What Is Startup Capital?

Startup capital is a financial investment in the development of a new company or product.

The term is often used interchangeably with seed money, although seed money is often a more modest sum that is used to create a business plan or a prototype that will pass muster with investors of startup capital.

How Startup Capital Works

Startup capital may be provided by venture capitalists, angel investors, or traditional banks. In any case, the entrepreneur who seeks startup capital generally has to create a solid business plan or build a prototype in order to sell the idea.

Startup capital is used to pay for any or all of the required expenses of creating a new business, including initial hires, office space, permits, licenses, inventory, research and market testing, product manufacturing, marketing, or any other expense.

In many cases, more than one round of startup capital investment is needed in order to get a new business off the ground.

Types of Startup Capital

Banks provide startup capital in the form of business loans. That is the traditional way to fund a new business. Its biggest drawback is that the entrepreneur is required to begin payments of debt plus interest at a time when the venture might not yet have become profitable.

Venture capital from a single investor or a group of investors is one alternative. Generally, the successful applicant hands over a share of the company in return for funding. The agreement between the venture capital provider and the entrepreneur outlines a number of possible scenarios, such as an initial public offering or a buyout by a larger company, and defines how the investors will benefit from each.

Angel investors are venture capitalists who take a hands-on approach as advisers to the new business. They are often themselves successful entrepreneurs who are using some of their profits to get involved in newer ventures.

Startup capital is often sought repeatedly in funding rounds as the business develops and is brought to market. The final round may be an initial public offering in which the company raises enough cash to reward its investors and invest in further growth of the company.

Disadvantages of Startup Capital

Startup capital, it goes without saying, is a risky business. The backers of startups hope that these proposals will develop into lucrative operations and reward them lavishly for their support. Many do not, and the venture capitalist's entire stake is lost. Thirty to 40 percent of all high-potential startups end in liquidation, according to a study published by Inc.

The few companies that endure and grow to scale may go public or may sell the operation to a larger company. These are both exit scenarios for the venture capitalist that are expected to provide a healthy return on investment.

That is not always the case. For example, the company may get a buyout offer that is below the cost of the venture capital invested, or the stock may flop at its initial public offering and never recover its expected value. In such cases, the investors get a poor return for their money.

To find venture capital's most notorious losers you have to go back to the dot-com bust of the late 1990s. The names live on only as memories: TheGlobe.com, Pets.com, and eToys.com, to name a few. Notably, many of the firms that underwrote those ventures went under too.

Benefits of Startup Capital: Big Winners

Venture capitalists have underwritten the success of many of today's biggest Internet companies. Google, Facebook, WhatsApp, and DropBox all got started on venture capital and are now established names. Other venture capital-backed ventures were acquired by bigger names: GitHub was bought by Microsoft, AppDynamics by Cisco, and Instagram by Facebook.

Key Takeaways

  • Startup capital is the money raised by an entrepreneur to underwrite the costs of a venture until it begins to turn a profit.
  • Venture capitalists, angel investors, and traditional banks are among the sources of startup capital.
  • Many entrepreneurs prefer venture capital because its investors do not expect to be repaid until and unless the company becomes profitable.