Types of Startup Investors

Startups receive funding from many types of investors, each with their own motivations, capabilities, and resources. Depending on your company’s size, capital needs, and strategy, you may prefer one investing group over another. Your company’s financing preferences may change over time as your company progresses through the stages of the financing timeline (for more information about the various phases of startup financing, see our article entitled The Stages of Startup Financing). A thorough understanding of different common debt and equity investors, as provided by this article, will help you to choose the investors that best meet your company’s needs.

For additional context about the nature of startup financing, please see our Overview of Startup Financing article.

Equity Financing

Equity investments come from a wide array of funding sources with very different characteristics. For example, early-stage investors (e.g., angel investors) have high levels of risk tolerance, while late-stage investors (e.g., mutual funds) exhibit much more risk-aversion. Other differences include available capital, investment time frames, and experience in startup investing.

Since 2010, the potential for large returns via startup investing has attracted many investors who have historically shied away from these types of investments. While no one knows whether these investors will continue to provide startup funding in the future, capital sources that specialize in startup investing, like venture capital, are committed to the industry long term. To better distinguish between these investors, we have broadly classified investors into one of two categories: Traditional Equity Investors and Other Equity Investors.

Traditional Equity Investors

Angel Investors

Angel investors (angels) are individuals who invest in the earliest stages of a company’s development. Each angel usually commits between $10k and $100k, although some wealthy “super-angels” contribute several times that amount. Startups usually seek investment from multiple angels, so the size of the aggregate angel funding can be hundreds of thousands of dollars. When courting angel financing during seed rounds¹ founders usually have an exciting idea, but may not possess a functional product or established customer base. As such, angels take on much higher levels of risk compared to later-stage investors.

Many angels are successful entrepreneurs themselves, who have amassed small fortunes from their previous companies. In addition to generating a healthy financial return, many angels invest for personal reasons stemming from a desire to give back to the startup community and empower the next generation of entrepreneurs.

Venture Capital Investors

Venture capital (VC) investors generally enter the startup financing cycle after angels, but before other financing sources. These investment firms identify promising young companies and provide capital to propel their growth. (Some VC firms specialize in debt investments, as mentioned in the “Debt Financing” section.) Startups rely on VC funding for the large amounts of capital needed to scale their businesses that other financing sources are unwilling to provide. A VC’s goal is to invest relatively early in a startup’s lifecycle, help grow the company’s valuation, and then sell its stake for a large profit at a favorable exit opportunity. In exchange for its investment, the VC firm leading a funding round typically receives at least one seat on the startup’s board of directors.

VCs only invest in companies with high-growth potential, but when a startup matches this profile VCs make sizeable investments. Hardly any VC firms invest in quantities less than $500k and larger VC firms often have a much higher minimum threshold. VC firms routinely make multimillion-dollar investments, and often work together to fund large deals. For context, early-stage rounds often range between $1-10 million while some late-stage rounds can surpass $20 million in aggregate and involve multiple VC firms. See our article entitled The Stages of Startup Financing for more details on the size of equity investments and our Venture Capital article for more information about VCs.

Strategic Investors (Corporate Venture Firms)

Strategic investors, also known as corporate venture firms, are large corporations that invest in startups whose ideas complement the larger company’s strategy and have the potential to create greater operational synergy. Although strategic investors have many different motives for investing in startups, two common reasons include the fear of disruption and the desire to support complementary product offerings. These investments often provide exposure to emerging technologies and enhance the investor’s products with cutting-edge features and complementary products.

Strategic investors typically create a specialized team that acts like a stand-alone VC firm, but is funded entirely by the parent company. For example, Alphabet operates a venture-capital arm called GV, previously known as Google Ventures. Although GV has some autonomy when making investment decisions, Alphabet determines GV’s investing philosophy and establishes guidelines and processes for approving investments. Corporate venture firms like GV primarily seek to support their sponsoring corporation by providing funds to startups related to the corporation’s industry. Unlike VC investors, the financial returns generated directly by the investment are a secondary, albeit important, consideration.

A strategic investors’ relationship with a startup is often very different compared to that of other types of investors. Due to corporations’ vast resources and industry experiences, corporate sponsors can enable growth in ways that VCs cannot, including offering technical engineering advice and providing access to a larger and more established customer base. Some strategic investors eventually acquire their investees, but the receipt of an equity investment from a strategic investor does not guarantee an acquisition offer. The largest corporate venture funds from most active from 2010 to 2016 to least are Intel Capital, GV, Qualcomm Ventures, Salesforce Ventures, SoftBank Capital, Caixa Capital Risc, GE Ventures, Comcast Ventures, Cisco Investments and Samsung Venture Investments.

