Different types of investors
In this unit, we're going to cover three of the most common types of startup investors: friends and family, angel investors, and venture capital (VC) funds.
Friends and family
It's reasonably common for startup founders to raise their first funding round from friends and family members.
The motivations of these investors vary. Typically, they want to support the entrepreneur. For example, the investor might be your uncle who wants to help you get started. They also might want to try to generate a return from their investment by getting in early.
It's worth noting that friends and family are generally the only investors who will fund you when all you have is an idea for a company.
Friends and family can be a good source of early capital if they're happy to be passive investors and don't expect to be involved in running your business.
For most founders, the biggest challenge with friends and family rounds is that you have a friend or a family member who's now a shareholder in your company. They're financially exposed to the success or failure of your business.
This arrangement can have a profound effect on your relationship with that person. It's wise to think about how you'd manage this relationship over the long term.
Tips for raising money from friends and family:
- Before any investment is made, discuss expectations. Ensure that you agree on the likelihood of success and failure, time frames, and how the company will be run.
- Agree on a reasonable valuation. For example, your uncle might not have a grasp on startup valuations. While it might be tempting to set a high valuation, this might cause trouble when you raise your next round from more sophisticated investors.
- Have a legal agreement that sets out the terms of the investment. Is it an equity investment, a loan, or a gift? How will the investor be compensated? What happens if the company fails? What input, if any, will they have?
- Make sure the person can afford to lose their investment.
Angel investors
An angel investor is a wealthy individual who's investing their own money, like Melanie in the previous unit's example. In many cases, they've been successful entrepreneurs themselves.
Good angel investors bring capital along with expertise and networks that can help you grow your company. Angel investors often work in groups. An angel round can have a few or sometimes 20 or more individual investors participating.
Angel groups often invest in a wide range of sectors, with their investment interests being heavily influenced by the individual expertise of their members.
Generally, angel investors will consider investing in a startup only after it has launched at least a minimal viable product and generated early traction in the form of product usage and, ideally, revenue.
Tips for raising money from angel investors:
- Research the investor and ensure that their investment profile is a match for your company. Consider the stage of investment, check size, and sector.
- Find opportunities for warm introductions via other founders who have raised money from the angel investor or angel group.
- Speak to founders of portfolio companies to find out whether their experience with the investor was positive.
- Be prepared to send your pitch deck in advance of any meeting. Most angel groups ask you to upload a pitch deck or executive summary via their website before they'll meet with you.
Venture capital
VC funds are professional investment firms managed by general partners who have often been successful entrepreneurs themselves. VC funds generally invest money provided by institutional investors like limited partners such as pension funds. These investors allocate funding to VC firms as part of their diverse portfolio of investments.
Some VC funds invest at seed stage, but it's more common for them to invest at Series A and beyond. They normally invest larger amounts than is typical for angel investors.
Most VC firms have a 10-year lifespan. They go through distinct phases:
- Investment sourcing and investing, usually in the first five years.
- Managing investments and supporting portfolio companies.
- Making follow-on investments.
- Exiting investments.
It's important to know where a VC fund is in its life cycle. There's little point in pitching a fund that's in its ninth year of a 10-year life.
VC funds generally have a preferred investment stage, like seed, Series A, and Series B. They also often focus on one or more specific sectors, such as blockchain, AI, and health tech.
Generally, VC funds will consider investing in a startup only after it has launched a product, generated early traction, and can show strong evidence of product-market fit. At this point, it's common for the company's growth to be limited by capital rather than by customer demand. The funding allows the company to rapidly accelerate customer acquisition and growth.
Tips for raising money from VC funds:
- The preceding tips for angel groups also apply to VC funds.
- Be prepared for multiple meetings and a time frame of several months from initial contact to investment close.
- Have a comprehensive set of due-diligence resources assembled so that the fund can complete its due diligence without adding extra delays.
Not all money is equally valuable
Good investors will add significant value to your company by sharing their expertise and networks. They'll also provide guidance to the founders as they work on growing the business. Recognized investors, such as top-tier VC funds, will also add credibility by association. Their involvement might make it easier for you to raise subsequent funding rounds.
There are investors who will add limited value, such as friends and family, as we discussed previously. There are also investors who add negative value.
A good rule of thumb is that smart, involved money is better than dumb, passive money, which in turn is better than dumb, involved money.
The benefits of smart money are clear. Smart money comes from someone who has relevant expertise. Being involved means they're willing to commit meaningful time to helping you grow your company.
Dumb money comes from people who don't know much about your business or about how startups work. Being passive means they're prepared to take a back seat, and they have no ambitions to contribute to running your company. Dumb, passive money is fine if you have access to other sources of experienced guidance and the investment is on general terms.
Dumb, involved money is problematic. It comes from people who don't have much value to contribute, but who insist on having an active role in your company. Sometimes dumb, involved money comes from inexperienced angel investors who have created wealth in other sectors, such as retail or property investing, and who want to try their hand at angel investing.
It's wise to avoid these investors. Experience has shown that the challenge of managing their involvement frequently outweighs the benefit of the capital they provide.