Private Investors for Startups: Everything You Need to Know

What is a private investor?

The short answer: A private investor is a person or company that invests their own money into a company, with the goal of helping that company succeed and getting a return on their investment.

The long answer: The field of private investment is more varied than the short answer might make it seem at first. It's important to note that while some types of private investors may be from firms that focus solely on investments — like VC firms and angel investors — they are never from banks (for example, SBA bank loans).

The four main types of private investors

a. Friends and family

Family and Friends are often the first private investors that startups and small businesses turn to. They're a great resource for seed funding and startup money for private companies, as family and friends already have that base of trust and involvement that founders usually have to build from scratch with other private investors.

b. Angel investors

Angel investors are private investors that are wealthy individuals who invest in startups, usually at the early stages with their own capital. Sometimes multiple investors pool their money with other investors, forming an investor pool, angel group, or angel capital association.

The typical angel investor is someone whose net worth is likely in excess of $1 million or who earns over $200,000 per year. Incidentally, those look a lot like the credentials of accredited investors.

Realize, though, that the angel investor is playing with their own money — not invested capital — so even though they may be a high net worth individual, they are private investors that are still looking at money coming out of their personal bank account.

c. Venture Capital Firms

Contrary to popular mythology, VCs are just regular people who make bets on big opportunities like anyone would in the stock market.

One way that they're different from “regular people,” however, is the fact that they work for VC firms. Unlike angels, they are private investors that are not investing their own money, but rather the money of their employer. As professional investors, they do everything in their power to make sure their equity investment bets pay off, but ultimately, even the best ones miss far more often than they hit.

A venture capitalist is charged with finding a relatively small number of investments (usually less than a dozen per year) to make over a seven to 10-year period. While VC firms may look at thousands of deals in a given year, they can only pick a handful of deals to pursue, generally targeting high-growth startups.

d. Private equity firms

Unlike just about every other type of capital, private equity (PE) isn't really associated with startup capital – it's associated with growth capital. PE is a type of investment typically reserved for companies that have already grown to a larger size and are looking for a particular growth or exit strategy that isn't available through traditional financing.

If you're a startup with just an idea, you're likely way too early for private equity investors. Typically private equity firms are looking for later-stage companies that require much larger sums of money — usually at least $5 million — in businesses that already have some sort of assets to leverage as investment opportunities. So if you are seeking initial funding, PE firms probably aren't the right investor type for you yet. Once you are more focused on your company's growth, and not its inception, survival, and initial traction, then PE Firms might become the right investors for your deal.

How does private investment work?

Each type of private investment works differently from the other types. Here is how the four most common types of private investment work.

a. Friends and family

Friends and family are a great source of early investment — but it can be a tricky relationship to navigate. It's common for people to feel like they can be casual and personal with these types of investments because their relationships with the investors are personal. That's a mistake.

Founders should treat investments from friends and family as a professional addition to their existing personal relationships. It's a good idea to get a written contract stipulating the terms of the investment and also to make it clear that it's very, very likely they won't get their money back.

Remember: the vast majority of startups fail and while every founder works their hardest to make sure their company isn't one of those failures, statistics are against them, even with a solid business plan.

b. Angel investors

Angel investors are typically high-net-worth individuals who look to put relatively small amounts of money into startups, typically ranging from a few thousand dollars to as much as a million dollars.

Angels are often one of the more accessible forms of early-stage capital for an entrepreneur and as such are a critical part of the equity fundraising ecosystem.

There is no definitive limit on what a single angel investor can invest, but a typical range would be from as little as $5,000 to as much as $5,000,000, although most angels tend to cap out around $500,000.

Angels may also invest incrementally, offering founders a small investment now with the opportunity to follow on at a later date with additional investment, typically when something important happens with the business.

Getting good angel investment deal structures is all about creating a win-win situation. Once a founder gets an angel investor interested in their deal and agrees on basic terms, they will need to discuss the best way to structure the investment.

