With the exception of self-funding and government grants, none of the financing money is free. Everyone expects to get back at least as much as they put in and in most cases a lot more. If you've been lucky enough to get a graduate student stipend or a grant, this might seem puzzling. After all, NSF or NIH doesn't ask you to pay back your salary, and they didn't expect you to develop a marketable product. Well, granting agencies are different from investors, believe me. Investors or lenders are not giving you a grant and they want their money back and more.Part of this has to do with inflation, which decreases the buying power of money each year. Suppose the inflation rate is 3% and you give me $1,000,000 for a year. Well, a million dollars at the end of the year is only going to buy $970,000 worth of goods compared to the beginning of the year. That's not a good deal for you, so you'll want me to pay back at least $1,030,000 so you're even.
But there is uncertainty in the prediction of the inflation rate. Lately (since 2010) inflation has been very low, under 1%, but in 1979 and 1980 it was over 10% per year. Imagine giving someone $1,000,000 at the beginning of the year and getting back the equivalent of $900,000. That would suck. If you are lending money for a year, you probably have a good idea of what inflation will be, but sometimes money is lent or invested for 10, 20, or 30 years. You need to make some assumptions about what inflation is going to do over that time in order to begin to set the interest rate.
And it's the same whether you are lending money or investing it by buying stock in a company. Your money is tied up and inflation is eating away at it.
But there's another problem: return risk. What if despite all my good intentions, I can't pay the money back? Maybe the economy tanked, maybe a competitor came out with a better product, maybe my gaming software caused people to go blind, etc. Tony Soprano would find a way to get his money back, but those techniques are generally frowned upon. [By the way, don't take money from Tony Soprano. Just saying.] So whether you get your money back will depend on how good a business man I am, plus how tough my competition is, plus how good the economy is, plus a lot of other factors you won't even think of until I tell you why I'm out of business.
Some people want to minimize this kind of risk. They'll only give money to big, established companies with lots of sales and profits. If you are investing your retirement savings it makes sense to minimize the risk of not getting paid back. Trouble is, in 2009 a big insurance company, a big financial institution and a big car manufacturer all declared bankruptcy. So risk is still a hard thing to measure. But in general, a company that's been around for a while, with good products and reputation is supposed to be lower risk.
What about at the other end of the spectrum? One or two guys out of college with some hot technology but no market and no way to generate revenue? Well, unless they are Larry and Sergei, or Zuckerberg, that's a pretty risky venture. In fact, the rule of thumb for VCs is that out of 10 companies they invest in, five will die without returning a cent, two will pay back the investment but nothing more, two more will do ok, but not great, and one will be Facebook. So they have to plan for making back 10x their investment from every company (on paper) and hope that a couple are going to actually strike it big because most won't.
So in general, the earlier the stage of the company, or the less developed the market, or the less experienced the management, the more uncertain the product, the higher risk of not getting your money back and the more you will demand from each investment to make up for losses in other areas of your portfolio. So a bank might require 1-2% over the inflation rate on a loan to IBM to account for return risk, while an angel or VC is thinking about 100-200% per year to stay afloat.
But really, all we've been talking about getting your money back accounting for inflation and the risk of the investment going bad. What's the point of that? You want your money to grow. But you're not greedy. Maybe an extra 2-3% if you're lending to a big company, maybe 5-8% if you're buying stock in public companies, and more if you are funding startups. So if you are taking money from one of these financiers, you better have a plan for paying it back plus a lot more.
Oh yeah, and you have to pay the costs of running the business too. So you have to find a way to make that $1,000,000 you're going to get generate 10% return a year (in the case of an established company) to over 100% a year (in startup) if you are going to have a reasonable chance of paying back the financing.
How do you do that? It's called 'Profit'.
