Equity investment is only appropriate for businesses that plan to have an exit, or future equity rounds. Why? Equity investors want their money back. Typically 5-10x their original investment. Therefore, a lifestyle business that will not grow is not a fit for traditional venture capital.
Special note: friends and family investment can sometimes result in granting of equity in the business. Early equity participation in a business can complicate matters in future, growth investment rounds. Therefore, we recommend advice before entering into any equity investment agreement.
Experienced angel investors can quickly lose interest if approached by an inexperienced entrepreneur. This is because there are several “golden rules” that a first time entrepreneur will not know. Here are a few.
Rule #1: Don’t ask for a confidentiality agreement. Savvy investors see hundreds of deals, know the importance of confidentiality, and the downside of signing several of them. If you have deep concerns, seek a professional investment group or family office that operates under confidentiality (do your homework).
Rule #2: Know your cap sheet. Your capitalization table lists the owners of the business, including any prior investors. You will need to know the terms of those investments to know how they will be effected by future rounds.
Rule #3: Know your audience. An investor or an investment group that only invests in software companies does not want to be approached by a consumer products company. On the same note, an investor that only follows one deal structure should not be approached to be deal lead with a pre-determined structure that doesn’t fit their model. Which leads to #4…
Rule #4: Understand equity deal structures prior to offering a term sheet. These vary and many investment groups are “one trick ponies” – only doing one type of deal.
Confused? Don’t worry – we can help you learn if equity capital is right for you, teach you what you need to know, and help you prepare for your first pitch.
Equity investment is when money is given to the business in exchange for ownership.
Angel Investors and Venture Capital are common early-stage source of capital for growth companies when:
- the business either needs substantial capital prior to proof of commercial viability,
- the business has a strong plan but does not qualify for other sources of capital,
- the owners do not wish to take on debt.
Angel investment should only be taken from qualified accredited investors; defined as individuals whose net worth is greater than $1MM, or whose income exceeds $200k for the past 2 years. Inexperienced investors and inappropriate documentation for equity participation causes business failure too often. Currently the U.S. Securities & Exchange Commission (SEC) mandates that only accredited investors are legally able to invest in private companies. Angel investors expect an exit or clear path to get their money out of the business; therefore, they rarely invest in Main Street or lifestyle businesses. They also expect a return commensurate with early risk, typically 5 to 10 times their initial investment.
Venture Capital Firms participate in Series A or B rounds, often over $2M. We recommend identifying the best VC firms for your industry and fostering relationships early. VCs will often gain a controlling interest, or have stipulations that require formalization of management and systems to prepare for eventual M&A or IPO.
A few considerations regarding equity investors
Equity investors take money out of their pocket and give it to you. Why? Some reasons include:
- to make a larger return on their money than may be achieved in the market (higher risk, higher reward)
- to give you or your industry an advantage (philanthropic or industry investors may take higher risk in areas of interest)
- to participate in a field they find personally interesting (for the fun of it or to be involved in cutting edge developments)
…just to name a few. Whatever the reason, these people or groups have expectations and are governed by their culture. Know what that is when you choose these partners. Therefore…
- Choose wisely. Choosing poorly and not protecting your interests can have catastropic conseuences–just as choosing wisely can help you achieve your goals, sometimes in even more meaningful ways than you imagined. If you pick experienced, well intentioned investors who are passionate about your industry, you may find value in not only financially, but with connections and support during the trials of growth.
- Protect your company. Have the right legal documents in place to reward your investors while protecting yourself.
- Investors require an exit. They only get their money out if you provide a mechanism for them to do so. That can be in the form of future equity rounds, the sale of the business, some form of a strategic alliance, or a generous return on their investment by some creative lending terms. Early investors require different terms than later stage investors, so knowing the pattern of these rounds is important.