It seems that the vast majority of young entrepreneurs seeking capital for their company are focused on Angel & Venture Capital investors. In short, the focus is on professional investors. There are a great many advantages to accepting capital from professional investors, but there is one major drawback: cost.
Professional Investors:
Angel Investors and Venture Capitalists (usually) bring with them a wealth of experience and expertise in business and management. These groups can provide high-octane guidance to accelerate a company’s growth.
Their expertise, however, comes at a price. A significant portion of the company’s ownership and profits are handed over to professional investors in return for their monetary investment and expertise.
One of the sources of the high-cost is that professional investors are typically middlemen; that is, they invest the money of other individuals and institutions. The implication of this is that the cost of capital is necessarily increased, as there are more hands in the capital “cookie jar.” The fundamentals of how these professional investment firms are compensated require rather high returns from their investments. The high returns are generated by establishment of high hurdle rates, large ownership percentages, and onerous profit splits.
The Alternative:
While, at first blush, they may not seem as easy to access, wealthy private individuals can be a fantastic source of funding. To fully capitalize on the advantages of funding from a private individual, you must cut out any and all middlemen. Go directly to the individual his or herself. This will help establish trust, and remove finders fees paid to third parties.
How to find wealthy individuals:
Use your creativity, but the main method is network, network, network. Get in front of as many people as possible. Go to coffee, lunch, or happy hour with people who are not in your age-group. You never know when or where you’ll find someone that has an extra several hundred thousand dollars sitting around (I’m not joking. Not even a little bit.).
While it’s always good to let someone else do the talking when your goal is to win them over, you should shamelessly discuss your projects with everyone you meet. A great way to get in front of successful business people and entrepreneurs is to ask for their advice. In doing so, show them that you’ve got a great business or idea and you’re looking for investors. If it truly is a good business, chances are they will desire to invest their own money or introduce you to others who may wish to invest and have the means to do so.
The value of a dollar:
As a hard working entrepreneur, you know the value of a dollar. If you’re in the midst of a start-up, you’re probably holding on to every single dollar as tightly as you possibly can. But that is not the case with everyone you meet. Many people have never been introduced to an opportunity such as investing in a small, interesting startup. Furthermore, if they compare the returns that they have been receiving on their stocks, bonds, and mutual funds, the returns that you expect to see in your start up are likely far-and-wide more appealing.
To capitalize on the alternative returns to which the individuals have access, you should provide a return profile that is better – but not too much better – than easily accessible alternatives. For instance, a guaranteed 12% return is extremely attractive to many investors.
Ideal structure:
In many cases, if you don’t wish to give-up too much ownership in the company, a structure that combines debt and equity is ideal. Pay a guaranteed return on the investment (i.e. 12% as discussed above) but have the repayment provisions such that you can either repay at your discretion, or upon the sale of the business. This means you will not need to worry about recapitalizing when you’re up against a balloon repayment at the end of the third year. This provides you, the entrepreneur, the ultimate in flexibility, while still providing the investor with a decent return.
Ownership:
The return alone will be enough to entice many investors. Ownership can be very limited. For instance, provide the investor with only 15% ownership, with a guaranteed return of 12% per annum. Create a series of “default” provisions with the investor that, in the event of the occurence of a default provision, the ownership of the investor will revert to 51%, ensuring that they have control to get the company “out of trouble.”
Ensuring Success:
If your investor, for instance, invests $100,000 with a guaranteed return of 12% per annum, simply set aside $12k in a separate savings account and use that money to pay the return to the investor. This ensures that you will not have a cash crunch and risk a default anytime in the first year.
What Really Matters:
Private individuals have different needs and desires that they seek to fulfill through their investments. You, as an entrepreneur, are looking to fulfill a need for investment capital. Listen to potential investors. Understand what they are looking for in an investment and work with them to create a structure that is the “ideal” investment for your investor. Go into all negotiations with an open mind, and see if you can find middle ground.
