Raising capital is a dual-sided sales process. Investors are selling their capital to you, and you’re selling your business to investors. Like any good salesperson, if you understand how investors make decisions and what their goals are, you are more likely to win the deal. This post is focused mostly on professional investors.
What Are Professional Investors?
Professional investors use private investor capital to buy equity ownership in companies directly. “Private investors” can be individuals or institutions who pool capital for individual investors (think pension funds, insurance companies, or endowments.) Professional investment firms invest in companies, hold the investment for several years, and then sell the companies for a profit (hopefully).
Professional investment firms make it easier for investors to access private companies and make it easier for entrepreneurs to access capital. They do this by pooling the capital from many different private investors into a “fund” and then make investments out of that fund.
“Professional Investor” is a broad category that covers everything from venture capital through huge leverage buyouts. We’ll get more into the different types of firms later in this post.
Main Priorities of Professional Investors:
While there are outliers, investors are usually fairly predictable creatures. They are looking to put money to work and generate a certain level of return in exchange for their investment.
Investors generate returns in one of two ways:
- They sell their shares for more than what they paid for them
- They receive payments out of the cash flows of the business over what they paid.
The returns investors expect are directly correlated to the amount of risk an investor takes. Equity investors are taking on a lot of risk. They usually expect minimum 20% annual return. On the other hand, debt providers who have assets for collateral in case something goes wrong, are taking less risk and may only expect a 6-8% return.
What Do Professional Investors Do?
Contrary to what you see on Shark Tank, investors don’t get to sit in tufted leather chairs all day while raining judgment down on entrepreneurs. Below is the high-level detail of where we spend most of our time.
- Fundraising: Professional Investors can’t make investments unless they have the capital to invest. Investors spend a lot of time and resources getting in front of high net worth individuals and institutional investors to convince them to invest in our funds.
- Sourcing investments: Once investors have the capital lined up, they need to find companies to invest in. Professional investors look at hundreds of deals a year and make only a few investments each year. To find the perfect “needle in the haystack” investment, they have to network. Some firms have teams who do nothing but call companies all day long.
- Forming relationships with management teams: This is one of the most critical elements of being successful at professional investing. Developing strong working relationships with management teams helps investors win deals and better manage investments.
- Evaluating investment opportunities: The pitch you see on Shark Tank is the beginning stage of evaluating a business. An investor’s job is to become a quasi-expert on a company in a very short period. They spend a lot of time getting to know management. Investors sift through hundreds of Excel files, legal documents and conduct countless hours of research to make sure they fully understand the business before investing.
- Negotiating deals: Valuation and ownership percentages are the tips of the iceberg when negotiating agreements. Negotiating a deal requires countless pages of legal documentation with every sentence being a potential point of negotiation. If this sounds more boring than Shark Tank, that’s because it is.
- Managing investments: Some professional investors are fairly hands off. Other firms are operationally intensive and will drop in their team members to work day-to-day with the management teams. The best firms offer strategic advice, support and connections to help improve the business.
- Selling investments: Investors make most of their money by selling investments, so they spend a lot of time making sure the businesses are best positioned to get the highest price.
What are the Different Types of Professional Investors?
Angel investors are high net worth individuals who invest their personal capital in pre-revenue or seed-stage companies. Not everyone qualifies as an angel investor. To comply with SEC regulations, only “accredited investors” or people with $1M in assets or who make over $200,000 a year, qualify as angel investors. Angel investing has dramatically increased over the last ten years, and websites like AngelList help match angel investors with startups raising capital. Angel investors typically write smaller check sizes ($10k – $500k), so startups need to sign up multiple angel investors to complete a capital raise.
Accelerators typically take 5-10% equity stake in a startup in exchange for strategic support, market exposure and sometimes a small amount of funding. Accelerators can be an excellent resource for first-time entrepreneurs who have limited proof points in their business. Like angel investing, the number of accelerators has substantially increased over the last ten years. Some of these new entrants offer very little strategic value in exchange for equity. If you go the accelerator route, do your diligence on the track record of the accelerator.
Venture capital firms invest equity in early-stage, unprofitable businesses. Capital is exchanged for equity and is used to fund the operations of the business. Venture capital often follows an angel investment or accelerator program. Venture capital firms invest in the entire spectrum of early-stage companies, from pre-product businesses through larger billion dollar “unicorns.” Venture capital is a high-risk form of investment where the majority of investments lose money or break even at best. To cover these odds, venture capital firms look for high-return opportunities in every investment. If your business doesn’t have the chance to grow 100%+ a year and be a minimum $100M business, it will be tough to get a venture capital firm interested.
Growth capital firms invest equity in a relatively mature business to fund expansion opportunities. Growth capital firms focus on breakeven or profitable businesses with strong growth trajectories. ROND Capital provides growth equity to small growing businesses, which you can learn more about here.
Middle-Market Private Equity
Middle-market private equity firms invest in established and profitable businesses between $15M-$500M in revenue (the financial thresholds differs from firm to firm). Investments are usually leveraged buyouts, where a combination of debt and equity are used to buy the business.
Mega Buyout Private Equity
Mega buyout firms invest in large companies with revenue worth $500M and above. Investments are typically structured as leveraged buyout transactions. Mega buyouts are the majority of big-name transactions you hear about in the news.
Mezzanine debt is not technically equity, however, it is commonly used in addition to private equity capital. It replaces a portion of the equity in a private equity transaction. Mezzanine debt is typically utilized for a business with steady cash flow.
Distressed investors invest in mismanaged businesses or companies on the verge of bankruptcy. They seek to revitalize struggling businesses by replacing management, rebranding, developing new products, divesting business units and other initiatives.