Command line millionaires

• Article 7 of 16
• LinuxUser & Developer, November 2005

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If you’re lucky and your needs aren’t that great, you might be able to interest an “angel investor”. This is effectively a wealthy benefactor who thinks you’re onto something. In return for a stake in the company, he or she will provide you with a significant sum of money. It might be enough to get you ready to release a money-making, market-changing product. More often than not though, it will get you to the point where you have something with which to attract venture capitalists.

VCs rarely have any more money than angel investors – in fact, a significant number of them are angel investors themselves – but what they do have is access ‘funds’. Very rich people give the VCs large quantities of money, which they then combine into a fund. The VCs will then look for companies they think could be worth far more than they’re currently worth. In exchange for perhaps 30%-40% of the companies’ shares, the VC will give the companies significant amounts of money from the fund, usually a few million dollars. Typically, the VC will also get a place on the board and the opportunity to advise management on the best way to develop the company.

Sometimes, during this first “funding round”, more than one VC will want to invest and the 30% stake will be shared between the VCs. There may also be subsequent funding rounds, typically a year or two after the first round, where the management sells more of its share in the company (at its new, hopefully higher value) in exchange for further funds. This is usually to expand the company’s operations now R&D is complete.

The main aim of all this for VCs is that within three years, the company will be able to float on the stock exchange in an initial public offering (IPO) or be bought by another, bigger company in a “trade sale”. In both cases, the company should have moved from being worth just a few million dollars, where a 30% stake cost $3 million or so, to being a $100 million company or more, where a 30% stake is worth $30 million – a big pay-off for the VC, which can sell its stake to the purchaser or on the stock market.

In case you’re thinking that’s effectively money for old rope, the vast majority of companies fail to reach that kind of value and indeed fail to get off the ground at all. The high return on the investments that do succeed has to compensate for all the companies that flop, taking all that funding capital with them. And if the VCs don’t make a high enough return for the investors, the next time they launch a fund, they’ll find the investors will have taken their money to a fund that does provide high returns – putting them out of a job.