Second post of a series with all you need to know about private investors for startups and small businesses.
“How should I fund my startup business?”
“How much funding do I need?”
“What’s the best source for funding?”
The short, unsatisfying answer is: “it depends”. Every startup is different, and so is the optimal funding strategy.
It is always thrilling to start a business. However, most startups lack sufficient funding for their growth. As they attempt to finalise their product or service, ramp up sales and achieve traction, it becomes more difficult for them to set aside time to raise funds for their business.
To take some strain off their finances, the startup founders often rely on private investors. So, who exactly are these private investors and how do they fund startups?
In this series of blog posts I’m deep diving into 4 sources of investment money:
- Friends and family,
- Angel investors,
- Venture capital,
- Late stage venture capital.
My goal is to help you make the right funding decision – what kind of startup funding options are available in different stages, what the strategies are for pursuing them, and how founders can determine a funding path that is right for them.
In the previous post I’ve looked into raising investments from family and friends, whereas this post is dedicated to raising private investments from angel investors.
Who are angel investors?
Angel investors are wealthy entrepreneurs with usually an exit in their past. They want to leverage their own wealth by investing in projects they are passionate about, especially startups at the early stages that may have difficulty accessing more traditional forms of financing. Many angel investors are successful founders themselves, as well as corporate leaders and business professionals.
They usually offer mentoring and advice alongside capital. Often angel investors pool their money with other angel investors, forming an angel syndicate.
How does raising private investments from angel investors work?
Angel investors are typically wealthy individuals who look to put relatively small amounts of money into startups, typically ranging from a few thousand euros to as much as a millions. They often invest at the local level, with “local” being as narrow as their own country, region or city.
Angels are often one of the more accessible forms of early-stage capital for founders and as such are a critical part of the fundraising ecosystem. Angels often look at the wider scope potentials of a startup rather than specific metrics, like for instance financials, which is what characterizes investments from VCs.
There is no definitive limit on what a single angel investor can invest, but a typical range would be from as little as €5,000 to as much as €500,000 although on average angels invest around €25,000 (at least in Finland which is where I live).
Angels may also invest incrementally, offering founders a small investment now with the opportunity to follow-on at the next round with additional investment, or invest only if some other investors are taking the lead (anchor), thus becoming minority investors.
There are three primary types of pre-seed and seed stage investments: an equity stake, a convertible note and a subordinated debt. Note that these investments are not strictly associated with angels but can also come from VCs.
An equity stake (or share) is when an investor exchanges their money for ownership in a startup. Equity investors often like to be involved in the decision-making process of the business. Their portion of the stake in the startup depends on the ownership size.
The amount of equity the investor receives will depend upon the company valuation that the investor and founder agreed upon. So if the founder valued the company at €1,000,000 and the investor put in €150,000 of cash, the investor would get a 15% equity stake in the company. This is something which needs to be put in what is called a shareholders agreement.
From there, equity stake can get complicated. Founders can start to issue different classes of shares, some which have voting rights or some that get paid back more quickly than others. Once again the shareholders agreement should be the source to highlight these aspects.
Sometimes the investor and the entrepreneur cannot agree on exactly what valuation the startup has today, because many variables are at stake i.e. financial projections, sales pipeline etc.
In that case, they may opt to issue a convertible note (also called convertible loan) that lets both parties set the value of the startup at a later stage, usually when more outside money comes in.
A convertible note is set up as a loan to the company. So if the investor put in €150,000 as a convertible note, it would mature and come due at a specific date in the future, e.g. a year from now.
During that time it will likely accrue interest. At the maturity date, the angel investor can choose to either ask to be paid back in cash or convert that money as equity into the startup based on a valuation determined at that time.
Convertible notes have become more popular with angel investors as well as founders over the years because they align both parties with the goal of maximizing the investment.
A subordinated debt is debt that is unsecured and/or ranks for interest and repayment after the senior debt of a company. In the case of default, creditors owning a subordinated debt will not be paid until the senior debt holders are paid in full.
Subordinated debt is riskier than any other type of debt. It can be any investment that’s paid after other debts and loans are repaid.
Advantages of working with angel investors
One big advantage of working with angel investors is that they are often more willing to take a risk than traditional financial institutions, like banks.
Additionally, while the angel investor is taking a bigger risk, the founder is taking a smaller risk, as private funding from angel investments typically don’t have to be paid back if the startup fails.
As angel investors are typically experienced business people with many years of success already behind them, they bring a lot of knowledge to a startup that can boost the speed of growth. As a result, they often invest not only money but also “sweat” equity, in the form of their active involvement, and often request a board member position in the startup.
Disadvantages of working with angel investors
The primary disadvantage of working with angel investors is that founders give up some control of their startup when they take on this type of private investment.
Angel investors are purchasing a stake in the startup and will expect a certain amount of decision making power as the company moves forward. Unlike VCs, angel investors do not usually have a website as such and it’s often difficult to know their investment criteria or portfolio of past investments in advance.
Another disadvantage is that individual angel investors can often not cover the full ticket size of the investment by themselves (like VCs or private equity forms would do) and need to come together in a syndicate. Of course when larger groups of investors are involved, the terms of the deal become more difficult to arrange.
Besides, founders should be aware that having a larger group of smaller investors can dilute their cap table a lot.
Some angels can turn out to be difficult to deal with. They may be ill motivated and in the long run cna even ruin the company. A word of advice is to check the background of the angels about their investments history.
Where to find angel investors
The first place most people can find angel investors is through a founder’s own network. Personal connections are always a good avenue when people ask someone to invest money and trust.
However, not everyone has networks that include very wealthy individuals. In that case, there are a few resources available.
Websites for accessing angel investors:
- National Angel Associations (e.g. Fiban, Estban, Denban etc)
- Angel Investment Network (USA)
- Funding Post
- Angel investor and pitch events
Every startup is different, and so is the ideal funding path. Usually founders start by raising early-stage capital from friends and family and angel investors to validate their value proposition, build initial traction and find their first customers. This is what investors refer to as: “early product-market-fit”.
As you’ll notice in the next posts of this series, additional funding alternatives from different sources are best suited for different startup stages. Choosing the right one can give you the boost you need. The wrong one might hold you back or lead you in the wrong direction.
In the previous post I’ve looked into raising investments from family and friends, whereas in the next post, I’m going to take a deeper dive into the pros, cons, and tactics of raising private investments from venture capital investors.
Marco Torregrossa is private investments advisor for Innovation Manager Finland Ltd. Follow him at @MarcoTorreg