First, you need to understand the types of investors. Not just anyone is eligible to invest in a private company, and not every investor invests in everything. You need to figure out what kinds of investors are out there before you can make heads or tails of your options.
You also might want to check out our earlier answer about how investment works.
What are the types of investors?
Investors are individuals, so these categories don’t cover every situation, but take some notes, and you will get a sense for the types of investors.
Chances at Investment
When you are searching for funding for your business, you may run across quite a few websites that dangle a “chance” of an investment. Be wary of these. They are businesses that sell a product that they want you to buy, such as small business coaching, entrepreneurship classes, or a business plan contest. The investment that you could theoretically win is often a lower dollar amount than what you will pay for their product. (For example, you could take a $5,600 entrepreneurship course at the end of which your team can compete for a $5,000 investment!) There are also business plan contests, investor cocktail parties, and even investment competitions on TV. Agreements for these opportunities may leave you holding the bill. They might include a royalty, or the right to use or publicize your idea. Before you enter a contest to potentially win an investment, make sure you read all of the fine print. (As Andy Rooney said, “Nothing in fine print is ever good news”!)
When you start telling your family and friends about your business, some of them may express an interest in investing. First, you need to determine whether they are even eligible to invest in your company. (We discuss this in our earlier answer about how investment works how investment works.) If your family and friends are eligible to invest, then you need to decide whether you want people who are so close to you involved as investors. Professional investors understand that they may lose everything they invest, and they do not risk funds that they cannot afford to lose. Your family members may not have the same understanding, and they may become upset if the investment doesn’t pay off. It may change your relationship, so consider saying “no” now to spare yourself heartache later.
If you do decide to take on “Friends & Family” investors, be sure to communicate that they could lose the entire investment and codify your agreement in writing. And, let them know if you think you could take on more investors in the future and how that might work. Early investors can be surprised (and hurt) when later investors come in and dilute their holdings or demand that they sell their stake as a condition of new funding.
The Internet has enabled new ways of telling fundraising stories and connecting with individuals who are interested in investing. The advantage of this kind of funding is that it enables participation from people who would otherwise not be able to invest. Depending on your company’s mission, this could be truly wonderful. However, you need to look carefully at any agreement before you sign it. The crowdfunding organization is itself a business, and its directors are likely to set up terms that are heavily in their favor. If you can, reject any agreement that limits your future options.
Angel investors are typically Accredited Investors who like to invest in early stage companies. They generally prefer to be the very first financial investor in a company, but some may participate in later fundraising rounds. Because they invest very early, they take a lot of risk, but they can also take a high percentage of the company. Angel investors can invest small amounts (under $10,000), but they more typically invest $25,000-$100,000 (Harroch, 2015). Some angels do invest millions, but more than $1 million is rare. In exchange for this early cash, these investors will take 20-50% of your company’s stock (Koss, 2007). The lower end of that range is more typical, but they are shrewd people and will ask you to part with a higher percentage if you seem amenable. Make sure you have done your research and know all of your choices before you sign away a large percentage of your company.
Successful existing companies in a given industry (referred to as “strategics”) will sometimes make investments in other companies in their industry or in new companies that serve the industry. This kind of investment enables them to learn from what creative entrepreneurs are doing in their field and to benefit from growth, since they can no longer turn on a dime. This can be a great way to get your company off the ground, especially if you bring a technology or skill that is difficult for the larger company to develop. Before taking this kind of investment, you will need to have a nondisclosure and/or non-compete agreement, so the larger company agrees not to take your idea or technology with them.
These firms gather money from Accredited Investors (called “Limited Partners”) who want to make high-risk investments in order to access potentially large returns but do not have the skills to identify those investments themselves. The venture capitalists (called “VC’s”) search for entrepreneurs with ideas that have very high growth potential, typically make investments of $1 million or more, and toss in support services and oversight to increase the venture’s probability of success. Some VC’s can make investments in the hundreds of millions of dollars.
VC’s require financial returns of 25-35% per year (Zider, 1998), so they do not typically invest in ordinary small businesses. This kind of investor banks on entrepreneurs who have big ideas and a successful track record of building and selling new companies quickly. They will look at a new venture’s leadership team very carefully and will be reassured by leaders who have elite executive experience in the field or specialized knowledge of a new technology or process. Venture capitalists, like all early stage investors, take a large percentage of the company’s stock, ranging from 25 to 55% (Inc., 2021), but they also provide large sums of capital that entrepreneurs couldn’t come up with themselves and often encourage their entrepreneurs to take a market-rate salary. This type of investor is best for founders who are not obsessive about control and are happy ending up with a tiny percentage of a very large company.
Banks have strict rules for when they can give loans, so they are a good option for businesses that already have revenue and assets and need money to open a new location or buy additional equipment. Banks look at revenue, profit, and debt, and they will usually want some kind of collateral, so they don’t typically fund completely new ventures. There are exceptions, though, such as SBA Loans, so it’s good to get to know your local business bankers and talk to them about what you are doing.
Private Equity Investors
Like VC’s, private equity shops gather money from limited partners and identify investment opportunities with very high potential returns. In general, private equity focuses on companies that have already achieved considerable success, but need investment to grow to the next level. These investors typically do not fund new companies, but are more likely to invest in existing companies where they can envision how a cash infusion can catalyze a specific path to dramatic improvement. Private equity shops have a wide variety of focuses. Some specialize in a particular industry, others prefer a particular scaling strategy, and most can bring in other investors (including Family Offices – private investment managers for extremely wealthy individuals) to share in big deals.
What’s the bottom line?
Oscar Wilde quipped, “When I was young, I thought that money was the most important thing in life; now that I’m old, I know that it is.” Money really isn’t everything, but it’s awfully hard to start a business without it. And raising investment can be crazy-making: The easiest time to get it is when you don’t need it. If you are desperate for investment, you may be vulnerable to unfair terms and even scams. So, before you take on any kind of investment, take a breath. Then, take another. Make sure that you have a plan for your business that includes financial projections, so you really understand how the money will work and how much cash you need. And, make sure you have a business mentor you trust, who can help you avoid the most common mistakes. A little time invested up front can make all the difference.
Harroch, R. (2015, February 5). 20 things all entrepreneurs should know about angel investors. Forbes. Retrieved on July 22, 2022, from https://www.forbes.com/sites/allbusiness/2015/02/05/20-things-all-entrepreneurs-should-know-about-angel-investors/?sh=399079c1c1aa
Koss, A. (2007). Best practice guidance for angel groups – deal structure
and negotiation. Angel Capital Education Foundation. Retrieved on July 22, 2022, from https://www.angelcapitalassociation.org/data/Documents/Resources/AngelCapitalEducation/ACEF_BEST_PRACTICES_Deal_Structuring.pdf
Venture capital. (2021, January 5). Inc. Retrieved on July 22, 2022, from https://www.inc.com/encyclopedia/venture-capital.html
Zider, B. (1998). How venture capital works. Harvard Business Review, 76(6), 131-139.