Sooner or later, every entrepreneur thinks about raising funds from outside investors. Although many look forward to the process, others find the prospects daunting.
Few of us are personally acquainted with a venture capitalist or even an angel investor. But we have all heard stories about how difficult, capricious, and predatory they can be. What we tend to forget is that they are real people, just like us. Their business is making money by making investments, and it is important that you understand their business before you approach them. This summary is intended to shed a little light on the industry and the individuals who comprise it.
For our purposes, venture capital firms are defined as partnerships that invest and manage funds raised from major institutional investors. Investment banks, who primarily borrow the funds they invest, share many of the characteristics summarized below.
- VC firms are partnerships run by their general partners. These partners are very bright and work very hard. Most had highly successful careers in other industries before they became venture capitalists.
- Individual VC firms normally, but not always, focus on a combination of specific industries, geographic areas, and firms at specific stages of development. The industry as a whole tends to focus in certain of these areas, which change over time.
- Individual partners who make up a VC firm each have different areas of focus and expertise. One will be assigned to take the lead if they agree to consider investing in your business.
- VC firms raise the money they invest in the form of limited partnerships – primarily composed of institutional investors such as pension funds. They normally manage multiple partnership funds simultaneously, only one or two of which may be making new investments at any time.
- Each limited partnership fund is raised with specific industry and other investment goals in mind. The various funds under management by one firm may or may not have similar goals.
- VCs categorize potential investments by stages of development. The earliest stage any VC will consider is normally referred to as seed funding. Despite its name, this requires more than just an idea. In general, seed funding requires that the product or service be defined well enough to be tested in potential markets, that key members of the startup team have been identified, and that a business plan, either formal or informal, has been developed.
- Because of the higher risk involved, many VCs will not consider any seed stage investments. Many of those who say they will are, in reality, reluctant to do so. Investment banks almost never make early-stage investments.
- Each partnership fund has a finite life, usually 8 to 10 years. This means that any investment made by that fund must have the potential to be liquidated within that timeframe. Investment banks may have longer time horizons.
- VC firms seldom invest alone, preferring to spread their risk by investing in each deal as part of a consortium. Although some firms may work with other firms more than once, each deal is unique and is negotiated separately. One firm will agree to be the “lead” investor, which means it will be your primary contact and that one of its partners will probably sit on your board of directors.
- Some VC firms prefer to invest in startups where there will be an opportunity to make repeat investments as the startup matures. Others prefer to get involved only once, usually at one of the later stages of development.
- VC firms are concentrated in a few geographic areas, primarily Silicon Valley and the Boston area. Most have more than one office, with an increasing number of these branch offices being overseas.
- VCs never sign non-disclosure agreements. They see such a volume of deals that signing NDAs would be impractical and expose them to lawsuits if they eventually invest in a similar startup which came in independently.
- VCs invest a substantial amount of time and money (due diligence, legal fees, etc.) in each investment they consider seriously. Accordingly, they only make a handful of new investments each year.
- No matter how good the business plan and the team which executes it, VCs know most startups they invest in will never achieve their goals, and a few will fail completely. Thus, each investment must have the potential for a significant return on investment (usual 10X or more for early-stage startups) to mitigate this risk.
- Because of their need for high potential returns, most will only consider investing in businesses based on a paradigm-shifting technology or some other potential home run.
- VC firms are never passive investors and will insist on at least one seat on your board. They can be a great help to a startup, as they have extensive expertise and networks in the industries involved. If the startup starts to miss key milestones or otherwise gets into trouble, the VC’s involvement will become more proactive and, in extreme cases, may result in their insistence on new strategies or even new management.
- VC firms receive hundreds of unsolicited proposals each month. Some actually assign a junior staff member to review these – but few, if any, are seriously pursued. Plans outside the firm’s areas of focus are especially apt to be discarded quickly.
- The best way to approach a VC is through a reference from someone they know – often a law or accounting firm. Even better would be an entrepreneur they have previously funded, or another VC or Angel Investor with whom they are personally acquainted.
The banking crisis which started in 2008 has been hard on the VC industry.
- Liquidation events, both IPOs and sales to established companies, have been harder to arrange and are at substantially lower valuations than previously.
- Many of their portfolio companies are in trouble, requiring that VCs focus most of their time sorting them out, with limited time left for evaluating possible new investments.
- Many VC firms have reserved most, if not all, of their remaining uncommitted funds for helping their existing portfolio companies weather the current economic storms. This leaves them with little, if any, funds available for new investment opportunities.
- New limited partnerships have been harder to organize and fund.
- The industry is contracting. There are an estimated 600 firms in the U.S. today, down from 2,000 a few years ago. It is expected to shrink even more, to around 450 firms, within the next couple of years.
Despite the above challenges, some firms are beginning to consider early-stage investments again.
In the broadest sense, the term angel investor refers to any individual who is investing his or her own funds. They vary widely, from individuals who make this their full-time job, to others who only occasionally invest in projects they find of interest. Although many of their objectives are the same as VC Firms, some of the differences are summarized below.
- Angel investors only invest their own money, which they usually made as highly successful businessmen or women in another career.
- Angels normally make smaller investments than VCs.
- Angels are less apt than VCs to insist on paradigm-shifting ideas.
- Angels are more likely than most VCs to make true seed-level investments. A few may even be prepared to do pre-seed funding, i.e., provide the funding needed to develop the product or concept to the seed-funding stage.
- Most try to emulate VC-type professional investment criteria but are more apt to invest in opportunities which appeal to them on a personal level.
- Angel investors may or may not focus their investments in a specific industry or technology. They usually, but not always, restrict their investments to the communities in which they live or at least have some involvement.
- They are more inclined than VC firms to pursue unsolicited proposals.
- They are less likely to have a target date for liquidating their investments and may be willing to stay involved with a portfolio company on a long-term basis.
- They are generally less involved in their portfolio companies than VC firms. Some, however, will only invest in companies where they can play an active role, at least at the Board level.
- Although most operate independently, some invest primarily through networks of other angel investors. There is no standard form for these networks, but most provide lead sharing and may also assist with due diligence. Some networks also require that multiple members participate in any investment they are involved with.
- Some prefer to invest in startups that will require future rounds of VC funding to meet their goals, while others refuse to participate in such opportunities.
Angel investors are steadily becoming a more important part of the investment community. The number of angels is growing while the number of VC firms is decreasing.
Raising investments for startups has never been easy. But through knowledge, planning, and perseverance, entrepreneurs succeed every day. The key is to do your homework before you start.
- Learn what investors want. As in any successful business relationship, you need to develop a win-win scenario that meets their needs as well as your own.
- Have a business plan. Whether a formal 30-page document or just a PowerPoint outline, it needs to be comprehensive enough to show you can turn your idea into a profitable business. You need to have answers to any questions that are asked.
- Have the core of your management team in place. Investors invest in people more than in ideas.
- Identify potential customers and have a marketing plan. The lack of a marketing plan is the number one reason investors turn down proposals.
- Identify specific investors who might be interested in your opportunity and go after them – don’t waste your time sending emails to everyone in a directory.
- Network. Try to find referrals to your targeted investors. And if an investor says no, ask if they know other investors they could refer you to who might be interested.