Here’s what you should know:
- This post is for startup founders who are new to raising money or simply want to learn more about the pros and cons of the various types of investors.
- There are multiple different sources of funds for your startup. Below is a simplified breakdown of the most common types of investor options available to business founders in the early and growth stages.
“An investment in knowledge pays the best interest.”
One of the most important and often confusing topics for founders is how to fund their business. There was certainly a learning curve for me the first few times I set out to pitch investors. If it is your first time raising capital or you’re simply not a finance wizard, the options and alternatives can seem overwhelming. This post is for startup founders who are new to raising money or simply want to learn more about the pros and cons of the various types of investors.
There are multiple different sources of funds for your startup. Below is a simplified breakdown of the most common types of investor options available to business founders in the early and growth stages. You’ll notice I include banks and other lenders as types of “investors” in this post. Often times we forget that an investor is simply someone who hopes to achieve a profit by providing capital for a given plan or purpose. The only things that differ between types of investors (such as a bank or a venture fund) are the structure of the investment and the cost of the capital.
Disclaimer: I realize this is not an exhaustive list of all the types of funding businesses can leverage. Rather than provide a laborious review of every capital source (unsecured, interest-free vendor leveraging through AP, for instance), I will focus on the most common types of external funding sources for startups.
The most common type of initial investor in a business is referred to as an “angel investor.” These investors are typically well-off friends and family of a founder, although there is a growing ecosystem of “professional” angel investors. They are referred to as “angels” because they often look past the higher face-value risk of an investment and are willing to bet on the individual. Terms are often less predatory, and risk is often disproportionate to the investor relative to statistically likely return.
Venture Capital Funds
Venture Capital is an asset class within private equities that focuses on higher risk, higher reward opportunities. As a result, investments are often in earlier-stage, pre-profitability companies with very high growth potential.
Private Equity Funds
Private equity funds are similar to venture funds in that they invest in private companies. However, the term “private equity fund” typically denotes a fund that focuses exclusively on more mature companies. Normally, a PE fund will focus on buying majority control of a profitable company that has the opportunity to increase profitability through operational efficiencies or as part of a “rollup strategy.” These companies often can be “leveraged” by a PE fund due to relatively low-risk existing free cash flows that can service the acquisition debt and increase equity returns.
Increasingly popular among startups are “non-bank lenders.” These companies, such as Pipe.com or Kabbage.com, will loan a business non-dilutive capital at a higher interest rate than traditional banks but without as stringent of underwriting requirements. For instance, they might use alternative data sources or provide loans directly against SaaS contract values.
Borrowing money from a bank is often the lowest-cost source of third-party capital for a company. Companies typically must be profitable and have current assets on their balance sheets such as equipment, AR, or inventory that they can pledge as collateral. Often, founders are expected to provide a personal guarantee of the debt. Bank debt can be a great way to finance business growth or expansion if the company is more mature and growth rates are more moderate.
Bootstrapping refers to the reinvestment of free cash flows produced by a business into the growth and expansion of that business. Essentially, this format of fundraising allows the entrepreneur to become the investor by constantly reinvesting their profits back into the business. The pros of this form of financing are that the entrepreneur retains all control and doesn’t have to give up equity or pay interest for use of capital (essentially free capital). The downsides of bootstrapping are that it dramatically restricts investment capital which can significantly inhibit growth.
Now that you understand the different types of investors, you can make a more informed decision about which sources of capital are best suited for your business needs. To learn more about the differences in debt and equity fundraising, check out this blog post Founder’s Guide to Debt vs Equity Fundraising.