Be cautiously optimistic

At this stage, many entrepreneurs (or small business owners) get so excited that they forget to dot the i's and cross the t's on their deals.

It's important that founders thoroughly review any term sheet with a lawyer to make sure they completely understand the deal structure and terms.

The best way to do this is by proposing deal structures that founders have already come up with.

The two most common seed-stage angel investments

There are two primary types of seed-stage angel investments: an equity stake and a convertible note.

There are other types of structures, but chances are startup founders are going to be talking about one of these instruments.

In either case, founders are deciding how much equity the investor will get for their investment. The difference between the two is when the founder makes the decision on how much equity will be decided.

The equity stake is simply the founder making the determination now.

The convertible note suggests that both parties agree that the valuation will be determined at some later date based on a few criteria.

Equity stake

An equity stake (or equity financing) is when an investor exchanges their money for an ownership interest in a company.

The amount of equity the investor receives will depend upon the valuation that the investor and founder agreed upon. So if the founder valued the company at $1,000,000 and the investor put in $150,000 of cash, the investor would get 15 percent of the company.

From there, equity stake can get complicated. Founders can start to issue different classes of stock, some of which have voting rights or some that get paid back more quickly than others.

If a founder makes it far enough to start having conversations with those details, it pays to get a lawyer involved because the variations on those provisions can be significant. Founders can't afford to not understand what's being proposed with this kind of financing option. (I repeat: don't sleep on the details of equity financing!)

Most of these private investment deals will be set up as an equity stake in exchange for cash.

Convertible note

Sometimes the private investors and the entrepreneur cannot agree on exactly what valuation the company has today.

In that case, they may opt to issue a convertible note that basically lets both parties set the value of the company at a later date, usually when more outside money comes in and values the company then.

A convertible note is set up as a loan to the company. So if the private investors put in $150,000 as a convertible note, it would mature (come due) at a specific date in the future, let's say a year from now.

During that time it will likely accrue interest. At the maturity date in the future, the investor can choose to either ask to be repaid back in cash (like a loan) or convert that money back into the company as equity based on a valuation determined at that time.

Convertible notes have become more popular with angel investors as well as entrepreneurs over the years because it aligns both parties with the goal of maximizing the investment. It should also be noted that a convertible note is very different than something like a small business administration loan.

The term sheet

In the context of startups, a term sheet is the first formal — but non-binding — document between a startup founder and an investor.

A term sheet lays out the terms and conditions for investment. It's used to negotiate the final terms, which are then written up in a contract.

A good term sheet aligns the interests of the private investors and the founders because that's better for everyone involved (and the company) in the long run. A bad term sheet pits investors and founders against each other — and that is not good for business growth.

It's not done until it's done

The most common mistake first-time entrepreneurs make is thinking that a done deal is a done deal. It's not.

Even getting a term sheet isn't the same as finalizing the closing legal documents that the term sheet outlines.

This involves a great deal of back and forth between the attorneys from both private investors and founders and can easily take 30 to 60 days to complete if it gets done right.

It's not unusual for this process to go over 90 days, but if it starts dragging over 120 days, the deal runs the risk of falling through.

c. Venture capitalists

A venture capital firm is usually run by a handful of partners who have raised a large sum of money from a group of limited partners (LPs) to invest on their behalf.

The LPs are typically large financial institutions, like a State Teachers' Retirement System or a university using the services of the VC to help generate big returns on their money.

The partners then have a window of 7-10 years with which to make those investments, and more importantly, generate a big return.

Creating a big return in such a short span of time means that VCs must invest in deals that have a giant outcome.

These big outcomes not only provide great returns to the fund, but they also help cover the losses of the high number of failures that high-risk investing attracts.

A small number of investments

Although VCs have large sums of money, they typically invest that capital in a relatively small number of deals. It's not uncommon for a VC with $100 million of capital to manage less than 30 investments in the entire lifetime of their fund.

The reason for this is that once each investment is made, the partners must personally manage that investment for up to 10 years. While money is often plentiful, the VC's time is very limited.

