By Graham McFarland, VAULT COO
In this blog post, I will be discussing the various types of investors that entrepreneurs can tap into, including customers, partners, friends and family, angels, and venture capitalists. Each type of investor comes with its own set of advantages and disadvantages, and it's essential to understand what each investor brings to the table before making a decision. By the end of this article, you'll have a better understanding of the investor landscape and how to find the right investor for your business's needs. So, let's dive in and explore the world of investing!
Let's be straightforward here – your first investor better be you. We are not talking about your time and energy but real cash put into the business. If you don’t have enough money to get the business going then don’t start the business.
Starting a business is not a fallback position to not working. Most start-ups are funded by their founders working multiple jobs and long hours to reach their goal of building a sustainable business. Working is key to providing the necessary capital to bring an idea to life and turn it into a career.
Full-time, part-time or odd jobs all count towards the end goal of making it happen and funneling your hard earned money towards your dream. Without hard work, your accomplishments will be meaningless. Missing a few meals along the way and introducing yourself to Raman noodles is part of the game. No one is going to invest in you unless you have invested in yourself first.
Your best investor is your customer. We know this may sound a bit foreign to some of you but this is the way it is supposed to work. Especially in today’s high tech environment where the cost of starting a business is small compared to the past. Focusing on raising capital by providing a valuable product or service is certainly the best way to fund a start-up. Not only does it help pay the bills, it validates your business model and establishes valuable reference accounts for future prospects.
Your first 10 customers could sell the next thousand. Get this right and you are done raising money from non-traditional sources. Once you have customers (otherwise known as traction) then you can use real orders and receipts to get loans from a banking institution rather than giving away your much deserved ownership.
Larger customers who express an interest in your product at an early stage could also become Strategic partner investors. These customers have a vested interest and can provide early stage capital in exchange for some special treatment such as requested feature and functionality development, competition exclusion, and other selfish advantages. Just like customers, strategic partners provide traction in terms of sales, potential sales, or the opportunity cost of working with you to figure out if there is synergy. All of the same caveats for customers apply to strategic partners when it comes to investors. Finding strategic partners is a great way to fund your startup.
This step begins the journey that VAULT likes to call “The Walk”. We call it that because from here on out you are on a journey that you can’t control and those with a weak stomach should stay away.
The first step brings you to the homes of friends and family. Many mistake success at this junction as validation of their idea. Wrong. This step only proves that you can beg with the best of them and you have people you know who support you and want to see you do well. That is a good thing but don’t let it go to your head.
There are a couple of things to remember when asking for money from friends and family. First use this opportunity to hone your skills and practice the pitch. This is the friendliest audience that you will face as part of the process. Second, never ask for a specific amount of money from friends or family. Tell them how much in total you are looking for to keep the momentum going for the next three to six months. Let them ask the question of how much you are asking of them. Once they do, politely say something that resembles the following sentence. “Although I have a well thought out business plan, as you know, start-up investments are risky. I can only ask for an amount that you are comfortable investing knowing that you could potentially lose it all.”
When dealing with unaccredited (amateur) investors this is the best way to handle the ask. You can do plenty of selling when talking about the business and how you are going to make it big. The ask should always be demure by design and separated from the pitch when dealing with friends, family and acquaintances.
Just because you have money doesn’t mean that you are smart. Most money comes from hard work and luck rather than smarts. This is important to understand when you are dealing with angel investors.
Angels, as their name indicates, are saviors and watch over you and intervene when required to save you from something (usually yourself). Angels specialize in total financing of less than one million dollars per venture. They typically partner together and invest as a group to share the risk of the investment. Angels like to invest in ventures that they know something about and can provide some value to the management team in the form of introductions, contacts or access to customers. Their expertise might be in a specific industry such as software, health care, oil and gas or in a particular type of company such as pharmaceuticals or mass storage solutions. Either way, angels usually want to help as well as invest.
A new definition called “Super Angels'' is starting to be used to define wealthy individuals who are making a large number of small investments in a variety of start-ups. One of the most famous and outspoken of this group is Dave McClure of 500startups. Dave is a wealthy Super Angel that makes small seed investments of approximately $100k into 60+ companies each year. Most of these companies will never make it, but his and other super angel’s objective is to play for the odds. It only takes a few big winners to keep the model working.
Angel funding comes in a variety of flavors. It can include debt, equity or revenue share. Debt that converts to equity at a specific time when a minimum amount of additional funding is obtained is becoming popular among angel investors. This method lowers the risk for the angel, kicks the can down the road on valuation and allows the entrepreneur to give up less equity. It does mean that the company has secured debt and if not converted, could lead to a loss of any or all the company’s assets, such as its intellectual property and equipment.
