How Does Investing in Startups Work?
Startups depend on investments to get business rolling. An investor provides the funding that allows them to lay a foundation for the company and hopefully expand in the future. That money can provide a startup with the resources to turn the concept for a product or service into a reality. Investing involves both parties taking on risk but offers the potential of exponential growth and significant profit for startups and their investors.
Investing in a startup can be a simple task or a very complicated one. Several details come into play when determining if a business will be willing to accept an investment. There are multiple methods of investing in startups, depending on how the investor intends to receive the return on their investment and what the startup needs to grow efficiently.
Investors can negotiate with owners over the timing, type of investment, and size of the investment. The process is usually kicked off through an investment proposal and if the owners accept, contracts are negotiated and signed, and the capital will be distributed to the owners.
Equity Vs. Debt Investment
Investing in a startup can be accomplished by either acquiring equity or offering funding the company can pay back with interest at a later time.
Equity investments are made to acquire part-ownership, or a percentage, of a startup. Investors provide startups with the capital and resources necessary for growth while startups exchange a percentage of their value, which will lead to profits once it’s time to exit. This investment does not have to be paid back to the investor.
Alternatively, debt investments are considered loans and are acquired against existing company assets. Startups agree to pay the total of the loan back to the investor, along with all interest accrued at a fixed rate, over time. While debt investments typically carry less risk and can be fulfilled quickly, equity has the potential for greater long-term profits.
Types of Investors
Equity Investors
Personal Investors
Personal investors are individuals or groups of individuals with personal ties to the company’s founders or executives, such as family and friends. These groups are generally only able to provide a low level of funding; however, they will often provide the most favorable equity rates of any lender. Crowdfunding methods can also be categorized under this category.
Accelerators and Incubators
Startups and companies in the pre-seed stage of growth can apply to enter into an accelerator or incubator program, which provides a company with a variable amount of funding and allows them to enter into a collaborative space with other founders in exchange for a percentage of the company at a later date. Accelerators and incubators provide network opportunities and lay the groundwork for a company to grow while also exposing companies to further investment opportunities.
Angel Investors
Many early-stage companies cannot acquire venture capital funding due to their size and age, which is where angel investors come in. This type of investor is usually active during seed funding and additional rounds, typically offering more favorable equity rates than VC firms, and is more comfortable investing in companies with high volatility risks.
Venture Capitalists
Venture capitalists, either individually or as part of a VC firm, often offer the highest amounts of funding to startups in their Series A, B or C rounds of funding. VCs typically take the most scrutiny when it comes to investing, considering everything from the age of a company to its location, but can make the biggest difference in gaining market share.
Corporate Investors
When corporations have huge amounts of cash on hand, they can put it to good use by investing in smaller companies. Like private investors, each corporation can have different policies when it comes to rates of equity and funding amounts. Corporate investors can sometimes put companies in the uncomfortable position of prioritizing profits over product but can be a great first step toward an acquisition.
Public Listing
The top growing companies have the opportunity to list their organization on the stock market to sell shares, or small percentages of the company, to individual buyers in various quantities. These buyers then assume the risk of those shares having a fluctuating valuation over time and can sell their shares to other individuals at virtually any point.
Debt Investors
Banks
Banks are among the most traditional lenders and can provide direct access to funding in the form of interest-accruing loans to be paid back over a set period. Banks take great discretion in providing loans and require extensive documentation and financial information, but they often are helpful partners in elevating the status of a small company.
Invoice Discounters
Invoice discounters enable growing businesses to make ends meet in the moment, providing advances on a percentage of the businesses’ invoices. They provide these advances for a fee and apply interest to the provided funds. Some invoice discounters will even manage the company’s debtor book so the organization can prioritize its growth.
Other Types of Investors
Many founders can find sources of funding through government grant programs meant to aid in innovative company growth. Grant money generally comes without the need for a return or equity provided but can be limited to specific groups and categories.
How Do Investors Make Money?
Equity investors are not paid back by the company. Instead, equity investors own a percentage of the company and have the opportunity to sell their shares at a later time, either on the public stock market, to other investors or to an acquiring company during an acquisition. These investors benefit from a company raising its valuation over time and accept the loss of their investment if a company fails.
Debt investors expect that a company will pay the entirety of the loan back, along with all interest accrued, over a set period. If a company fails to do so, the collections process will begin and company owners may be forced to pay more. If a company lacks the assets to pay a loan at the time of liquidation, bankruptcy proceedings may begin and the lender may seize a portion of the remaining company assets.
What Is a Fair Percentage for an Investor?
Investment percentages have a high degree of variability depending on the terms of each agreement, but these are some of the most common rates to know by investment type:
- Most accelerators have a non-negotiable equity share percentage of 4-7 percent.
- The amount of equity provided to angel investors is wholly dependent on the amount of capital they are willing to provide in their investment. The more capital they provide, the more equity they will receive. Ultimately, a company should prepare to divide 20-30 percent of its equity among its angels.
- Venture capitalists will want more say over a company’s decisions when making their investment but can typically provide the most amount of funding of all investors, so companies should expect to have 30-40 percent of equity divided amongst this group.
- Banks can often be the most scrutinizing loan providers and consider many factors when determining interest rates, including the size of the loan, business credit score, the age of the business and its financial standing. Conventional small business bank loans typically fall in the 3-7 percent range but can sometimes be much higher.
After completing all fundraising and acquiring the loans needed to grow, founders can expect to retain 20-30 percent of the company among their group.
How to Find Investors
Attracting Angel Investors
Like many facets of business, the best way to attract angel investors is through networking. Whether it’s getting in touch with connections made over the years, being recommended to an angel by somebody else, or online methods such as apps or networking websites, angel investors can be found in a variety of places. Having a presence in an accelerator or incubator can also be a natural way to attract angel investors where they are already looking.
Pursuing Loans for a Small Business
Small business owners may be best suited pursuing private loans from independent parties or acquiring bank loans. A combination of each will allow these owners to pursue their primary vision with less interference from outside parties while retaining a larger share of their business's profits. Private loans are often made among friends, families and associates and carry both low-interest rates and favorable terms.
