Types of Investors: Everything You Need to Know
While we often hear stories about intrepid individuals funding start-ups using the bootstrapping strategy and investing their own wealth and earnings.8 min read
Types of Investors
While we often hear stories about intrepid individuals funding start-ups using the bootstrapping strategy and investing their own wealth and earnings, that strategy is sometimes unrealistic or downright impossible. More often, fledgling start-ups must seek investors to help foot the bill for their projects. Five common investor types for start-ups include:
- Angel investors
- Peer-to-peer lenders
- Venture capitalists
- Personal investors
Typically, funds from these types of investors are used to introduce a new product, expand operations, or upgrade equipment and supplies. However, each situation is different, so companies should take legal precautions before reaching out to any investor.
Banks as Investors
Some small businesses seek bank loans to help with start-up costs. Because of the 2007 mortgage crisis, it is now more challenging to qualify for a bank loan. It helps to have personal experience in the industry or a good mentor who is well-versed in the industry. Companies may have to provide collateral, such as a home equity loan, and as much start-up cash as possible.
The bank typically requires a comprehensive business plan that includes:
- A complete, detailed description of the business
- A description of the business's core products and/or services
- Financial projections
- Management projections
- Plans for goal implementation
You'll also have to prove that you are financially responsible. For best results, start with a bank where you have an existing business relationship. You should also research loans guaranteed by the Small Business Administration (SBA). This agency guarantees loans for partners that include banks and other types of traditional and nontraditional lenders. Because these loans are guaranteed, it may be easier for new businesses to qualify. SBA loan programs include:
- 7(a) loan program
- Microloan program
- 504 loan program
The 7(a) loan program is designed for businesses working with a small and/or rural lender, implementing measures to control pollution, or impacted by NAFTA.
Microloans can consist of as much as $50,000 for working capital, to purchase supplies or inventory, to furnish a location, or to purchase equipment or machinery. Debts you've already accrued and real estate that has already been purchased are not funded by microloans.
Administered by Certified Development Companies, the 504 loan program helps start-ups enlarge operations or bring them up to modern standards through purchases of buildings or land, improvements to buildings or land, construction or modernization of facilities, renovation of existing facilities, machinery purchases, and debt refinancing. According to the SBA, these loans are 40 percent funded through the SBA and 50 percent by the lender, requiring a down payment of 10 percent.
An estimated 268,100 active "angel" investors in the United States invest an estimated $20 Billion into 60,000 companies a year. The average investment of this kind totals $74,955. Angel investors are usually wealthy entrepreneurs who want to leverage their wealth by investing in projects they are passionate about, especially start-ups that may have difficulty accessing more traditional forms of financing. Many angel investors are successful entrepreneurs themselves, as well as corporate leaders and business professionals.
This investment is typically in the form of either a loan or a stock purchase. Sometimes, they also mentor or advise the business in which they are investing. For example, some angel investors specialize in a specific type of company, such as new technologies.
In some cases, these "angels" make a high-risk investment in hopes of receiving a large return if the company is bought out by a larger corporation or is publicly traded on the stock market. This type of angel investor is usually most active when the economy is strong or stable.
If you have been approached by or are considering approaching an angel investor, ask the following questions:
- Do you expect control in return for your investment? If so, how much?
- What is your motivation?
- What is your experience in the industry?
- Does our start-up meet your requirements?
The terms of a loan from an angel investor are detailed in a promissory note. With angel groups, angel investors can pool their capital to make larger investments. The Angel Resource Institute database listed 385 groups of this kind in the U.S. in 2012.
With peer-to-peer lending, start-ups and entrepreneurs can create online profiles for their projects on websites like Prosper and Lending Club to be considered by investors. These services strive to match small business owners with entrepreneurs while cutting out the middle man.
The SBA recommends that start-ups interested in peer-to-peer lending develop a business plan and company story that shares their progress and key achievements, as well as results of market research, industry analysis, and financial forecasting. You should also be prepared to share how much you've already invested yourself. The goal is to show potential lenders that your business has what it takes to earn money and be successful
Potential peer-to-peer loan investors will have access to your credit history. In some cases, lenders will ask you to take steps to raise your credit score before receiving loan approval. Once you've been approved, you'll negotiate an interest rate for the investment with the lender, who is often a private individual. It's important to understand the terms of the loan and avoid falling behind on payments. Doing so can increase the fees you're charged and make you ineligible for future loans of this kind.
