Posted by Aaron Harris - Investor, Founder of Tutorspree, Round A Leader at Y Combinator.
If you want to raise money for your startup, it is extremely important to understand the motivations of investors. It used to be pretty simple - you got money from venture capitalists (VCs), and they in return - a large return on investment costs. The best investors focused on what they did really well: investing in technology companies.
But since then the world has changed: today there are a large number of different types of investors, each of which has its own approach to investing and its own motivation for this. And although they all expect to at least not lose their money invested, it is important to understand the differences in their intentions and expectations in order to make important decisions - to work with them or not, how to negotiate with them and how to interact with them over the course of your entire relationship period.
Below I have tried to highlight the key motivations and organization of each of the types of investors you are likely to come across. Although I have not listed all the ways in which investor motivation influences their behavior - probably to the detriment of startup founders - my article can still serve as a starting point for thinking about these questions.
One big difference in investor motivation that I have chosen not to address in this article is the difference between privileged and ordinary shareholders. This leads to a whole host of other questions that are beyond the scope of this article, so let's assume that the investors listed below own preferred shares.
VC Firm. Before us is a classic investor, whose main goal is to profit from the funds collected by him from a group of investors - partners with limited liability. Partners are rewarded in two ways: they receive a certain percentage of the funds raised and a percentage of the profits they get from the total amount invested. Depending on the performance of previous investments, venture capital funds may also attract additional investment.
While investors regularly make money from their management fees (a percentage of the funds raised), they only get big payouts when they manage to get a return that is many times the amount of capital raised. Due to the high concentration of investments, venture capitalists usually invest only in those deals that, in their opinion, will return them all or most of their invested amount.
Business Angel [1]... A business angel is usually a wealthy individual who invests their own money in startups. Sometimes these are people who made money from their own startups, sometimes they are those who inherited their wealth. Business angels may have experience in different industries, so knowing which area your angel is from is helpful.
Recently, this type of investor has become especially relevant for startups in the early stages of development, since traditional venture funds can no longer financially support the huge number of startups that we see today. More importantly, the widespread use of business angels has significantly lowered the barrier to investment that startup founders face at the stage of raising capital.
Business angels have a wide variety of incentives to invest. While many of them do expect big profits in the future, there are many who are also looking for a reason to be proud that they have invested in a hugely successful startup. Interestingly, angels often just want to show off their investments in startups, even regardless of their success - in narrow circles, this really became a great reason for pride.
While investing is far from their core business for most business angels, there is a wide variation in the amount of time and effort that angels are willing to devote to your startup. Understanding that an angel is focused on more than just investing in your company should help you determine the right approach to them. It is also important for you to understand how experienced a business angel is, what size startups he invests in and how much time and energy he is really ready to spend working with you.
At one end of this wide variety of business angels, you will find those who are essentially small funds in their own right. These angels invest significant sums in startups on a regular basis. It's lucky if these angels have a deep understanding of the companies they invest in - they can be incredibly helpful to you. Such investors are aware that they can lose all their invested capital, and understand the conditions and tools with which startups raise money.
On the other end, you'll find small, inexperienced investors who just want to invest in startups, no matter what. They are willing to invest small amounts in the first company they come across and, since they are usually not familiar with the specifics of how startups work, they are often difficult to deal with. In addition, these angels are overly focused on the risk of losing their capital. Such investors should be avoided, except in exceptional cases when their support is absolutely necessary for you.
Accelerator... An accelerator is, for the most part, a group of venture capital funds, in which professional investors raise funds from outside to invest in startups. They usually fund more companies than classic venture capital funds, and they do this through batching. As is the case with venture capital funds, most accelerators need to provide investors with a return on their funds in order to continue further work to collect them.
Accelerators also have intangible motivation - they look for examples of breakthrough success in their piggy bank to prove that they really help companies make a leap and “accelerate” their progress.
Syndicate... Syndicates come in many varieties, but they are usually groups of angels who jointly invest in the same company. Syndicates usually have a head who will be your main point of contact. The head of the syndicate, as a rule, invests money at his own risk in the hope of returning funds in multiples and receives a certain percentage of other funds that are contributed to the transaction.
Be careful with syndicates in which its head takes a management fee for the funds raised and urges to invest more than a reasonable amount. Also, be careful, because you cannot know in advance who exactly will invest in your company: it is possible that one of the investors is your direct competitor who is simply seeking to find out confidential information.
Crowdfunding... Crowdfunders are people who can be found on special Internet sites: they invest in an unfinished product, “pre-ordering”, in the hope that when it comes out, they will solve a big user problem. Crowdfunders do not expect financial compensation, but expect to receive regular updates on what is happening with the project and when it will be ready. When dealing with crowdfunding, it is much better to inform investors directly about emerging startup issues than to hide them.
