It is always thrilling to start a business. However, most startups lack sufficient funding for their operations. As they attempt to address the difficulties that no one has recognised yet, it becomes more difficult for them to raise funds for their business.
To take some strain off their finances, the startup owners rely on private investors.
So, who exactly are these private investors and how do they fund startups?
What Is A Private Investor?
A private investor is an individual or an organisation willing to invest their own money in a company or a startup to give it financial aid, contribute to its growth, and earn profits on their investments.
Investment can be made through equity, i.e., exchanging money for ownership, or debt. The investors will be paid back according to their equity in the company or the company share that they hold based on their investment.
Startups are disruptive businesses that are just getting started or are in their initial stages. They need money to expand their business. Private investors are the primary source of raising capital for such companies. They open a window of opportunities and exposure for businesses.
Types Of Private Investors
Private investors are people with abundant knowledge, experience, and expertise in their field and high net worth. They have a wide range of interests, preferences, strengths, and work routines.
So, the founder of a startup company must understand the various types of private investors, their investing methodologies, and their willingness to contribute to their startups before approaching investment.
There are four types of Private Investors, and they are as follows:
- Friends and Family: The easiest way to raise cash is through one’s closest social group. Friends and family are usually the first private investors for startups and small enterprises. They’re an excellent source of investment as friends and family already have the trust and the confidence that founders need to build with other private investors. Friends and family can either lend money or invest in the startup business.
- Angel Investors: Angel investors are high net worth individuals who are keen on investing in upcoming startups in return for profits. They also offer mentoring or advice alongside capital. But the Securities and Exchange Commission has defined angel investors as accredited investors who have a net worth of at least $1 million and earn $200,000 per year or $300,000 per year jointly with a spouse.
- Venture Capitalists: A venture capital firm is a private investment firm constituting a group of investors who act as one while investing in a startup. They bet on business the same way individuals do in the stock market, and they do all in their ability to ensure that their bets pay off. Venture capitalists carry out fewer investments but invest more than angel investors in business development in exchange for a stake in the company. They invest for the long term. So, the founders need to have a well-established business, a strong management team, and a good track record of success to get investment from venture capitalists.
- Peer- to- Peer Investors: Peer-to-peer (P2P) investing includes three parties, i.e., a borrower, a lender, and a middle-party company. The borrower is the business owner, and the lender here is the investor. The borrower seeks a loan from a middle-party company. The investment process begins here. Then, the middle party which is a well-established firm gathers funds from a group of investors and distributes them to borrowers as loans. The middle party is in charge of transferring interest and principles from borrowers to lenders. Both parties then pay a certain amount of money to the platform. The money is repaid with interest, and none of the investors owns any share of the companies. This way, the investors gain higher interest rates than regular bank loans. However, the risk in this type of investment is higher since such investments are not protected by the government.
- Private equity firms: A private equity firm is an investment company that allocates investment money from institutional investors and uses it to invest in companies with a proven growth record. These companies don’t usually invest in high-risk startups as there is a huge amount (>$5 million) involved.
How Do Private Investors Invest In A Startup?
The money needed to establish and run a business is called funding. The monetary investment in a business is for its expansion, product creation, sales and marketing, office space, inventory, etc.
Startups need funding, especially when they try to grow and scale up their business. They rely on private investors to invest in their startups.
Private investors may invest funds in startups in the following ways:
Equity financing is a method of obtaining funds for a startup to meet its needs by selling the company shares in exchange for cash.
There is no payback component for the invested funds in equity financing. Although the companies do not feel pressured to meet the repayment deadlines, investors continuously strive and constantly push them to meet the growth objectives. Equity investors often like to be more involved in the decision-making process of the business. Their portion of the stake in the company depends on the ownership interest.
Moreover, when a startup seeks equity funding to support its needs, it must submit a prospectus outlining the financial facts of the company to the investors. The firm must also explain what it intends to do with the acquired funds.
Angel Investors, Family, Friends, Venture Capitalists, and Crowd Fund are examples of Equity Investors.
Debt financing is a method of raising funds that entails borrowing money and repaying it with interest.
The borrowed funds must be repaid with interest in a specified time range. The startups may be required to keep a company asset as collateral to get the debt, and they need to adhere to the repayment timelines.
Debt financing requires more effort to produce cash flows to fulfil interest repayments. However, the debt financers have relatively less say in decision-making and have no control over the business operations.
Debt financing includes loans from Banks, Non-Banking Financial Institutions, and Government Loan Schemes.
A convertible note is a type of short-term debt that converts into equity in the future.
In simple terms, investors lend money to a business as an investment, and instead of getting their money back with interest, they receive shares of the startup on a future date according to the conditions of the note.