Companies should also familiarize themselves with state regulations about peer-to-peer lending.
The United States is currently home to 465 active venture capital firms that together invested $22 billion in 2012. The average investment in each company is $2.6 million, larger than that of any other investment type. Venture capitalists typically invest in only 1 out of 100 deals they see, compared to about 1 in 10 for angel investors. They also conduct substantial due diligence, a process that takes up to five months for each investment.
Venture capitalists invest millions in a company by securing a share in the company known as equity capital. The investment is predicated on the idea that the equity capital will increase in value over time and they'll receive a return on their initial investment. This type of investor typically works with companies who have a solid business plan and have already displayed some measure of success. You'll need to show a solid business plan and high-profit return. Venture capitalists rarely invest in start-ups perceived as risky.
Business owners should know that when investing with a venture capitalist, they are giving up partial ownership in the company. Some venture capitalists will want a say in management decisions. You'll also likely pay a higher ROI to this investor than the cost of interest on a traditional business loan.
When working with a venture capitalist, consider establishing a detailed partnership agreement that indicates the rights and expectations for each party. While venture capitalists sometimes act in a mentorship role, they are usually more active in operations. When seeking venture capital opportunities, it's best to be referred by a mutual acquaintance. For example, you can ask existing investors to share your business with their networks to open even larger opportunities for funding.
While you might not have considered approaching friends and family to invest in your start-up, this is not an uncommon approach. In fact, personal investors represent a bigger piece of the pie than any other type of funding source, investing over $66 billion annually with an average personal investment of $23,000 per project. This approach is best suited for funds to get a new company off the ground. However, loyalty and affinity for the business opens personal investors up to potential long-term investments.
According to CNN Money, personal investments should be governed by a contract just like any other type of investment. This may prevent the risk inherent in mixing business with family. Make sure your familial relationships are strong enough to be separate from the business relationship; for example, you could damage your loved one's finances as well as your own if the endeavor is less successful than projected. Sign a promissory note spelling out the terms of the loan as well as a separate agreement if a partnership is on the table.
Types of Investors that Entrepreneurs Need to Avoid
All investors are not created equal, so it's important to scrutinize potential investors with the same due diligence investors take when considering start-up opportunities. Investigate the lender's track record, values, and management style. Remember that you're entering a long-term relationship, which should not be done lightly. Certain types of investors seek to take advantage of inexperienced entrepreneurs.
Avoid investors who are also frequent litigators. If they think you don't have the money to battle them in court, they may use intimidation to gain more control (and more money) after investing. By the same token, avoid investors who want you to sign a lengthy contract with obscure clauses that can be used in their favor.
Avoid investors who try to take over all the company's strategic decisions, sometimes called imperial investors. While some level of coaching and mentorship is helpful, constant oversight is not.
Be wary of those who call themselves investors but don't actually have the capital to invest in your business, as well as those who don't have business sense themselves. Sometimes these individuals try to get a piece of the pie through finder's fees without actually putting up their own cash. In fact, perform due diligence on any investor who charges a fee.
How to Seek the Right Investor
Instead of passively waiting for investors to approach your business, take the time to proactively network with investors within your industry niche by talking to others you have a business relationship with and attending networking events. Cold calls or emails are usually unproductive. Before approaching investors, develop your own term sheet that details the investment terms that make sense for your business, rather than passively accepting the investor's term sheet. Legal advice from a trusted source is invaluable during the investment process.
Customers as Investors
More than $5.1 billion was raised in 2013 through crowdfunding campaigns targeting customers. Each company who raised money using this tactic received investments of about $7,000. With crowdfunding, a start-up relies on support and donations from personal and professional networks using a carefully crafted marketing strategy.
This type of approach is best for social media savvy businesses, with returns increasing dramatically in proportion with shares on Facebook and similar sites. The more direct links to a crowdfunding campaign, the more successful a campaign will be, so it's important to urge contributors to share the campaign with their own networks as well. Most crowdfunding supporters are between the ages of 24 and 35. The most avid supporters of these campaigns are men who earn more than $100,000 per year.
The Three Types of Investors
Each investor has his or her own attributes as well as desired results. The first type, the buy-low, sell-high investor, usually doesn't remain an investor for very long as emotional decisions result in bad investments. The index investor strives for passive management, seeking average performance with good results in good markets and not so great results in poor markets. Value-investing investors keep emotion out of it, investing more money in bargains and less money in high-value assets. Entrepreneurs who have the time to manage their investments can often come out ahead.
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