Family and friends... While your friends and family are probably hoping to make a big return on their investments, they are likely much more willing to see you succeed and be happy. They are unlikely to try to conclude strict terms and conditions with you, but there is also a downside to the coin - in case of failure and loss of their money, you will feel as uncomfortable as possible. Take money from relatives and friends if you really need it, and only after making sure that your family fully understands the risks of losing the funds lent to you. At the same time, you should also take this risk calmly: if it is difficult for you to accept money from loved ones, it is better not to do this so as not to harm your relationship.
Family office... Family offices are private investment organizations for high net worth individuals and families. While ordinary business angels invest their own money in startups, some of them reach a certain investment scale and often hire portfolio managers and investment specialists on their staff. The types of organizational structures in this case can be different. Some family offices are stand-alone hedge funds with limited participation and high risk tolerance, while others are more traditional in structure. Regardless of the acceptable level of risk, family office employees tend to re-invest and also receive a salary, which makes their motivation similar to venture funds.
As a rule, such organizations are very concerned about not losing their capital. While it will not be easy for a venture capital fund that loses its investment to attract new ones, it is still possible that a family office losing all its capital may not be able to receive additional investment. Typically, if you receive investments from a family office, they come from a small portion of the overall investment portfolio.
Corporate investor (direct)... Many corporations talk about their interest in investing in startups: some of them do, and some do not. When a company invests in a startup from a specific industry directly from its balance sheet, it usually has a specific strategic goal. Most of these companies realize that investing in startups is unlikely to change their valuation. [2]
This means that companies that invest in you either want to be able to take over your startup at some point, or believe that investing in you will help improve their bottom line. For example, corporate investors can prevent you from working with competitors in their market, and may also have other cunning designs. This is because their motivation will never match the motivation of the startup itself - they are more concerned with how you can be of service to them than with how they can help you grow.
Corporate investor (venture arm)... Although corporate venture divisions have some of the same motivations as direct investors, they are generally empowered to receive a return on the company's balance sheet. This means they are more like venture capital funds and tend to have a better understanding of how startups work.
State . The government has many reasons to invest in startups. There are many government grants available in different countries to promote startups with the aim of increasing the number of jobs. There are also government agencies with their own venture capital funds to fund technology that could be beneficial to the government in the long run.
Endowment... A university endowment is generally similar to a family office. Its goal is to get a return on investment in the university budget over time. These organizations usually do not invest in early stage startups unless they work together with a foundation with which they have a strong relationship.
Sowing fund . Seed funds are venture capital funds that provide small amounts to early stage startups. The motivation and organization of seed and venture funds are generally the same.
Hedge fund... Hedge funds are generally unrestricted capital pools. Traditionally, they focus on investments in the state market, although in the past few years they have begun to invest in startups as well. As a rule, they invest in the later stages of the company's development and expect a return on capital, since they operate on the principle of limited partnership (LP) and have an organization structure similar to venture funds.
Mutual investment fund... It is a large pool of capital managed by portfolio managers. They do not work on the principle of limited partnership: instead, the fund gathers large groups of retail investors who buy shares (units) in the portfolio, and whose capital the fund subsequently uses for investment. These funds only invest in startups in the late stages of development, as they need to invest large amounts of capital in order to have influence at the portfolio level. Mutual fund managers are paid based on performance and often have requirements to publish their accounts and internal valuations of private companies. This has been a major concern recently, after Fidelity has released ever-changing ratings for a number of companies such as Dropbox for some time.
Sovereign wealth fund . Sovereign wealth funds are the largest capital pools in the world, essentially huge family offices for entire countries. These funds can afford to invest in any asset class that managers believe will generate a return on investment. Like mutual funds, these funds rarely invest directly in startups - they usually invest directly in venture funds.
However, in the past few years, some have started investing directly in startups as well. While the managers of these funds are usually rewarded on the basis of performance, in some funds there are many other complex incentives and motivations that arise from political demands. It's quite difficult to disassemble them.
[1] In general, I do not like the term "angel": it does not seem accurate enough, given the wide range of investors to whom it is applied. It probably makes sense to look for other terms for the various subgroups of business angels - perhaps we will try to rename them in the future.
[2] Yahoo's investment in Alibaba is a rare exception to this rule.
Thanks to Paul Buheit, Jeff Ralston, Daniel Guckle, and Dalton Caldwell for your help with this material.
Thanks to Polina Verigo for the translation.
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