind of cheap because you don't have to pay it back. But if you build a successful business, this person's getting 25% of that business so it's very expensive.

There are things in between that have been developed over the years for various things and these things are evolving. Every three or four months there's kind of an evolution in how these things are done. But for today's purposes, let's just call them convertible notes. And a convertible note starts off like debt. Somebody says, "Here's a million dollars. Pay it back to me after 24 months with X interest rate." It starts off like debt. But the company, in certain situations, instead of paying it back with cash can pay it back by giving equity.

So it starts off as debt and the debt has to be repaid. But if certain things happen, like let's say if the company generates $100,000 in revenue, then the note will convert into equity instead. So if the company goes nowhere, I want my money back. But if you take my money and you do pretty well with it, you start to really build a business with it, then I want a piece of the business. That would be kind of a hybrid. It's a little bit of debt, little bit of equity.

A more classic Silicon Valley style deal would be here's my money, it starts off as debt, and you have to pay it back after 18 months or whatever. But if you raise financing from a venture capital firm, I want my money to convert into the same equity that that venture capital firm gets. So if you sell equity to the venture capitalists, I want equity. And then you don't have to pay back my debt.

That's a more classic Silicon Valley approach to a convertible note. So the lender lends the money. It has to be paid back unless a certain trigger happens and one of those triggers would be if the company raises money from venture capitalist, whatever stock the company gives to the venture capitalist, you have to give the debt holder also. And then you don't have to pay back the debt. That's a classic Silicon Valley convertible note. And, again, these come in many, many different flavors and they're being experimented with daily.