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Informal Financing General Review

Financing provides the lifeblood of a new startup. A weak financial structure can create problems in all areas of a startup's operations, delays in research and development, ineffective marketing, and inability to hire qualified personnel. Adequate capitalization, on the other hand, shields against the liabilities of newness and smallness, and allows the startup to continue product development and to pursue market opportunities. Capitalization levels, therefore, are strong predictors of a new startup's survival prospects and growth, particularly so for technology-based startups that run out of money if and when technology has problems.

When the young Alexander Graham Bell needed money in 1874 to complete his early experiments on the telephone, bank officers thought that the idea of a telephone was a foolish one. The consensus was that the nation had a workable telegraph communication system and the concept of individuals communicating across great distances through speech was considered to be a bit extreme. Besides, Bell did not have a company with any tangible assets to provide collateral. Recognizing an opportunity, Boston lawyer Gardiner Green Hubbard and leather merchant Thomas Sanders of Salem, Massachusetts, helped out. Later, these same two individuals put up the equity capital to start the Bell Telephone Company in Boston, Massachusetts.

While institutional venture capital financing has been glamorized in the press as the primary source of outside equity finance, statistics indicate that only one to two percent of all new ventures obtain financing from venture capital firms. In addition, venture capital firms are typically interested in making large investments to established businesses that have a track record of performance, making it difficult for younger, less established startup to obtain this type of financing. For growth-oriented new startups, informal angel financing fills the gap between cash infusions from friends, fools and family and later financing from formal institutional investors such as venture capital firms, which, because of their high transaction costs, do not engage in small investments. In terms of number of ventures funded, it is estimated that angels invest in ten to twenty times more companies than venture capital firms.

Angel financing is an informal equity investments by private individuals using their own money, directly in unquoted startups to which they have no family connection. It is one of the most common methods to finance new startups. Angels usually invest in early-stage startups, both for the potential of high return – an early-stage successful deal can give ten times or more return on investment – and for the enjoyment that they receive helping entrepreneurs launch their startups. In addition, angels usually have entrepreneurial backgrounds and are known to be hands-on investors, contributing their skills, expertise, knowledge, and contacts in a variety of informal and formal roles to the startup businesses. In dollar amounts, angel funding is most commonly sought when a new venture needs more than $25,000 but less than $2 million.