Crowdfunding

Crowdfunding, a relatively new source of financing, enables young startup companies to collect small donations from the mass public. For the Kickstarter crowdfunding platform, individual donations typically range from $1 to $500 with the aggregate funding totaling between a few thousand dollars to over $1 million. Most crowdfunding platforms, like Kickstarter and Indiegogo, are rewards-based platforms where individuals contribute money towards the development of a product and receive a completed version once the project is complete. Those who donate to these types of platforms are not investors in the company, they are customers who pay for a product upfront. For startups that have an exciting idea but struggle to raise seed money from angels, crowdfunding may be a viable alternative to jumpstart the company. Most ambitious startups eventually tap into more traditional funding sources, like VCs or angels, to access larger amounts of capital.

The regulatory and technical landscape for crowdfunding is still developing, and it may become an increasingly important source of financing in the future. Through the JOBS Act, the Securities and Exchange Commission (SEC) has relaxed many prior restrictions surrounding equity crowdfunding. Investing platforms such as AngelList provide individuals the opportunity to make small equity investments in privately-held companies. Likewise, the growth in fintech² companies, like LendingClub and Prosper, may lead to increased opportunities for individuals to extend loans to startups.

Accelerators and Incubators

Joining an accelerator or incubator is another way to supplement seed fundraising and establish market credibility. Both types of institutions involve temporarily relocating a startup into proximity with other emerging companies. Although the terms “accelerator” and “incubator” are often used interchangeably, subtle differences exist between the two concepts.

Accelerators offer a short, but intense period of mentoring accompanied by a small seed investment. Acceptance into the top accelerator programs is highly competitive. After a specified period, ranging between one to four months, startups must “graduate” from the accelerator, which often includes pitching their business models to VCs, and try to survive on their own. One of the most successful Silicon Valley accelerators, Y Combinator, has been instrumental in launching many successful companies including Dropbox, Airbnb, Stripe, and Reddit.

Incubators are environments designed to help entrepreneurs develop their ideas into viable businesses, and are usually sponsored by economic development organizations, governments or universities. Compared to accelerators, incubators have a less rigid timeframe, lack a formal instruction program, and do not provide financing. While accelerators aim to achieve rapid progress in a compressed timeframe, incubators provide limited support over a longer period. Some companies spend years at an incubator as they work through product development. While instruction and training are some of the main advantages of accelerators, collaboration with fellow innovators and low-cost office space are the primary benefits of incubators. Some companies participate in both incubator and accelerator programs as they grow. For example, a few college friends may join a university-sponsored incubator as they begin to explore potential product innovations and then enter an accelerator program to further refine the company’s business model.

Other Equity Investors

Investment groups that have historically specialized in other asset classes have started participating with and competing against VCs in late-stage equity rounds. Partnering with non-traditional investors such as sovereign wealth funds, mutual funds, hedge funds, and private equity firms give startups access to wealthy backers. While these investors may lack the industry expertise of a VC firm, most late-stage startups already have several VC partners on their board of directors from prior funding rounds.

Private Equity

Private equity (PE) firms typically specialize in buying privately-owned companies, improving their financial condition, and then selling them for a large profit. Compared to the VC funding model, the PE buyout model focuses on much larger deals; the largest firms routinely close multi-billion-dollar deals. PE firms are often buyers of late-stage startups that are unable or unwilling to go public.

Many PE firms also invest in mid- to late-stage startup companies without buying all of their equity ownership. Instead, these PE firms make minority stake³ investments in relatively-mature companies to help them engage in significant business expansion. These types of PE investments are called growth capital or growth equity. Some of the most reputable names in PE, including KKR and Blackstone, have increased their involvement in later-stage growth equity funding since 2010.

Sovereign Wealth Funds

Sovereign wealth funds are state-owned investment vehicles generated from the surpluses of foreign governments. These funds usually have a twofold purpose: sponsoring governments hope to (1) learn about emerging technologies and gain experience to foster startup communities in their own countries, and (2) generate large returns to finance government expenditures in other areas.

Mutual and Hedge Funds

Mutual funds and hedge funds pool together large sums of money and invest it across a wide variety of securities in hopes of making a substantial overall return for their investors. These investment vehicles usually have a predetermined percentage of the total fund amount allocated to specific asset classes based on the corresponding risk associated with each type of investment. Given the risky nature of startup investments, only a very small percentage of a mutual or hedge fund’s overall portfolio is comprised of startup investments. Mutual funds and hedge funds function similar to VC firms and PE firms in that all four investment vehicles seek to generate returns for their shareholders or limited partners.

Working with mutual fund investors can present unique challenges due to regulatory reporting requirements. Unlike VCs, PE firms and hedge funds, mutual funds are legally obligated to revalue their holdings daily, and publicly report the value of each investment holding quarterly. If a mutual fund’s independent valuation analysis concludes that the startup’s value has declined, the publicly announced devaluation can cause negative publicity and scare off future investors.

Debt Financing

As an alternative to the equity financing methods discussed previously, debt financing provides some unique advantages, including a reduced amount of ownership dilution. Startups utilizing debt arrangements face other challenges, including lenders’ demands for interest payments and loan covenants⁴, which may restrict management decision-making. Depending on your startup’s situation, taking on debt may be more attractive than using an equity-only approach to financing. This section discusses two debt financing sources that are available to startups, then explains a unique type of debt agreement called a bridge loan.

