Investor Dilemmas – Week 7

Money. Without it, building a business is impossible – and although varying amounts of funding are needed for different businesses, the need for capital is crucial and there are primarily five ways of getting it. First, the founder might choose to invest his or her own money and initially either self fund the entire business, or a portion of it. Second, borrowing money may be an option for the founder, although this is often limited if their collateral is limited. Third, the founder could ask for help from friends and family while awarding equity stakes in the company in exchange for the funds. Fourth, angel investors may help fund the business – and fifth, venture capitalists may also invest in the business. In this article, we’ll examine the latter three of these methods and identify the pros-cons and dilemmas of each funding source.

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.

Angel Investors

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.

Venture Capitalists

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.


Sources:

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

What did you think? Leave some feedback! :)

14 thoughts on “Investor Dilemmas – Week 7

  1. Austin,

    You pointed out three of the most common funding sources and analyzed the pros and cons help realizing the important of building financial capital for business, from the early start to any stage of business growth. Financing issues forced founders to take money from outside investors, begin the complex and complicated operations.

    Great post!

    Mary

  2. Once again you impress me with your well thought out post. I just have one request, could you use a darker font. I stare at a computer screen all day and the light text messes with my eyes. I found myself losing my place or not being able to follow the line correctly. It is likely just a personal issue; however, I know you take pride in your posts and thought you might want to know.

  3. Austin,

    Based on your blog it sounds like venture capitalists would be the most ideal and productive investor to get because they provide more than money. They can provide social capital and high value in business. Although it is much easier to get family, friends or angel investors, but they can usually only provide money and not business experience. I think if you had a friend or family in the same type of business that was willing to invest in your business that would the most beneficial.

    Thanks,
    Mackensie

    1. Exactly, Mackensie. I think you’re correct. Ultimately, I suppose that each type of investor has their advantages (and also different degrees of feasibility). Thanks for the comment!

  4. Austin,
    The article link was excellent information with all things to thing about with angel investors. I would be interested to speak with an angel investor and learn how they ended up in that position. I noticed you brought up borrowing money and I wonder with what happened in 2008 if it has become even more difficult for a founder to get money from a bank.
    Always informative posts.
    Cece

  5. Hi Austin,
    I enjoyed your blog on the overview of different types of investors. The structure setup for this chapter was really descriptive and explanatory about the different investors available to startup businesses, which you gave a great account of each type of investor. As you said it was just for a starting point, and it has had me thinking of my starting point. So, I was thinking about my future venture and what direction I would take, and it would definitely start with family. I then would ATTEMPT to find venture capitalists because of their need and desire to make the business succeed for financial gains. It is a little stressful knowing that if I was lucky enough to find those investors, then I would lose more equity than if I took a different route…although would that other route assist me as much in being successful with my business? Great post!
    Colleen

    1. Thanks so much, Colleen. That’s an interesting question to ask yourself, and one that is filled with tradeoffs. I feel like finding venture capitalists would be a good achievement if possible. Expanding the business would just happen a lot quicker with their help!

  6. Thanks for providing that link about angel investors on forbes.com. It seems like angel investors are a great way to go, partly because they seem to ask for less control of the business. But primarily because if the business goes under (causing the investment to be lost), you can still count on being able to go to Thanksgiving dinner. If family and friends were the investors whose money your business lost, maybe it’s better to skip Thanksgiving this year.

    Thanks,
    Nick

    1. Glad you enjoyed it, Nick. You’re right – those family investments can cause some problems like that. I’m glad we are learning more about this subject! Thanks for the comment!

  7. You continue to impress me with your writing skills and how you break these big tasks down to chewable bites. I never knew starting a business had so many moving parts! I started my business with little to no money, but now I know I need to work on that. You gave some great pointers on where to look for money and those who can truly invest in our businesses. Great Job!

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