When Family and Friends Invest
One of the first sources of funding for a new startup is often family and friends. After all, this source is often close by and people tend to have more confidence (founded or unfounded) in the success of a friend or family member’s business venture. Because there is a deeper relationship here that usually isn’t made with the direct intention of return-on-capital, this funding is easier to obtain than the other sources. Yet this street goes both ways and the pros can quickly turn into cons. For example, since the friend’s trust often lies more in the entrepreneur than his or her idea, the entrepreneur can “get away” with a sloppier execution of the business and business planning – which may hurt or kill the business later on.
Money is also often the only type of capital that family can contribute, versus the human or social capital that angel investors or venture capitalists usually have. In The Founder’s Dilemmas, Noam Wasserman explains this by saying “because friends and family typically lack expertise or credibility in the most important business issues, they usually have little human or social capital to contribute.”
These cons are in addition to the glaring strains that an investment can make on a relationship. With all of this considered, however, a well thought-out business and an investment from family and friends truly may still be the best way to turn an idea into reality.
In between the initial funding from personal sources, friends and family, angel investors can play a big role in providing the capital needed for a startup’s growth. Angel investors usually provide a larger amount of money for the startup than friends and family, and do so without the strain of a pre-existing relationship. These angel investors also serve as a way to attract venture capitalists for a second round of funding since they are often influential people with social capital.
On the down side, angel investors may or may not be knowledgable about the industry that the startup is in. For this reason, their guidance and advice may be hit-or-miss and isn’t something that can be relied on. Additionally, although a business will most likely be less “sloppy” in their organization from when family and friends first invested, angel investors usually don’t require a well organized structure – which, although easier, is not better for the trajectory of a business.
The Forbes article 20 Things All Entrepreneurs Should Know About Angel Investors provides more interesting information about angel investors, and I recommend if you’re curious to learn more about how they fit in a startup and how an entrepreneur should plan to reach out to them.
Providing much more money than friends, family, or angel investors, venture capitalists are highly sought after for a variety of reasons that stretch beyond their initial cash investment. For example, the right venture capitalist will bring key social capital to the startup. Additional rounds of financing are also usually provided for a startup that is moving in the right direction. And finally, venture capitalists require a high degree of organization and professional structure in the business. This in itself can increase the value and chance of success of a business.
Like most things, however, venture capitalism is not without it’s tradeoffs. Venture capitalists, for starters, are primarily attracted to high risk/high reward businesses – which automatically excludes most of the startups out there. But if you find yourself with such a qualifying business, other tradeoffs include less personal control over the business and loss in ownership through long-term equity positions since venture capitalists typically stay involved in the business much longer than angels or family members.
It’s important to note that the tradeoffs mentioned here are not an exhaustive list of the pros and cons of each type of investor, but rather a starting point explaining a few of the major benefits and pitfalls of each.
Harroch, Richard (2015). 20 Things All Entrepreneurs Should Know About Angel Investors. Forbes.com. Retrieved from http://www.forbes.com/sites/allbusiness/2015/02/05/20-things-all-entrepreneurs-should-know-about-angel-investors/#2c3ae163483a
Wasserman, Noam (2012). The Founder’s Dilemmas. Princeton, NJ: Princeton University Press