Early-Stage Investment

Businesses that are just beginning often have an idea or a prototype for a product or service to sell, but they have few customers, or even no customers at all, and are not earning profits. Banks are often unwilling to loan money to start-up businesses because they’re seen as too risky. Or if a bank is willing to loan money, the business owner has to already have a valuable asset such as their home to offer as collateral in case the business fails. Such firms face a difficult problem when it comes to raising financial capital: how can a business that has not yet proven any ability to earn profits pay a rate of return to financial investors?

For many small businesses, the original source of money is the owner of the business. Someone who decides to start a catering business or car detailing business, for instance, might cover the start-up costs by using their own savings or by borrowing money from family and friends. An entrepreneur who is good at using social media might also use crowdfunding on platforms such as Kickstarter and Indiegogo to get many fans of their business to each contribute a small amount that adds up to enough financial capital for their next stage of growth. Often, crowdfunding involves people committing a small amount of money to receive a product that has not yet been manufactured.

Alternatively, many cities have a network of wealthy individuals, known as angel investors. These investors will put their own money into small new companies at an early stage of development, in exchange for equity, that is, some amount of ownership in the company.

Venture Capital

Venture capital firms make financial investments in new companies that are still relatively small in size but have substantial growth potential. These firms gather money from a variety of individual or institutional investors, including banks, college endowments, insurance companies that hold financial reserves, and corporate pension funds. Venture capital firms do more than just supply money to small start-ups. They also provide advice on potential products, customers, and key employees. Typically, a venture capital fund invests in a number of firms, and then investors in that fund receive returns according to how the fund performs as a whole.

The amount of money invested in venture capital fluctuates substantially from year to year. In 2020, venture capital firms invested more than $167 billion in the U.S. but that amount rose to $333 billion in 2021.^[1] All early-stage investors realize that the majority of small start-up businesses will never hit it big. In fact, many of the start-ups will go out of business within a few months or years. However, investors also know that getting in on the ground floor of a few huge successes like a Netflix or an Amazon.com can make up for a lot of failures. Early-stage investors are therefore willing to take large risks in order to be in a position to gain substantial returns on their investment.

Reinvesting Profits As a Source of Financial Capital

If firms are earning profits (their revenues are greater than costs), they can choose to reinvest some of these profits in equipment, structures, and research and development. For many established companies, reinvesting their own profits is one primary source of financial capital. Companies and firms just getting started may have numerous attractive investment opportunities but few current profits to invest. Even large firms can experience a year or two of earning low profits or even suffering losses, but unless the firm can find a steady and reliable source of financial capital so that it can continue making real investments in tough times, the firm may not survive until better times arrive. If a business does not have a reliable stream of profits, it needs to seek out other sources of financial capital.

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