Ask HN: Why are VCs needed?
My father worked in a bank and one of the main tasks of commercial banking was to give loans to start businesses. The entrepreneur has full ownership of the company and loan was repaid at normal interest rate. Why dont tech companies use this method and why do they need VC funding instead. If the entrepreneur is confident of his revenue model why not get a bank loan and start his company
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Why dont tech companies use this method and why do they need VC funding instead.
Because they need more money than banks are willing to lend, their present circumstances do not imply collateral/predictable revenues/etc which would justify an underwriting decision to lend more, and their implied failure rates would make lending at commercially acceptable interest rates a prohibitively expensive proposition for the bank.
For example, take stock of two guys in their mid-twenties with $30k of their $40k combined net worth tied into a business. The business has proven revenues of $10k. They seek $2 million in capital to expand to their next milestone. No bank in its right mind will loan them $2 million -- they're literally incapable of making the interest payments on it, to say nothing of predictably paying it back. By comparison, a VC firm might assign a notional value to their business of $3 million (the bank would say "It's, literally, worthless: liquidation costs swamp accumulated value of capital."), put in $2 million and own 40% of the company, and see 10 similarly situated investments fail totally to sell this one company for $200 million 5 years from now.
Because they need more money than banks are willing to lend, their present circumstances do not imply collateral/predictable revenues/etc which would justify an underwriting decision to lend more, and their implied failure rates would make lending at commercially acceptable interest rates a prohibitively expensive proposition for the bank.
For example, take stock of two guys in their mid-twenties with $30k of their $40k combined net worth tied into a business. The business has proven revenues of $10k. They seek $2 million in capital to expand to their next milestone. No bank in its right mind will loan them $2 million -- they're literally incapable of making the interest payments on it, to say nothing of predictably paying it back. By comparison, a VC firm might assign a notional value to their business of $3 million (the bank would say "It's, literally, worthless: liquidation costs swamp accumulated value of capital."), put in $2 million and own 40% of the company, and see 10 similarly situated investments fail totally to sell this one company for $200 million 5 years from now.
and see 10 similarly situated investments fail totally to sell this one company for $200 million 5 years from now.
That's the important point. Lots of VCs aren't really investing in a company, but are aiming to have invested in the next Google or other large tech company. They are playing blackjack.
That's the important point. Lots of VCs aren't really investing in a company, but are aiming to have invested in the next Google or other large tech company. They are playing blackjack.
Practically all VC invests this way; it's the model.
Startups have no collateral.
The goal of a bank is to minimize risk, as they have a capped return. On the other hand, the goal of a VC is to maximize return, as their is no cap on the return. The business models are different, and both have their places.
A VC is your business partner. If you fail, they fail as well right along with you to the tune of their money.
A bank is not your business partner. If you fail via a bank loan, the bank still wants their money AND interest.
A bank is not your business partner. If you fail via a bank loan, the bank still wants their money AND interest.
> If you fail via a bank loan, the bank still wants their money AND interest.
If your business goes bankrupt, the bank only gets their money if they required you to personally cosign for the loan. Of course, if your business isn't profitable yet, it's likely that they'll make you do exactly that, as a condition of getting the loan in the first place -- especially for tech companies that don't have many assets that can be liquidated in case of failure.
If your business goes bankrupt, the bank only gets their money if they required you to personally cosign for the loan. Of course, if your business isn't profitable yet, it's likely that they'll make you do exactly that, as a condition of getting the loan in the first place -- especially for tech companies that don't have many assets that can be liquidated in case of failure.
True but bankruptcy would be the step after failure. They want their money but doesn't mean they will get it back.
For a tech company, common sense would require to make the founders liable to the debt, otherwise they can pay themselves a good salary -with the money borrowed to the bank - and then bankrupt the company.
For this reason - as well as other reason people here already mentionned - the banks won't lend so much money to a young tech company.
For this reason - as well as other reason people here already mentionned - the banks won't lend so much money to a young tech company.
"Why dont tech companies use this method and why do they need VC funding instead"
Banks do not have as much vested interest in a startup as VCs. So their risk appetite is much lower than VCs. VCs lend money based on future potential of making it big and they take a lot more risk than a usual lender/bank.
Thats just the money part. VCs always provide a network of connections and key contact (mostly) who can also help your startup. Good VCs will provide mentorship and valuable help.
Banks do not have as much vested interest in a startup as VCs. So their risk appetite is much lower than VCs. VCs lend money based on future potential of making it big and they take a lot more risk than a usual lender/bank.
Thats just the money part. VCs always provide a network of connections and key contact (mostly) who can also help your startup. Good VCs will provide mentorship and valuable help.
VCs are needed as an asset class because there is a market opportunity to service a small segment of the population that are trying to create high risk, capital light, and high growth potential businesses that do not fit the risk/collateral/historical cash flow characteristics that banks need to believe that you can service their debt. VC money is EXTREMELY expensive and can be thought about as similar to credit card debt and payday lending. Sure, VCs have value added services like contacts and expertise that help portfolio companies potentially have a higher chance of success, but their primary motivation to help you is to return money to their limited partners (and themselves through management fees and carried interest). I'm an entrepreneur and know many amazing VCs who hopefully will someday fund my business but I'm realistic in acknowledging the nature of the relationship.
The first rule of banking is you HAVE to get your principle back. I worked at Capital One and with 30% and fee's for everything you can lose money, key is getting paid back.
Banks will loan money for working capital, if your startup needs a lot of working capital to finance inventories etc. banking might work.
A good VC brings more than money; they bring expertise and experience. They have networks and connections that you probably don't. If you really want to grow, VCs can give you the kind of resources and expertise to actually do that...a bank can only give you money.
A VC can also offer mentorship, provide some advice, and one of the most important thing is connections. They can introduce you to another VC or investor that might boost up your startup.