So you’ve decided to take the leap and launch a business. One of the most challenging things you will need to do is fund your venture. Sometimes entrepreneurs just don’t know where to go for funding, and they waste considerable time and effort chasing down potential investors with no tangible results.
So, just how do you access “other people’s money,” beyond friends and family, for your start-up? Here’s what you need to do.The first thing you need to ask yourself is…
“What’s the size of the market I’m targeting and how big is the opportunity — both in terms of market size and the projected size of the required investment?”
Start-ups can be grouped into two categories. The first is the big market opportunity. This is where the start-up is targeting a huge market (i.e., the market is in the trillions.) Even a small share of this type of market will yield a huge business. Usually this type of large scale opportunity requires a large investment. The second category is the smaller market opportunity. When a start-up has an interesting idea, but the potential market is smaller or hard to define, the start-up investment will necessarily be smaller.
The sources for funding for these two different types of start-up opportunities are vastly different.
Large Market Opportunity Start-ups
There are two types of institutional equity investors that invest in non-publically traded equity in very small businesses: venture capital (VC) investors and private equity (PE) investors
VC Funding: VC investors have an investment model where they expect a complete loss on many of the investments they make. For example, for every 10 investments they make they may lose all their money on 5 of them, they may make 3x their money on 2 of them, a 10x return on 2 of them, and a whopping 100x return on 1 of the 10 investments. The key for the VC investor is to generate a total return on the money invested of at least 20% compounded per annum. VC investors take a substantial amount of risk because they need to have the potential to generate at least one 100x return home run. To do this, they usually only pursue ideas that have the biggest payout potential. However, even the best ideas can have disastrous outcomes, and it’s impossible to figure out with any degree of certainty which investments those will be. So VC investors expect that many of their investments will be complete write-offs, offset by a small number of home runs.
What does this all mean? Start-ups pursuing the big market opportunity will have the best shot at obtaining VC funding.
While the investor for the big market opportunity is easily defined, this isn’t the case for the small market potential start-up. Clearly, this type of opportunity is not as interesting to the VC investor. Why? Because VC investors see all the risks of the start-up without the potential for a 100x return. One can argue that the competition is less and the total investment is lower, but because the potential return will also be lower the VC investor generally won’t invest in this type of opportunity.
PE Funding: The question then becomes, will the lower risk associated with the smaller investment opportunity be interesting enough to attract the PE investor? Private equity investors do not have the same tolerance for risk as VC investors. PE investors do not expect to lose money on 5 out of every 10 of their investments. Conversely, they also don’t expect to make a 100x return on any single investment. Unlike the VC investor, PE investors’ return expectations are in the 12% to 14% range. Given their lower tolerance for risk, it is often difficult for PE investors to get comfortable with businesses that have little, or rapidly changing historical financial information, and few real assets to rely upon in a worst case scenario. Therefore, most start-ups will not find funding from PE investors.
Smaller Market Opportunity Start-ups
Angel Funding: Angel investors are the best option for smaller market potential start-ups. Angel investors are typically wealthy individuals interested in investing in start-ups. Angel investment funds have also been crowd funded. Angel investors tend to have less rigid investment criteria than VC and PE investors. Angel investors can be more difficult to find, and the amounts they typically invest are smaller, making the capital raising process more challenging. While the trend is for angels to form groups or networks, the leg work required to reach this type of investor can be extensive. Take a look at website directories of angel investors such a Gust or New York Angels. The Angel Capital Association has a helpful FAQ on angel investing, as well.
This article was contributed by guest author and Ivy Exec member, Bruce G. Rigione, founder and Managing Partner of the Capital Ideas Group. During Bruce’s 30+ year career, he has worked as an investment banker and finance executive, at Bankers Trust, Chase Manhattan, HSBC, and Nextcard.com, successfully completing billions of dollars of transactions in major global capital markets. Bruce’s broad experience ranges from raising venture capital funding for start-ups, to AAA rated bond financings for multinationals. He has successfully completed transactions in the US, as well as Asia, Europe and Latin America.