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Financing Best Practice

Sources of Venture Capital

by Lawrence Brotzge

Executive Summary

  • Sources of capital depend on whether it is an early-stage company or a rapidly expanding business that is seeking significant financing.

  • Angel investors rather than venture capital funds usually provide seed capital for new companies.

  • Use your network to get connected with sources of venture funding, and know your audience before you meet with them.

  • Venture capitalists look for high rates of return and have a relatively short time horizon.

  • These investors will assist the entrepreneurs with many aspects of their business besides capital.

Introduction

There are many sources of venture capital. They include:

  • friends and family;

  • individual angel investors or angel investor groups;

  • early-stage venture capital funds (VCs);

  • expansion-stage and later-stage VC funds;

  • community-based venture funds; these are often run by development agencies, which are usually funded or subsidized by local government funds designed to stimulate business growth.

This article answers a number of questions about obtaining venture capital. When is it appropriate to seek venture funding rather than bank financing? How do you go about finding these funding sources? How do they differ, and what drives their investment decisions? Entrepreneurs and their management team need to understand the role of these investors, what expectations they will have for return on their investment, and over what time frame they will expect to earn those returns.

Early-Stage Companies

Companies are usually started by a single entrepreneur or a small group of entrepreneurs. These founders frequently work for no pay, a situation that is referred to as “sweat equity.”1 The initial cash needed is likely to be provided by the founders, but may be supplemented by money from friends and family members who have a variety of reasons to want to be a part of what the founders are doing. This type of funding is sometimes referred to as “seed capital.”2 The founders may also seek bank financing, but if the bank is willing to extend credit it will probably be based on their personal assets or borrowing capacity. Banks rarely lend to companies that do not have a track record of revenues and profits.

Venture capitalists generally expect to see that the founders have put in a combination of sweat equity and personal cash, and they prefer to see that they have raised some money from friends and family. After exhausting these sources, entrepreneurs may think it is time to approach VCs to raise the funds they need to grow their business. In fact, although VCs did invest smaller amounts in the 1970s and 1980s, they are now much larger funds and tend only to invest when companies need multiple millions. As this transition was taking place, angel investors began to fill the gap between friends and family and VCs.

Angel Investors

Typically, angel investors are thought of as wealthy financiers who want to fund startup companies that have a change-the-world idea or invention. They do usually have some wealth, but it is not necessarily the case that they are extremely rich. Successful business men and women may be sought out by entrepreneurs for their particular expertise. These individuals may not have previously thought of themselves as angels, but they may become interested in the business and impressed by the entrepreneurs and decide to invest. On the other hand there are those who regularly look for such opportunities. Angels generally invest in companies in their local area so they can keep an eye on their money.

Beginning in the mid-1990s, angel investors began to realize that there were some disadvantages to being a lone investor. For example, it is unlikely that one or even a couple of people possess all the knowledge necessary to make wise investments. They may have knowledge of many aspects of the business they are considering, but they are not likely to understand everything about the business and how to structure the investment. Additionally, a single investor would have to put a fairly large sum in a single company to have any real say in the business. A group of angels is more likely to have a breadth of knowledge and, by pooling their funds, an impact on the company. Angel investment groups have been forming over the past 10 to 15 years, and there are now several hundred such groups in the United States and Canada.

A 2008 study of US angel investing3 showed that in 2007 some $26 billion was invested in over 57,000 entrepreneurial ventures and that the number of active investors totaled almost 260,000. It can readily be seen that individual angel investors still make up the lion’s share of investors, which creates a challenge for those entrepreneurs trying to connect with them.

Finding angels requires networking. Ask attorneys and accountants, especially those who frequently work with and specialize in startup companies. If your business is technical in nature, you might contact universities, and you should certainly try to make contact with current and retired executives who come from industries related to yours.

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Further reading

Book:

  • Van Osnabrugge, Mark, and Robert J. Robinson. Angel Investing: Matching Startup Funds with Startup Companies—A Guide for Entrepreneurs, Individual Investors, and Venture Capitalists. San Francisco, CA: Jossey-Bass, 2000.

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