A convertible note delays the valuation conversion and allows the company to access the capital sooner with less negotiation. It is like a loan, but instead of using an asset of the company as collateral, the company’s stock is the collateral.
Pros of a Private Investor
Private Investors have certain advantages. Some of the pros of private investors include:
- It is not a bank loan. Private investment is an easier fundraising option than obtaining bank loans. The bank loan needs to be supported with a mortgage. However, it is not the case in private investment usually. Private investors know that if the enterprise fails, their money is lost. The business owner is not liable to return the money.
- It does not need proven credit history. Private money financing is not the same as typical bank financing. It does not require any credit or demonstrated financial history like commercial lenders or banks. Private investors are more interested in their future earnings than what the company has done in the past.
- It gives access to investors’ expertise. Private investors are individuals who have extensive knowledge, experience, and skill in their chosen field. They also provide mentorship and guidance in addition to funding. There are a lot of books available regarding business strategies, startups, funding, and product success. However, first-hand access to the high-level expertise of investors is unmatchable.
Cons of a Private Investor
Despite the advantages of Private Investors, there are a few disadvantages that the business owners should be aware of. They are as follows:
- It dilutes the share earnings. Private investors expect ownership and a share of profit in return for their investment. As a result, the company shares are distributed to investors. The high ownership share will affect the company’s earnings, and would not be profitable in the long term.
- It affects the controlling power of the business owner. Private investments have an impact on the founders’ authority. An increase in stakeholders makes the founder more answerable to the investors, resulting in a significant delay in the decision-making process.
- The stakes are at higher risk. Investors demand higher efficacy from the businesses in which they invest. There is constant pressure on the management team to meet the investor’s expectations. So, one must ensure that the investor’s demands are as per the capabilities and potential of the team. If not, it is preferable to seek alternative suitable investors and company funding choices.
What Do Private Investors Look For In A Startup?
Searching for a private investor would be a difficult task. Before investing in any business, an investor would look for various factors. It includes having a well-prepared pitch, executive summary, pitch deck, a proven business plan, and financial predictions for at least three to four years.
However, some investors bet on the skills of the founder. They assess the founder’s competence, potential, and resoluteness that would help the business succeed. So focusing and working on oneself is as vital as starting a business.
So, the following are the essential factors that a private investor looks for before investing in any business:
- Idea or Product: The investors look if the business idea or the product is an original work. They look for it to have distinctive features that sell in the market.
- Business Plan: Investors examine the business plan, including its marketing analysis and product execution.
- Management Team: A capable team is an essential element for running a business successfully. Investors look if the management team has the necessary education and experience to meet the objective.
- Cash Flow: Investors do not invest in a company that barely generates a profit. While assessing the firm, they look for earnings before interest, taxes, depreciation, and amortisation, known as EBITDA. The upward trend of EBITDA implies more money as the company is meeting the market needs.
- Liquidity: The firm may not pay its debts if it doesn’t have any liquid assets. So, the investors need assurance before investing in a company. They ensure that the company stays within the liquidity agreement.
- Expenses: High expenses can ruin a firm. Investors look to see if a company has an expense control methodology to keep the unnecessary cost in check.
- Metrics: A business metric is a quantifiable criterion used to track, monitor, and assess a company’s success or failure. There is no one-size-fits-all scale. Different companies use different indicators to measure their success.
Private investors would want to look at these indicators to see how the company is performing in the market. They would want to know how they could get their profit from the firm when the time arrives.
Where To Find A Private Investor?
Finding a private investor would be a difficult task. But, it would be beneficial if one figured out the type of investor they needed for their business.
Searching for investors on the internet or social media is one of the ways to find an investor. Various databases are available online that have the details of the investors. One can look for the preferred investor in these databases. Some of the databases are Angel Capital Association, Angellist, Angel Investment Network, etc.
Another approach is to promote oneself. It would help someone engaged in business networks and participates in startup events. It might attract the attention of investors.
The next step is to fine-tune the business pitch. The pitch is the deciding factor for investments. It should include diagrams, pie charts, and graphs and needs to be informative and precise.
Above all, one needs to have good communication and presentation skills with a great business idea to attract investors to invest in their company.
Private investors want a good return on a successful business initiative. They seek networking opportunities and business connections. Sometimes they take on a management role in their invested firm.
Getting an investor on board is difficult for most small business owners. It may be appealing to seek financing wherever it is found, but it is essential to consider the pros and cons of each option before moving forward. Understanding the investors’ management style, objectives, and goals and following their past performance is crucial before accepting an investment for the business.
Access to guidance might be what the organisation would require to thrive in the long run. However, mentorship by the investors should be allowed, but not the complete authority of the organisation.
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A lawyer and an avid reader with a keen interest in company laws. Anwesha has good experience of writing in the legal and startup industries for well over 10 companies. In her free time, you can find her reading fiction and stargazing.