Finance Your Business 2: Investors

Finance Your Business 2: Investors

There are four main types of investors for startup businesses: yourself, friends and family, angel investors, and venture Finance your business - investorscapitalists. “Crowdfunding” is a way to cast a wider net for angel investors, and is described in Brief 05.10.

Within these categories, an investor may be accredited or unaccredited. To be accredited, an investor must meet certain criteria on net worth and income. At this writing the requirements are on the order of $1m net worth and/or annual income of $200k. There’s an exemption from strict security law that is allowed because friends and family investment does happen—but there are strict limits on the number of unaccredited investors allowed. For more information see “Accredited Investors.”

You

Startup capital is generally an investment. Future capital requirements may be treated as loans, which could have some tax advantages. For more information, see “Lending to your business? Do it right.”

Friends and Family

Friends and family are best used only at the beginning of a company, when there are few or no alternatives available. They also make sense for very long-term investments motivated more by friendship or family than by strict return on investment. They might also provide the earliest seed money for companies that grow and receive other investments later on. For more, see

When using friends and family, always be sure to document everything thoroughly. They should also sign a document acknowledging the risk and clarifying that they may not be getting their money back.

Angel Investors

What distinguishes angel investors from friends and family is that angel investors are accredited. They do meet the securities law requirements of income or wealth to be legally allowed to invest in your business. Unlike venture capitalists, angel investors invest their own money, not other people’s.

Angels often join groups, and invest in groups. They are usually more comfortable investing in the same industry from which they originally profited. There’s a huge range with angels in how sophisticated they are about analyzing a business (called due diligence) before they invest, and what sort of terms and deals they’ll take. They tend to pool together tens of thousands of dollars to invest a larger sum of hundreds of thousands of dollars, rather than tens of thousands or millions.

Depending on the successes of angel investment, it often leads to venture capital investment later on. The process and thinking of sophisticated angel investors is very much like that of professional venture capitalists.

Venture Capitalists

Venture capital is generally difficult for a startup to acquire. Exceptions might be high- tech ventures, or those expecting a high rate of growth. Another limitation on their use by new small businesses is that venture capitalists are not interested in deals where the amount requested is less than some threshold, which may be on the order of $3m. Still, it is important for startups to be aware of the venture capital process and at what stage of growth that it might be appropriate.

Let’s answer some basic questions about venture capitalists:

Who are venture capitalists? Generally they are investors that make “high risk” investments in young companies. These investments typically involve equity (ownership) positions, but are often combined with debt and sometimes involve several lenders/venture capital companies working together.

Why would I seek venture capital for my company? If you are experiencing or expecting rapid growth, you may need financing that exceeds your personal resources, those of “family and friends” and funds that you can borrow from traditional lending institutions like banks. Venture capital may be the answer.

What does it cost? It’s not unusual for a VC firm to target a return of five times their initial investment, which equates to an annual return of about 35% over the expected life of their investment. They make most of this money when they sell their investment, and they like an “exit strategy” that materializes within 3 – 7 years. An exit strategy typically involves an IPO (“going public”), selling to a large competitor (or other investor) or refinancing.

Would my company be attractive to venture capitalists? Following are some of the important criteria that VC’s look for, since companies that meet these criteria are most likely to be able to achieve the investment returns sought:

  • a product or service that is unique and has high growth potential – frequently this translates into a heavy emphasis on companies in technology, life sciences, etc.
  • a product or service that is “scalable” in that revenues can be quickly expanded by reaching national and perhaps international markets
  • a strong management team with a proven track record of success
  • a management team that is “coachable”
  • a product or service that has been proven as a concept and has a market. While there are exceptions, this usually means that the company has been in business rather than a “start up”.

How would I choose a venture capital partner? VC’s should bring more to your company than just money. Look for those with experience in your industry, have contacts that could help you, etc. Remember that the VC will own a percentage of your company and likely have a presence on your Board. Be sure that you’ll work well together and that they will be in a position to add value. You should also check on the reputation of the VC and talk to the founders of other companies in which the VC has invested.

Look at the web sites of the VC’s in your geographic area to see if your company matches well with their investment criteria. You’ll also be able to see the names of the other companies they’ve invested in along with their industries. Look at the names and backgrounds of the principals. If you can find someone to refer you to one of the principals, that’s certainly helpful (your bankers, accountants and lawyers could help here).

You should avoid sending your full business plan out at this stage. Prepare a two or three page summary that you can provide. At this point, you’ll also need to place a value on your company since you’ll be selling a percentage to the VC. There are valuation professionals who can help you with this.

Is there venture capital available locally (Cincinnati)? It is useful to separate VC’s into two groups, angel investors and all others.

Angel investors are wealthy individuals who are interested in investing in young companies for any number of reasons. This may be your neighbor, a friend of a friend or a retired executive living across town. Since they invest as individuals, their investment criteria can vary widely and can be affected by a passion for a “cause” like curing a disease. Unfortunately, it’s hard to find these investors and it’s difficult for them to find companies to invest in. As a result, these organizations have emerged to facilitate this process in the Cincinnati area:

  • C-Cap (c-cap.net) was formed to link entrepreneurs with angels. Their activities include an annual “bootcamp” to educate entrepreneurs and introduce them to investors and business experts. “Mentoring Mornings” are held monthly. They allow entrepreneurs to meet individually with a small group of investors and business experts.
  • Queen City Angels (qca.com) is a group of Cincinnati angels. The investments are still made by individuals, but QCA serves as the administrative arm and screens investment opportunities. Their web site indicates that they are interested in investments of between $200,000 and $1,000,000, though it appears they’ve invested less in some cases.
  • Queen City Angels First Fund (qcafirstfund.com) will make investments typically in the $50,000 to $100,000 range. Much of the funds come from Ohio’s Third Frontier Project. Recipients must be Ohio companies (or willing to move to Ohio). Heavy emphasis is given to technology companies.

Other locally based venture capital firms in the Cincinnati area include:

  • Cincy Tech http://cincytechusa.com/entrepreneurs/application-process/ is also funded by Ohio’s Third Frontier Project. They have two funds, a seed fund and a fund for “imagining grants”. Companies eligible for seed funds must be less than $5 million in sales and could be start ups. The focus is on information technology, biosciences and advanced manufacturing. “Imagining” grants are typically in the $50,000 range and are designed to help entrepreneurs turn ideas into prototypes, etc. There is also some portion of these funds carved out for women and minorities.
  • Blue Chip Venture Co. (bcvc.com) was founded in 1990 and has invested over $1 billion in 170 portfolio companies. Their executives have P&G backgrounds and their focus is on later stage, venture capital funded, digital media and data analysis companies.

There are many other regional and national firms that are based outside of our local area. You should consider them particularly if you believe they may have a unique understanding of your product or service.

If you are not local to the Cincinnati area then contact your local SCORE chapter as they will be able to direct you to funding opportunities in your market place.

Need a free SCORE mentor to help you prepare for successful funding? Request your free mentor here.

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