How to choose the right investors for your startup

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As an early-stage startup founder, it’s normal to assume you should accept funding from wherever you can find it. The true value of an investment, however, might come from your relationships with the investors you choose to work with. The partners you bring into your business, and the tenor of the relationships you build with them, are often more important than the “name recognition” of the venture capital  firms they work for. 

Types of startup investors
Broadly speaking, investors typically fall into one of three categories:

Angel investors 

Often former entrepreneurs themselves, angel investors are typically high-net-worth people who invest their own money. That means they’re incentivized to be a bit more cautious in their decision-making, so they tend to come in with lower amounts than venture capital firms do. On the plus side, they’re often willing to invest at earlier stages such as the seed round. Angel investors are often interested in backing something they’re personally interested in: founders in their local area, companies in their industry, or ideas they believe in.

Finding the right angel might be a challenge. While these types of investors may be looking for investment opportunities, they typically don’t have formal submission processes or junior analysts to sift through lots and lots of business plans. So you’ll want to network, starting locally. You can also search for and follow angel investor websites and networks, and look for angel investor events both locally and online. Then you can research individual angels to see if any of them share your industry or focus.

Venture capital

The most senior people within a venture capital (VC) firm are called partners, with a managing partner typically as the final decision-maker. Venture capital firms don’t invest money in startups themselves; instead, they invest on behalf of limited partners (LPs), who provide the capital. 

In some cases, these investors provide additional “follow-on capital,” meaning they’ll fund subsequent rounds after their initial investment to enable the company to grow without finding new external partners. 

To find firms to work with, you’ll want to explore your personal network (cold introductions do happen). Accelerators often help introduce founders to potential investors, as well. An introduction through an entrepreneur who has already generated good returns for the firm can help get your foot in the door.

Corporate VC
Corporate venture capital (CVC) is a subset of venture capital. Partners in these firms make investments on behalf of large companies that invest in startups—often those either operating within or adjacent to their core industry. Unlike VC investments, CVC investments are made using corporate dollars, not through capital from limited partners. GV, the corporate venture arm of Alphabet, Google’s parent company, is an example of a corporate VC firm.

Structuring your fundraise

In the early stage, a typical seed round might include between one and three angel investors, along with a lead investor who often contributes at least one third of the round. This lead investor sets the terms of the round and makes sure that all other investors are aligned on important items like valuation, preferred shareholder rights, and deal terms. The lead investor typically also takes an active role in your company’s forward-facing strategy, helping with executive hires, director-level work on your board, and key introductions for future funding rounds. Simply said, your lead investor provides a certain degree of safety and security for other investors, as they know you have a well-equipped support system for continued growth and success.

Choosing the right investors for your startup

Finding investors who might be interested can feel like the end of the story—but you owe it to yourself to keep the conversation going until you’re confident you’ll work together well. When thinking about which investors you want for your fundraise, it’s helpful to look at a few different criteria:

Industry expertise 

What industry does your investment partner come from? It’s typically a good idea to find investment partners who understand the ins and outs of your industry, ideally through hands-on experience. These investors should have deep knowledge of how the industry has historically changed over time, the market forces affecting it now, and where it’s headed. When your investors are familiar with your industry, they can provide insight and practical advice to address the market and avoid pitfalls. 

Functional expertise

Investors with functional expertise have mastery in some or all of the foundational skills associated with entrepreneurship and fundraising. Basically, you want your investors to know what they’re doing, so that they can help take your business to the next level. 

If they’re angel investors, have they built and/or sold a company? Have they acted as advisors to startups in the past, or been founders themselves? If they’re firms, do they specialize in finance or industry-specific analytics? Do they typically help startups with their operational challenges? Ask other founders about the investors you’re talking to, and dig into their backgrounds to uncover the value they can offer you beyond just money. 

Network

When evaluating firms, it can be helpful to research their portfolios for other companies that you might be able to network with to find partners, talent, advisors, and even other potential investors. A solid network can also bring you personal mentorship as well as advice to help you strengthen your business plan, operations, and other potential areas for improvement. Take a look at the size and location of an investor’s network, as well as the industry and functional expertise it comprises. 

An investor’s relationships with seasoned, all-star serial entrepreneurs—or their lack thereof—can also be an indicator of their reputation in both the founder and investor communities. 

Track record

An investor with deep pockets may seem great, but if they lack experience with startups like yours, you may be better off without their money. It can be helpful to do some research into their investing track record. Have they worked with companies that look like yours?

Ideally, you’ll look for venture capital firms with a history of successful investments and exits. One way to evaluate a firm’s track record is through its gross internal revenue (IRR). Firms with a higher IRR over a longer period of time are theoretically more seasoned and better suited to help you grow your business. Different firms typically set different IRR goals for their portfolios, depending on the stage of companies they routinely invest in. Early-stage investors, for example, typically target a 30% net IRR over eight years, while many late-stage investors set a target net IRR of around 20% over the same period.

Many of the most successful angel investors are former entrepreneurs who built successful startups of their own. You can also seek out references from people who’ve previously worked with a particular firm to get an idea of how they respond when their investments begin to go south.

A platform to help you grow

 

The most helpful VC firms tend to provide not only capital, but also a suite of services to help you. For example, they may have an in-house operating partner or a head of marketing to connect you with public relations contacts. While investors should be able to help you, they’re not necessarily an extension of your team. Very few investors will be able to commit to a full-time level of support. As you try to determine a VC firm’s bandwidth, consider what they say about the services they provide as well as how other founders who have worked with them say. You can also look at how many startups they invest in. Those who invest in fewer startups may be more likely able to provide more time and resources to you as a founder—but that’s not universally true.

One red flag when looking for investors

Just as important as knowing what to look for in an investor is knowing what to avoid. One main pitfall is an onerous term sheet. 

Term sheets are fundamental to the nature and value of an investment. If you’re raising a priced round, they can be notoriously lengthy. Term sheets can be hundreds of pages long, and may potentially create a disconnect between the valuation you desire and the valuation an investor is willing to give you. Here are a few things to watch out for when looking at a term sheet.

As a founder, how to get investors for your startup is a key question. But how to choose them is just as critical. You’ll be working together for a while, after all. It’s worth taking the time to consider what kind of investor will provide you the most value—and doing some research and outreach to find a good fit.

At Carta, we help startups with fundraising, compensation, valuations, equity management and much more. Talk to us to find out how we can help you grow.

DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta Inc. (“Carta”).  This communication is for informational purposes only, and contains general information only.  Carta is not, by means of this communication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services.  This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests.  Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor.  This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein. ©2021 eShares, Inc. d/b/a Carta, Inc. (“Carta”). All rights reserved. Reproduction prohibited.

 

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