After many first time entrepreneurs discover that debt financing will not work for their startup, many turn their sights to equity investors for startup capital. They see the success stories that come out of silicon valley and think that they need to follow a similar path to raise money from investors before they try to launch their business. While a business’s funding plan changes based on where the company is in its journey most small businesses think they have to raise money from investors to get their business off the ground.
When it comes to finding investors small business owners need to understand that they are not all created equal. Essentially, there are 3 types of potential investors.
Dumb Money Investors
First, there are friends and family which are most often considered dumb money. Dumb money investors provide capital for the business but usually provide nothing in terms of support or contacts for the fledgling business.
Similar to friends and family but less popular when it comes to dumb money is using equity crowdfunding platforms to source investors. With equity crowdfunding, a business can sell stock to unaccredited investors through a platform that matches investors and businesses.
While many entrepreneurs think they know it all and want dumb money silent partners, the reality is that most entrepreneurs would benefit from smart money investors.
Therefore, the second type of equity investor is commonly referred to as an angel investor which in most cases is smart money. Often the angel investor tries to leverage their investment by providing some level of expertise and contacts along with their money to the business.
The TV program Shark Tank is a good example of angel investors since the sharks provide not only money but expertise and contacts.
Venture Capital Funds
Finally, there is risk capital that comes from venture capitalists (VC). Rather than funding coming from a single investor, VC companies pool funds from a group of investors which invest in an entire portfolio of companies, spreading out the risk for the individual investor. The fund is then administered by a fund manager or a committee for the enrichment of the investors.
From the perspective of the small business owner, dumb money, angels, and VC’s are all investors, however, VCs are a different animal from the other two.
All Investors Are Not Equal
In the first two (Dumb Money and Angels), the investor and the business are one step removed from the business. In a venture fund, the investor is two steps removed.
So why is this important? The business and the investor’s goals should be aligned. More specifically, the business is obligated to provide the outcomes desired by the investors. After all, this is why they invested in the business in the first place.
When outcomes are aligned, all is good. With dumb money and angel money, the investor believes in the company’s business model and the business’s goal is to provide a good return for the investors.
However, when it comes to venture funds, the fund manager’s goal is to provide a return to the fund’s investors and the business is just a tool to accomplish that goal. Often what is good for the VC fund investors may not be good for the business. Consequently, the fund manager will often use his influence as a shareholder to provide a return to the investor at the expense of the business.
For example, VC firms may install key management that does not fit very well with your team. They may cause you to spend the invested capital on things you feel you could do without, causing you to need more money from them and in turn further dilute your equity even more. Perhaps the VC firm may orchestrate side deals with other VC funds or with other businesses in their portfolio to provide some level of synergy for the investors at your business’s expense.
Community Ecosystems, Tech Companies, and VCs
Every community wants a vibrant economy for its citizens. Of all the categories of business, the most coveted businesses tend to be tech start-ups because of their higher-paid employees. However, to provide the fertile environment necessary for them to spring up requires access to a pool of risk capital often provided by the VC community. Incubators and accelerators are created to nurture the tech start-ups, which are mostly product-based and get them ready for VCs. However, while this may appear to be a strategy made in heaven, it’s full of landmines for the start-up and the community that are all too often ignored.
Moreover, local governments are often convinced by wealthy VC investors to support and enrich a successful tech start-up through tax credits. Additionally, these wealthy VC investors convince local governments to offer the tech start-up other perks to keep them from relocating after they launch.
These wealthy VC investors are able to convince local governments to give the start-up these breaks by repeating the mantra that the tech start-up will provide higher-paying jobs. However, while the business might create good jobs, the company profits go to investors. In the case of VC funds, this profit is most often sent outside the community.
The whole notion of a community trying to foster economic growth by supporting tech start-ups with tax credits and other perks needs to be challenged. While VC money may be right in some situations it is not right in many cases.
As a business, seek advice from experts that do not have a dog in the hunt before you submit to the narrative that you need VC money to start and grow your business.
Are you guilty of drinking the VC cool-aide without exploring all the other options of raising capital such as dumb money, angel investors, and even crowdfunding?