Venture capital is another name for professional investors who specialize in taking risks. Seed or early stage VC’s focus on start-ups and are looking for companies that have the potential for a 10X return in less than three years.
These groups are located all over the country but concentrate their efforts around entrepreneurial hotspots such as San Francisco, Boston, New York, Austin, Philadelphia and Chicago. The most famous (or infamous) of the VC’s have offices on Sand Hill Road in Menlo Park, California about 40 minutes south of San Francisco. Sand Hill Road is to private equity as Wall Street is to the stock market.
Venture capital firms usually look at deals requiring over $1M in funding. As a result of the recent economic downturn, VC’s and angels have been competing with one another on deals. VC’s have begun looking at deals closer to the $1M mark and angels, specifically angel groups, have begun to fund deals over the $1M threshold.
VC’s typically purchase equity that comes with preferences that ensure they are well compensated for their risk if the company successfully negotiates an exit event. These preferences include liquidation factors, accumulated dividends, drag along rights and voting privileges senior to those of common shareholders. VC’s come in a variety of categories based on the size of the funds they manage and their historical success. They are generally labeled as A+, A, B or C. A good listing of the top 25 are noted here.
Most others are considered A, B or C level VC’s. Local firms outside of the major hubs such as New York, Chicago and Los Angeles in your area are typically B or C level and sometimes if those firms have gained a national reputation, then they can be considered A’s. Austin Ventures (Austin, TX) and Sevin Rosen (Dallas, TX) are examples of such firms.
Some VC firms specialize in certain types of investments and industries based upon their expertise. Such VC’s may only make investments in healthcare, mobile, media or SaaS ventures for example. Many of these smaller niche firms may be an A+ in their focused segment even though their fund size may be considerably smaller.
Venture Capitalists have a similar motto as Chuck Norris. You don’t find VC’s, VC’s find you. This may sound arrogant but as the saying goes “if the shoe fits”. Networking with VC’s and people who interact with VC’s is the best way to get noticed. Every VC is looking for the next big thing and constantly searching to find it. Sending your executive summary directly to a VC without a valid introduction is a waste of time and money. The probability that it will be seen is close to zero. Spend your time networking and asking for introductions to both angels and venture capitalists. Let others introduce your venture to the decision maker and help sell your idea.
Take every opportunity to get your executive summary out to those who matter and can make introductions for you. These include mentors and other executives that have existing relationships with investors that funded them in the past or are aware of their success. These folks are influencers that can get your executive summary reviewed. Next are incubator staff who are in direct communication with local and national investors. They are on the front lines and provide not only the ability to source but also may have valuable insight into the founders.
These folks get paid to bring deals to the table for VC’s. They earn a commission for sourcing deals. They do the leg work and if they see a fit, they sell the idea directly to the VC. If your venture begins to grow rapidly and you are getting noticed in your industry, through articles, PR, awards, etc., you will begin getting emails and calls from brokers. Many say that they represent a particular firm and you may not be aware that they are a broker. Brokers can be helpful but just remember that you need to educate the broker so they can eloquently sell your story.
In contrast with venture capital, most private equity firms and funds invest in mature companies rather than startups.
Private equity describes investment partnerships that buy and manage companies before selling them. These firms operate these investment funds on behalf of institutional and accredited investors. Private equity funds may acquire private companies or public ones in their entirety, or invest in such buyouts as part of a consortium. They typically do not hold stakes in companies that remain listed on a stock exchange.
They manage their portfolio companies to increase their worth or to extract value before exiting the investment years later. Private equity funds have a finite term of 7-10 years. Private equity comes into play usually when your business is established and successful. Private equity is usually looking for companies with a track record of success that need some additional capital, business knowledge, or strategic execution to experience that next surge of growth. This can be achieved by merely providing working capital and talent; or it can be a platform company that gets funded to make acquisitions to create growth synergy in a particular industry segment in which it has an advantage.
Remember this is not an easy process and takes an inordinate amount of time to do it well. Networking, strategic planning, and preparation are the keys to success. For most the money never comes. But for those that are fearless, diligent, and determined, your chances of success increase a hundred fold. This isn’t a competition against other startups, this is about your story and passionate ability to tell it in a way that wins over not only investors but your first customers. Investors invest in people more than they do the business. Meaning the business has to make sense and be logically viable. Once that hurdle has been cleared then the investor will only invest if they think you are capable, willing, and determined to make this work. If they believe in the business but are not interested in you then they will not invest.