As an entrepreneur sets off on their journey from humble beginnings to startup success, they will inevitably need financial support to fund their business. This funding may come from a variety of different sources, such as their own bank accounts, friends and family, business loans, grants, or private investment.
So how does a promising new entrepreneur get a handle on how and when to seek out sector and investor help? Here’s a guide to some of the most common avenues founders will encounter when navigating the weird and wonderful world of startup investment.
A founder who can start their company with little outside investment is said to have ‘bootstrapped’ their startup. They may have little to no assets, but they get things up and running. Later in the evolution process the business and founder may need to scale up or go public to attract investment, but for now they’ve managed to get off the ground without any external investments.
Friends and Family
When a business is first starting out – and is perhaps better described as an ‘idea’ than a fully-functioning organization – capital is an essential asset in funding market research, developing prototypes and testing their business hypothesis. The journey for this capital among many entrepreneurs begins at home, with friends and family.
At this point, the company would usually not have any sales or customers. The founders are simply looking for capital to explore their business idea to see if their concept has further potential. This stage of VC is also called pre-seed investment, as this capital raise is fairly unofficial with little (or no) paperwork completed.
In short, this is usually an entrepreneur’s first try at raising capital for their business if they don’t have enough money to ‘bootstrap’ the business and lack the information and business proof-of-concept to look to larger investors.
However not everyone is comfortable bringing their nearest and dearest into their business plans.
Angel investors are typically individuals or family offices who are looking to provide capital to startups they believe have potential. Angel investors can range from a single person to official angel groups who invest across multiple businesses.
These business angels tend to be wealthy individuals who are entrepreneurial in nature and want to support other entrepreneurs while also seeking a high return on investment. Alongside capital, it’s important for founders to consider what expertise and history of success angel investors bring to the table before offering them a seat at the table.
While securing capital from friends and family is considered pre-seed funding, working with an angel investor (or anyone else who gains equity in the business) becomes the first round of fundraising – otherwise known as “seed funding”. Angel investors will look for a stake (or equity) in the company in exchange for their investment and may or may not be interested in actively assisting in growing the company. Exchanging shares of a company for capital is an official transaction and is considered to be seed funding.
Lead investors or early stage investors are a form of angel investor; however, early seed rounds are less about one individual who might invest in a business. Instead, they are based on a fund and due-diligence process around private investment.
Family offices are private wealth management advisory firms dedicated to serving high net worth individuals or families. They generally fall under the label of LP (limited partners) who invest in larger VCs or funds. Traditionally, family offices are categorized into two separate types – single-family offices (SFOs) and multi-family offices (MFOs)
Single-family offices serve only one family and are responsible for managing their finances. This includes allocating capital into various investment opportunities such as venture capitalism, along with functions such as succession planning, lifestyle management, risk management, filing taxes, and more.
Multi-family offices serve similar functions with one important distinction: where single family offices only serve one family, MFOs can be thought of as more traditional private wealth management firms who serve multiple different clients. This allows them to enjoy economies of scale by pooling their clients’ resources together when appropriate.
The value behind family offices is their ability to manage the entire financial umbrella of a high-net-worth family. Functions like estate planning and taxes are typically done by separate institutions, and for families with extreme wealth these processes can become quite complex. Family offices enable wealthy families to have all financial tasks handled by a single entity, simplifying the process and ensuring their capital resources are managed efficiently.
Venture Capital Firms (VC)
Venture capital firms can be similar in function to angel investors, yet differ in their expertise and access to resources. These VC firms are most often led by former entrepreneurs who exited their own businesses successfully. They are experts in evaluating and analyzing the potential of other startups, and typically have teams of investment analysts to help them sift through research reports. This makes it easier for them to determine where their investment capital is best allocated.
VC firms draw their funding from pensions, family offices, and other institutions. For this reason, they have a substantial amount of capital to invest in prospective startups. Many VC firms will focus on companies who have moved past the prototype stage and are looking to expand operations and grow their customer base. However, some firms focus on the early-stage startups where founders are still testing their business hypothesis and researching their proposed market opportunity.
Just like angel investors, VC firms will gain a portion of ownership in an entrepreneur’s business in exchange for capital, and take a hands-off or hands-on role in assisting the entrepreneur in building their company.
A common question is how much equity is a VC firm likely to want in exchange for the capital a founder needs? This is a complex question that unfortunately does not have a simple answer.
The important thing to remember is that VC firms operate with precision and intention. When determining how much equity they are looking to gain in exchange for providing a business with capital, they will usually resort to some sort of valuation model. One such model called a discounted cash flow (DCF) attempts to forecast how much revenue a company will achieve in the future and then work backwards to what a company is worth today. VC firms will then take into consideration other important factors such as risk tolerance and the total return they want to gain from this investment.
Upon understanding what a company is worth, what sort of return they want to achieve, and what their risk tolerance is, a VC firm can begin to determine the equity required to align with their strategy.
As an example, let’s say a founder wants to raise $500,000. A VC firm, through using a DCF model, values their company at $23 million in five year’s time. Assuming they are looking for a return of 9-10 times their initial investment, that would put the startup’s worth at $2.5 million today. This means that for an investment of $500,000 the founder would give 20% of the company’s equity to the VC firm. Check out this handy startup valuation calculator to understand the relationship between the capital entrepreneurs are looking to raise, the value of a company, and the equity stake a founder would give to a potential investor.
The above is an example of one possible methodology a VC firm may use to begin to value a company and determine how much equity they wish to receive. In reality, several factors – including operating history and whether there is a developed prototype – will come into play when negotiating with a VC firm on the investment amount and equity stake.
The most important thing to remember when beginning conversations with a VC firm is to work with them and not against them. Founders should come prepared with a clear outline of the future potential of their business, as well as projected revenue/earnings. This will help to navigate preliminary negotiations and assist in determining what percentage of equity an entrepreneur is willing to give in exchange for capital.