From Incubator to IPO: Understanding the 5 Types of Startup Investor

This is part three of my big ol’ nine-part series, exploring every imaginable aspect of startup funding. From funding rounds to valuation methodologies, get ready for a complete crash-course in funding.

Click to read all nine parts as a complete post, or download as a PDF.


From the world of startup incubators to the glamour of the New York Stock Exchange, startup fundraising is fuelled by a diverse array of investors.

From philanthropic ex-founders to massive financial institutions, your choice of investor has far-reaching consequences for the capital, guidance and direction you can expect from each funding round.

So to help you understand the different types of investor (and their different agendas), it’s time to separate out the incubators from the accelerators, and the micro-VCs from the super-angels.


STARTUP INCUBATORS & STARTUP ACCELERATORS

Famous examples: Y Combinator, 500 Startups, Techstars, AngelPad

A startup incubator supports new ventures during the idea stage, providing access to the infrastructure and environment required for developing a Minimum Viable Product (MVP). With no offer of funding (and no expectation of equity in return), proven performance isn’t a prerequisite, with incubators collaborating with their participants for anywhere from a few months to several years.

In contrast, startup accelerators are a fast-track towards further funding. They offer capital in exchange for equity in your company (usually up to a maximum of 10%), and for a period of several months, provide a crash-course in growth and fundraising designed to accelerate your existing growth. After “graduation”, an accelerator’s alumni are expected to have honed their performance metrics and pitch, and be ready to raise a full seed round.

@microventures

PROS OF STARTUP INCUBATORS & ACCELERATORS

  • Mentorship. The best accelerators and incubators provide advice and guidance from some of the smartest startup minds around.
  • Access to future investment. Accelerators offer a direct and reliable route to investment, with many backed (and mentored) by VCs, angels and seasoned founders.
  • Credibility and social proof. Acceptance into Y Combinator or 500 Startups’ latest batch is guaranteed to boost the visibility of your startup.

CONS OF STARTUP INCUBATORS & ACCELERATORS

  • Hugely over-subscribed. The best incubators and accelerators are incredibly popular: both Y Combinator and Techstars only accept 1 to 2% of applicants.
  • Varying quality. With the top names so over-subscribed, newer incubators and accelerators open all the time. While some offer great value guidance and support, others offer a fast-track to the startup graveyard.
  • Expensive. Equity is an expensive commodity to trade for relatively low amounts of capital.

ANGEL INVESTORS

Famous examples: Jeff Bezos, Paul Graham, Kevin Rose, Dharmesh Shah

Angel investors are wealthy individuals that offer capital to early-stage startups, in exchange for an equity share in the company. Given the relative volatility of angel investing (it’s hard to pick a winner at such an early stage), many angels pair financial motives with a philanthropic bent — often resulting from their own entrepreneurial background.

Angels, like most types of investor, need an exit to make their investment work: in order to “free-up” the money they’ve spent on you, and unlock their profits, they need you to A. sell your company, or B. go public.

bhorowitz

PROS OF ANGEL INVESTORS

  • They’ll take risks other investors won’t. Angels have a higher tolerance for risk than most other investors. If your fledgling startup needs someone to take a chance on it, chances are, angels will be the ones to supply the capital.
  • Flexibility. Angels don’t operate to the same limitations as VCs and financial institutions (one of the pros of investing your own money), and can often flex investment terms for the benefit of both parties.
  • Experience. Many of the best angels are former founders, and bring their own experience (and network) to the table.
  • Quick Decisions. Without other investors or a board to answer to, angels can make investment decisions extremely quickly — perfect if you’re running out of runway.

CONS OF ANGEL INVESTORS

  • It’s still expensive. Giving away early-stage equity can be extremely costly, especially if you’re trying to court a big-name angel with preferential investment terms.
  • Not all angels are created equal. Without other investors to be accountable to, it’s easy for an angel to take advantage of a naive founder. There’s also huge variance in the time, energy and expertise individual angels will be willing to invest in your startup.
  • Pockets aren’t always deep enough. Though wealthy, angels will still have less capital available for investment than VC funds or financial institutions. At some point, you’ll outgrow their support.
  • They need a big return. Early-stage angel investments are high risk, and future investment can heavily dilute an angel’s equity. The best way to compensate this? A 10x return on their investment.

VENTURE CAPITAL FIRMS

Famous examples: Andreessen Horowitz, Sequoia, Point Nine, Redpoint

Unlike an angel, venture capital (VC) firms invest using a fund: a pool of money provided by the company’s own investors (typically referred to as Limited Partners) and the fund’s managers (or General Partners).

The VC’s job is to invest that money into promising new startups, often over the course of a decade, and generate a return for both themselves and their investors. VCs offer their capital in exchange for equity, and like angels, require an eventual “exit” (usually an IPO, merger or acquisition) to generate a return on their money.

The size of the VC’s fund will determine the size of return required, impacting both the amount they’ll invest, and the types of companies they’ll invest in.

