What it means
The name comes from silicon, the material used to make computer chips, which were first produced in large numbers in the area in the mid-twentieth century. Over time, the region attracted engineers, universities, lawyers and investors, creating a self-reinforcing cluster.
Today the term is used for the whole ecosystem rather than a strict map boundary. For finance professionals, the important feature is the venture capital model.
Venture capital firms raise money from institutions and wealthy individuals, invest in dozens of young companies, and expect most of them to fail or return little. A few big winners are supposed to repay the entire fund and more.
Start-ups there usually raise money in stages, called rounds, such as seed, Series A and Series B. Each round sets a valuation, which is the price put on the company, and gives investors shares in exchange for cash.
Founders accept dilution, meaning they own a smaller percentage after each round, in return for the money to grow faster. Investors often value growth over profit in the early years.
Companies may lose money for years while building users and revenue, supported by funding rather than earnings. This approach can produce very large companies, but it also produces failures, and it works only while investors are willing to keep providing capital.
The phrase is also used loosely for tech culture and for places that try to copy it. Many cities describe themselves as a "Silicon" something, such as Silicon Roundabout in London.
When you see the term in a business setting, it usually hints at fast growth, equity funding and high risk. Costs in the region are a practical point for any finance team with staff there.
Salaries and office rents are usually higher than in most other places, and many employees receive stock options as part of their pay. Budgets must therefore allow for share-based compensation, which is an accounting cost even though no cash leaves the business.
In practice
Real-world examples.
Example
Two engineers leave a large technology company to start a software business and move to Silicon Valley to raise money. They pitch to venture capital firms and secure $2,000,000 at a $10,000,000 valuation. The money pays for hiring, servers and the first year of salaries, and the founders agree to a vesting schedule so that their shares are earned over time.
Example
A pension fund in Europe commits $50,000,000 to a venture capital fund based in the area. It expects that the fund will invest in around 30 companies. The pension fund understands that most investments may fail but that a few could return many times the cost.
Example
A manufacturing company opens an office in Silicon Valley to scout for new technologies and potential partners. The finance team treats the cost as a research and development expense. It judges the office on the number of useful contacts and pilot projects.
Formula
Calculation
Post-money valuation = pre-money valuation + new investment
Investor ownership = new investment / post-money valuation
Suppose a start-up is valued at $20,000,000 before a funding round and raises $5,000,000 from a venture capital firm. The post-money valuation is 20,000,000 + 5,000,000 = $25,000,000. The investor's ownership is 5,000,000 / 25,000,000 = 0.20, which is 20%. The existing owners keep the other 80%, although their shares are now worth a portion of a larger company.Case study
Seen in the real world.
Brightloom Labs is an illustrative, fictional start-up founded by two graduates who built software that helps small shops manage inventory. They moved to Silicon Valley and raised $1,500,000 in a seed round at a $6,000,000 pre-money valuation.
Over two years they grew from 20 to 400 customers but still made a loss, and the founders raised a larger Series A round of $8,000,000 at a $32,000,000 pre-money valuation. After that round they owned less of the company, yet the value of their holding had increased.
The business later struggled to turn a profit when funding conditions tightened, and the founders cut costs and focused on customers who paid on time. The illustrative lesson is that start-up funding can build a company quickly, but it depends on investors continuing to believe in the growth story.
Watch out
Common mistakes.
- Believing every start-up there succeeds, when venture investors expect most of their companies to fail or return little.
- Assuming a high valuation means a company is profitable, when it often reflects expected growth rather than current earnings.
- Ignoring dilution, so founders are surprised at how little they own after several funding rounds.
Questions
People also ask.
Is Silicon Valley a single city?
No, it is a region that includes cities such as San Jose, Palo Alto and Mountain View, and its boundaries are loosely defined.
What is venture capital?
It is money invested in young companies with high growth potential in exchange for shares, with investors expecting a few big winners to cover the losses.
Do you have to be in Silicon Valley to raise venture capital?
No, many funds invest globally, although the area still has an unusually high concentration of investors and experienced founders.
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