Commercial Bank Loans

Startups with sufficient size and financial stability can apply for commercial loans, like most other corporations. Unfortunately, many early-stage startups may not qualify for traditional commercial loans because they have negative cash flow and few collateralizable assets. As a result, startups may have a difficult time raising debt financing.

Some resources do exist to help startups obtain commercial loans. For US-based startups, the US Small Business Association (SBA) can help facilitate commercial loans for some startups by offering a partial guarantee to the lender. Also, some commercial banks have specialized practices dedicated to serving startup clients. Since commercial banks have stricter regulatory requirements than venture debt funds (see “Venture Debt Funds” below), they are generally more conservative in their lending. Nevertheless, startups that qualify for commercial loans often receive lower interest rates than they would from a venture debt fund and startups do not have to give commercial banks any equity in the company.

Venture Debt Firms

Venture debt firms specialize in loaning money to companies with higher risk profiles than a commercial lender would be comfortable with. A venture debt loan operates like a traditional loan, with the principal to be repaid at the maturation date and a specified amount of interest accruing every fiscal period. Because of the higher risk profile of venture debt clients, the interest rates are often higher than traditional commercial bank loans.

An additional feature that may accompany venture debt loans is a small equity “kicker” for roughly six to eight percent of the total loan amount. Equity “kickers” are warrants⁵ that allow the venture debt firm to capture some of the startup’s potential upside as a reward for the risk of the loan.

Generally, equity warrants represent a small percentage of the overall ownership, so taking on a venture debt loan does not significantly dilute existing shareholder ownership. This is important because many founders and early-stage investors want to limit the dilution of their equity stakes to enable a higher return. Debt financing minimizes the dilution that accompanies an equity round.

Most venture debt firms act as advisors to their portfolio companies in a manner comparable to VC investors. Like VC investors, venture debt firms have a vested interest in the startup’s success because they want the startup to fully repay the loan principal and interest payments. The best venture debt firms leverage their network, experience, and balance sheet to help startups succeed.

Other reasons for accepting venture debt loans include achieving an optimal capital structure by using the tax-deductible interest payments and maximizing corporate profits through leverage.

Despite these benefits, management teams should carefully consider whether their cash flows will allow them to meet interest payment obligations associated with the venture debt loan. Also, lenders typically require a borrower to have significant amounts of prior equity investment, meaning that venture debt serves as a complement to equity financing, not a complete substitute.

Bridge Financing

Bridge loans are a type of short-term convertible debt meant to provide needed funds until more permanent financing can be secured. For example, a startup company that is running low on cash but has started the process of securing a new equity round is an ideal candidate for bridge financing. The bridge loan provides the company with enough cash to continue business operations as it procures additional equity financing.

Once the startup receives additional financing, the terms of the bridge loan agreement determine how the startup repays the debt. Often, the outstanding debt is converted into equity shares in the startup, typically at a discounted rate. If the startup can’t procure additional equity financing, then the bridge loan may convert into equity shares at a rate similar to the latest round of equity financing or remain debt, whichever is more profitable for the bridge loan investor. Other times, the bridge loan agreement may enforce repayment of the loan principal and interest when the company receives (or fails to receive) additional equity financing.

Startup management teams should pay careful attention to the clauses within bridge loan agreements and determine the financial impact on the startup in both favorable and unfavorable scenarios. If a scenario arises wherein the startup cannot meet the debt repayment schedule or faces other liquidity problems, management should seek to renegotiate the bridge loan or pursue alternative forms of financing.

Conclusion

Capital for your startup can come from many different sources including individuals, investment entities, and even other companies. Some of the most common sources of financing take the form of equity investments, via angels, strategic corporate investors, VCs, and others. Through debt financing, you can access funds provided by commercial banks and venture debt firms. Investors and lenders are some of your startup’s most important stakeholders. Through careful study of each prospective financing partner, you can select the capital providers that will be of most benefit to your startup.

Resources Consulted

• CBInsights, The Rise of Hedge Funds and Mutual Funds in Tech Startup Investing in Two Charts
• The Entrepreneurial Bible to Venture Capital by Andrew Romans
• Statisticbrain, Angel Investor Statistics
• Preqin Equity Round Average Deal Sizes (2010-2013)
• GV
• Pitchbook, The 10 most active corporate venture capital firms
• Kickstarter, Trends in Pricing and Duration
• Forbes, Is A Startup Incubator Or Accelerator Right For You?
• Y Combinator
• Preqin 2017 Private Equity Report
• Crunchbase, KKR & Co. (Kohlberg Kravis Roberts & Co.)
• Crunchbase, Blackstone
• Personal interview with Bret Jepsen, founder of C6 Partners LP, a national venture capital and PE fund of funds⁶
• Term Sheets and Valuations by Alex Wilmerding