Tom Tunguz

PROS OF VENTURE CAPITAL FIRMS

  • Advice and experience. VC’s have a (literally) vested interest in your success, and that often translates into more guidance and advice than angels would be willing to offer.
  • Access to a ton of capital. VCs have far deeper pockets than the average angel (or even super angel).
  • Network effect. Working with a big-name VC offers credibility, social proof, and most important of all, access to their personal network of experts.
  • Clear path to follow-on investment. Most VCs are in for the long-haul, and will lead subsequent rounds of funding (more on this topic later).

CONS OF VENTURE CAPITAL FIRMS

  • They need massive returns. Venture investments are risky, and there are huge amounts of capital at stake, both of which translate into the firm’s Limited Partners expecting pretty serious returns. If we dig into the maths of how large VCs operate, it quickly becomes clear that “successful” investments won’t cut it — they need mega-successes just to survive.
  • They need control. With investors to appease and investments to justify, VCs don’t just want more control over the direction of your company — they need it, usually in the form of board seats.
  • They’re more risk averse than angels. VCs are after proven performance and water-tight metrics, and their due diligence process can take a seriously long time.
  • Conflict of interests. What you want to do as a founder doesn’t necessarily align with what your VC investors want.

EQUITY CROWDFUNDING

Famous examples: Indiegogo, CrowdCube, Crowdfunder, Seedrs

The “traditional” crowdfunding model operated by companies like Kickstarter is known as reward crowdfunding — allowing people to pre-purchase goods and services, in exchange for select rewards. Though great for hardware startups (like the Pebble smartwatch), without a physical product to sell, this type of fundraising wasn’t viable for SaaS startups — until equity crowdfunding appeared.

Equity crowdfunding allows individuals to invest small amounts of capital in exchange for a small share in equity. While many equity crowdfunding platforms allow anyone the chance to invest, others offer the opportunity to contribute to angel- or VC-lead rounds, providing a hybrid funding model that combines expert experience with crowd-sourced funding.

As with other types of equity-based funding, for investors to make any money, they require an eventual exit: selling their shares in the event of a merger, acquisition or even IPO.

Danae Ringelmann

PROS OF EQUITY CROWDFUNDING

  • Set your own terms. Equity crowdfunding affords you the freedom to raise what you want, how you want, without the added complications of investors trying to steer your ship.
  • Relatively fast. Most equity crowdfunding platforms give startups 30–60 days to raise investment.
  • Democratise investment. Startups like to disrupt, and take-down big, inefficient businesses, so it’s no surprise that the idea of democratising investment would prove to be a big attraction for many founders.
  • Crowdfunding is evolving. This type of fundraising is in its infancy, but as more companies facilitate crowdfunded investment, more options appear: affording founders never-before-seen flexibility to raise capital in a way that suits them.

CONS OF EQUITY CROWDFUNDING

  • Capital is pretty restricted. As it stands, regulations on crowdfunding are pretty tight, with restrictions imposed on the number of investors you can have, and the amount of capital you can raise (currently capped at $1 million in the US).
  • Hidden fees. It’s common practice for equity crowdfunding platforms to charge fees for facilitation and payment processing. Though relatively small, these charges can quickly add up.
  • Easy to trivialise. Without lengthy due diligence or a drawn-out fundraising process, it might be easy to underplay the impact of equity crowdfunding. As with all investment types, it needs to be approached with caution and planning.
  • Lack of guidance. For many fledgling startups, expert guidance from experienced VCs or angels can prove to be as valuable as the capital they provide. With most types of equity crowdfunding, you’re on your own.

IPO (INITIAL PUBLIC OFFERING)

Famous Examples: Facebook, LinkedIn, Workday, HubSpot

When a company reaches a certain size, continued growth requires a serious injection of capital: too much even for VCs to contribute. It’s here that some companies will consider an Initial Public Offering, and transform into an organisation that anyone can invest in.

Often called a stock market launch, in practical terms this means transforming from a privately held company into a public one, selling a portion of shares to institutional investors (like banks, insurers and hedge funds) who then make the shares available for purchase on the public stock exchange.

Dharmesh Shah

So what does an “average” startup look like at IPO? Data from Equityzen has the answer:

PROS OF AN INITIAL PUBLIC OFFERING

  • Massive funding potential. Big angel and VC investments can net a growing startup millions of dollars in investment — but an IPO can raise billions.
  • Liquidity. IPOs often make it possible for founders and other investors to sell their shares. As well as rewarding the startup’s long-standing investors, this helps free up liquid capital for the company to spend in other areas of growth.
  • Attract talent. Raising an IPO also makes it possible to offer stock options as incentive for top talent.
  • You did it. For many people, hitting IPO is the ultimate hallmark of success.

CONS OF AN INITIAL PUBLIC OFFERING

  • It’s expensive. The average cost of an IPO is $3.7 million, and with a whole plethora of regulatory commitments to adhere to, it’s estimated to cost $1.5 million per year just to function as a public company.
  • Loss of control. Public companies often have thousands of shareholders, each with voting rights. Performance needs to be reported, each and every quarter, and poor performance will need to be answered for.
  • It’s a different job. Running a public company is a very different job to the one most startup founders sign-on for.