Choosing the right investor can mean the difference between success and failure for entrepreneurs. It is therefore essential that founders conduct due diligence on potential backers, including vetting their experience, domain expertise, and strengths and limitations, as well as assess reviews from previous clients before accepting money. Ultimately, identifying the appropriate investors and managing their expectations will help you maintain control over decision-making. Let's take a look at the different types of investors who may help fund your startup and the reasons why founders must be prudent before accepting an offer from each.
Friends and Family
Friends and family are often the first people startup founders look to for cash. But before you let members of your inner circle invest in your startup, be sure to:
- Present them with your business plan, just as you would with any investor
- Clearly explain the potential risks of the investment
Individuals who don’t understand the uncertainty that investing in a startup entails are widely considered to be risky investors, and founders should avoid them at all costs. Also, steer clear of accepting an investment from someone you know to be highly controlling as they may expect you to follow their advice when running your business in exchange for their financial support.
Angel investors are usually high net worth individuals who provide funding for a very early-stage company in exchange for an ownership stake. Along with providing funds, they may also offer guidance and demand some control over your business decisions. Before agreeing to their offer, first ensure that:
- The angel investor has at least some experience in this type of startup investment
- The angel investor possesses a portfolio consisting of multiple investments
- You have conducted sufficient research to know your potential angel investor
- You have spoken to other CEOs about their relationships with this investor to determine whether they are easy to work with or too controlling to be effective
Accelerators are fixed term, cohort-based programs that provide founders with money, office space, mentorship and marketing in exchange for a share in the startup. But founders must thoroughly weigh the primary benefits that they seek from participation in an accelerator before joining. When considering a partnership with an accelerator, be sure to do the legwork, such as:
- Identifying the most appropriate accelerator for your particular business
- Understanding the terms of participation
- Talking to other startups funded by the accelerator to determine whether they found it effective
- Keeping your investors informed and seeking their counsel while not allowing them to make decisions for your startup
Like angel investors, venture capitalists may offer mentoring and guidance while also demanding an equity stake in your business. Protective provisions, which are a standard part of most such deals, give the venture capital firm the right to block some actions by the startup. Be aware that this can prevent a business owner from taking certain actions and lead to a loss of control.
Potential consequences of accepting funding
You may need to cede partial ownership of your startup to raise funds from angel investors, accelerators or venture capitalists. Understand that this may entail the following consequences:
- Loss equity at an early stage
As you hand equity over in your business as part of the deal, founders are essentially giving away a portion of their future net earnings. If your startup takes off, the percentage of ownership granted to the investor may tally up to a lot of money you will no longer be able to lay claim to. It is therefore advisable to hold onto your equity until you really need to use it. The more revenue you drive, the higher your valuation, and that will make your equity more valuable.
- Less control over decisions
Business owners have less control over the firm’s decisions as more directors join the board. Since many decisions require a majority vote from the board of directors or shareholders, conflicting goals among shareholders may lead to poor business outcomes.
Wrap-up: 4 Tips on deciding whether to take an investment
- Entrepreneurs have more freedom in making business decisions if they avoid giving away an ownership stake in early funding rounds. It is in their best interest to maintain a larger percentage of ownership in their startup.
- Founders should seek advice from mentors and experts before selecting any funding option. They should look for an investor whom they can trust, shares their vision, is willing to provide money at the best possible terms and has experience in the industry.
- Avoid needless debt. Lean startups avoid external funding until the business has a successful product and focus on developing a minimum viable product by using resources effectively. In addition, lean startups accomplish growth via sales to customers, thus avoiding external funding.
- Founders who have built scalable businesses in the same domain can be great investors to bring on board. They can identify areas where your product can be differentiated, help assemble the right team and attract new customers or partners.