One of the most critical resources or enablers for start-ups is funding. As founders develop their idea into a proposition, they must have early endorsement from customers, either with some successful pilots or assurance to buy. This proposition now needs to quickly convert to a product or service embedding the early user/customer feedback.
The founders have to start building a business with a sales and delivery team, vendor network, and operational and logistic processes, and build the requisite infrastructure for seamless delivery, which will all together should build the revenues. But to get all of this done, the company requires funding. Most entrepreneurs have by this time consumed the “FFF” (family, friends and faith) monies. It is then that they approach early investors.
Angel and early-stage venture capital investors fund start-ups when these ventures are at the highest level of risk in their life cycle. Apart from the funding, these investors also help and guide the founder, and leverage their global networks and credibility for the company, which is very critical for start-ups. It is imperative to remember that these investors will look for a return on their investment.
It is, therefore, important for entrepreneurs to understand the investing model of angel/early-stage investors. These investors buy shares of the company, which means that they are equity investors. Their investment model is really very simple: They buy shares at a certain price and sell them at a much higher price, at a later date, once the company has grown. The difference between the purchase and sale price of these shares is the return on their investment.
This is the gains on the capital they have invested. When they buy, the share price is arrived at based on the valuation of the company at that time and its future potential, as discussed and agreed with the founders. They sell the shares to either the investor who puts in money when the company grows to the next stage, or when the company is bought out or acquired. Investment at the initial stage of a company is high risk and therefore the investors would need a high return. To justify the risk they take, this investment will need to give them far better returns than normal market ones. Further, as they invest in a number of start-ups, they expect a few of their investments would fail.
Hence, they need at least some of their start-up investments to not only provide them excellent returns on the capital invested, but also provide them really good returns to justify the funds they have put in and risks taken in the entire start-up portfolio. It is imperative to clarify that these investors do not:
1) provide loan/debt with an interest rate.
2) look for year-on-year dividends on their shares, but ensure that the company ploughs back surpluses into growth that will lead to a higher valuation for the firm.
It is, therefore, imperative for these investors that the valuation of the company increases as that is the only way the price of their shares (and that of the company) increases. Hence, they invest in companies whose revenues are growing in a hockey stick curve and are also moving towards profitability, providing a strong foundation to the company.
These investors do purchase shares in the company and in essence are co-owners. However, high-quality investors, be they angels, VC or corporates, would not take a majority stake in the company. If they do so, they would have to run the company, which they do not want to do. They are primarily investors who bet on the ability of the founders and the growth potential of the company. They want the founders to drive the company and add value by guiding and helping them.
In addition, these investors understand that as the business grows, the company will need to raise the next round(s) of equity funds, and the entrepreneurs along with themselves will need to dilute. And after that round as well, the founders should still hold a majority stake as that will be required to give confidence to the next-round investors as well as to remain passionate to grow the company further.
Another useful insight for entrepreneurs is that early-stage investing is a combination of promoter and peer investing. While these investors do bet on the promoters/founders, they also take a bet on who else is investing. It is important for them to know whether there are angels/VCs who understand this space and are committing to invest.
That provides them confidence and also helps them to mitigate risk, as they can now leverage their co-investors’ domain understanding, networks, etc. Today, in fact, we are seeing a growing trend of co-investing. This helps investors and also the companies. The founders now not only have more heads on the table for ideas, brainstorming and connections, but also access to a larger pot of monies of these investors as they grow their companies. We have frequently seen companies raise their next round of investment very quickly from their existing investors. This is very useful as founders then spend very little time on fund-raising and their growth trajectory doesn’t miss a beat!
Co-founder, Indian Angel Network, and Founding Partner, IAN Fund