Understanding our investors: from business angels to venture capitalists
Many times ambitious expeditions require of outside investment. Christopher Columbus couldn’t have crossed the Atlantic without the funding from King Ferdinand II of Aragon and Queen Isabella I of Castile.
Ernest Shackleton had to painfully raise over £80,000 (current value of $8,500,000) from “business angels”, philanthropists and the British Government for his epic Antarctic Expedition.
These two enterprises had something in common: people willing to take on an enormous enterprise but unable to fund it on their own. They both had to compromise part of their potential earnings in exchange of risky funding.
Why investors?
Factorial got started by three founders — more details in the third post of “An honest startup story” — and we quickly realized the company we wanted to build required more funding than we could afford.
Bootstrapping (that is, self-funding a new business and growing only with reinvesting the company’s profits) allows founders to retain all of the control and financial upside. On the other hand, bringing in outside investment dilutes the ownership (both financial and control rights) but allows for more aggressive investment in long-term assets and can generate an advantage against the competition.
Factorial is basically a subscription business model based on a software platform: the software is free, but each month we get paid a fee from benefits providers, such as insurance companies. That means that both the technology and the payback period need to be financed.
To make this dead easy to understand, imagine the following uber-simplification:
- We need to invest $1,000 in building a software platform (a long term asset)
- Each customer costs us $10 to acquire (CAC)
- Each customer generates us $2 a month (ARPA)
- There are no other costs of operating the business
Now, imagine we have $2,000 in the bank. We could invest $1,000 in the technology and $1,000 in getting us 100 customers. Those customers would be generating $200 a month, so it would take 5 months before recovering their acquisition cost, and it would take another 5 months to recover the technology investment.
So 10 months after starting the original investment of $2,000 would be generating $200 a month, profits for the shareholders, plus the company would own a valuable piece of technology. Of course this is a ridiculous simplification, but it illustrates the value of an initial investment for both acquiring valuable assets and financing the customer growth.
Our angel round
Back to our story: after building the first version of Factorial and start getting customers, we went out to raise an angel round. We’re in the process of closing it and the goal is to give ourselves enough runway to get to the next milestone.
We’ve closed a big part of our round exclusively with business angels, that is, wealthy individuals — in our case successful entrepreneurs and executives. The advantage of working with business angels is that they can bring their knowledge and experience to the company and they are highly motivated since they give you their own money.
We’ve also been talking to some very early stage funds, mainly because of their ability to follow on and keep investing in the company as it evolves and its financing. Also, early stage funds are used to pass the baton onto later stage funds, and their existing relationships can help us in the future.
A challenge with venture capital firms (even if they are very early stage) is that the people running them are not the owners of the money, so they have to answer to limited partners (that is, the actual money owners) and this forces them to be more systematic and rigorous when they invest. This means that they sometimes want to see detailed financial records and forecasts as well as business metrics, instead of focusing on the long term opportunity and the ability of the team. Of course, there are better and worse VCs, the challenge is getting the best ones to invest.
Understanding investors
I remember the day I started understanding how VC funds work. That day changed how I read their investment decisions, board proposals and even CEO hirings and firings. Here’s my two cents about the different types of investors I had to deal with:
Friends, Family and Fools
From the wealthy uncle to the (financially) successful friend, there’s sometimes the opportunity to take money from a friend, relative or fool when raising money. This is the easiest money to raise (if you have access to this kind of people) but it definitely comes with a heavy burden: you’ll do whatever it takes to avoid losing their money. They are trusting you with their savings, not analyzing a business opportunity and investing like a professional.
Some questions I like to ask these kind of investors, unless I already know the answer because we’re good friends are:
- Did you do other “angel” investments? How much were they? How is it going?
- Are you able to lose this money? Will you ever need it back?
- Do you have at least 5x this amount of money in liquid assets?
These questions are by no means scientifically tested or imply that positive answers mean anything. They just mean that if there’s a hint of doubt or a single no, I will definitely not take their money.
Business Angels
I assume that business angels are businesspeople, executives or entrepreneurs that know what they’re doing.
It might be worth asking some of the questions above, but chances are it’s not the first time they’re investing and they've probably even raised money themselves.
Here, I often find it valuable to focus on their expertise and connections. Ask about their career, achievements and skills. Investigate a bit into their previous investments and look for co-investors that you might want to talk to in the future. A warm introduction from an existing investor is one of the most effective ways to get to a VC.
Family Offices
Family offices tend to have more money than they can manage. There’s a thin line between professional asset management and amateur investment.
In my experience, getting money from those kind of investors can be good: it’s not going to be smart money but you’ll probably not hear much from them, so let them finance your company and simply keep them informed. No need for board seats or other control rights.
Venture Capital Funds
So far all the types of investors mentioned had something in common: they invest their own money. Venture Capitalists (as other type of investment vehicles) are the opposite: a group of managers invest the money from other people and institutions aggressively to beat the market.
From a single investment perspective, VC's look like crazy gamblers placing all or nothing bets. From their limited partners perspective, they are an opportunity to generate 10–20% annual returns by picking companies with growth potential.
There are many ways a VC can become a great ally and make the difference between a good business and a massive success. But there are just as many ways VC's can get in the way and take a company down. This deserves a post (actually a whole book) on its own, but here are some key concepts I learned:
- VC's have a lifetime. Typically 5 years to invest and another 5 years to divest. This means that the day before their divesting period ends they will be forced (and might force you) to liquidate their shares. This can motivate them to push for an acquisition or merger even when there are better options for the long term shareholders of the company.
- They have a pre-defined amount of funds. Once they run out, that’s it. They are dry and will not be able to invest anymore in your company, even when you read in the news that the same “fund” just invested $50 million in another company. It might mean that the same fund managers raised a newer fund and are investing that money now, but they can’t invest newer funds in the companies from an older one because its limited partners are never exactly the same, and there could be a conflict of interest.
- Venture Capitalists have “bosses”. It’s easy to feel like the people writing checks worth millions of dollars are above everyone else. The truth is, they (the individuals) are entrepreneurs just like a startup founder. They also have investors (their limited partners) and if they don’t make a handful of great investments, their career as a VC will be over, not being able to raise more funds nor getting the upside from the “carry” (or carried interest, typically 20% of the investor’s upside).
- They are real professionals. This means that they see hundreds of companies and end up investing in 5–20 each year. They know much more about the investment process than you will ever know. They share information with other VC's and business angels. They study markets and trends and have tons of valuable information that you can’t afford to get on your own.
I think that VC's are great partners if you understand well who you’re dealing with. I like to ask about their fund’s timings, how much money they have left, ask founders of companies they invested in and research the fund’s managing partners’ careers. It helps getting us both in a similar level.
There are other types of investors but I don’t have any experience in dealing with them.
To summarize:
Raising money from investors is not a success, but it’s not a failure either. It’s an important and sometimes necessary milestone.
Fundraising is extremely time consuming and it steals the focus from the rest of the business, thus many tend to celebrate closing rounds. I think founders are really celebrating the end of pitching, due diligence and being rejected by investors.
Remember: even Columbus was rejected multiple times by the king of Portugal before he was able to raise funds!
See you next week! I’ll try to share some of the day to day of a startup CEO.