With such a small number of investments to make, VCs tend to be very selective in the type of deals they do, typically placing just a few bets each year.

Regardless, they still may see thousands of entrepreneurs in a given year, making the probability that an entrepreneur will be the lucky recipient of a big check pretty small.

The most common check written by a venture capital firm is around $5 million and is considered a "Series A" investment. It's relatively uncommon for these checks to be the first capital into a startup. Most startups begin with finding private investors in friends and family, then angel investors, and then venture capital firms or other financial institutions.

Depending on the size of the firm, VCs will write checks for as little as $250,000 and as much as $100 million to private companies. The smaller checks are typically the domain of angels, so VCs will only go into smaller sums when they feel there is a compelling reason to get in early at a startup company.

Favored industries for venture capital

VCs also tend to migrate toward certain industries or trends that are more likely to yield a big return. That's why it's common to see so much venture and angel investment activity around technology companies because they could be a huge win for private investors.

Conversely, other types of industries may yield great businesses, but not giant returns for private investors. A landscaping business, for example, may be wildly successful and profitable, but it's not likely to generate the massive return on investment that a VC needs to make its fund work.

The other reason VCs tend to invest in a few industries is that that is where their domain expertise is the strongest. It would be difficult for anyone to make a multi-million dollar decision on a restaurant if all they have ever known were microchips. When it comes to big-dollar investing, VCs tend to go with what they know.

VCs know that equity investments are a big risk, for every 20 they make, only one will likely be a huge win. A win for a VC is either one of two outcomes – the company they invested in goes public or has enough growth to be sold for a large amount.

VCs need these big returns because the other 19 investments they make may be a total loss. The problem, of course, is that the VCs have no idea which of the 20 investments will be a home run, so they have to bet on companies that all have the potential to be the next Google.

Unlike a bank that takes all interested customers, VCs tend to be far more selective in who they take pitches from. Often these relationships are based on other professionals in their network, such as angel investors who have made smaller private investments in the company at an early stage, or entrepreneurs whom they may have funded in the past.

VCs will expect entrepreneurs to be very buttoned up. They are writing big checks to a small number of companies, so they have the luxury of only investing in well-prepared businesses with solid business plans.

While some VCs will in fact take pitches from an unsolicited source, it's the best bet to find an introduction through a credible resource. The VCs are the big leagues in terms of private investors, so founders will want to make sure they do everything to make the most of their time in front of them.

d. Private equity firms

Private equity is a type of investment typically reserved for companies that have already grown to a larger size and are looking for a particular growth or exit strategy that isn't available through traditional equity financing.

When private equity makes sense

Most startups or small businesses have little use for private equity. Technically, venture capital is considered private equity, but for the purposes of this explanation let's leave venture capital out of it.

A startup with just an idea is likely way too early for private equity. Typically, private equity firms are looking for later-stage companies that require much larger sums of money, usually at least $5 million, in businesses that already have some sort of assets to leverage.

For businesses with existing revenues or assets, again usually north of a few million dollars, private equity becomes an interesting option for business funding.

Private equity is valuable to businesses that may have a strong operational profile, but don't have the high return growth prospects of a technology startup or some other trendy investment type.

How private equity works

Private equity firms pool their money from Limited Partners (LPs), who tend to be pension funds, insurance companies, high net-worth individuals, and endowments. The LPs invest in a private equity fund in order to employ a management group to seek out high-yield investments on their behalf.

Unlike venture capital firms that make big early-stage bets that they hope will have an enormous return when the company explodes with growth, a private equity firm bets a little less on speculative growth and a little more on demonstrated growth or opportunity.

The focus of the group is to purchase a company that they can either IPO, sell, or generate cash returns on. The private equity group is essentially betting on the fact that the asset is worth more in the future than it would be worth presently.

This may mean providing more operating cash, providing the owners with liquidity (buying the business from them), or potentially orchestrating a merger or acquisition that will generate more value.

Working with a private equity fund

There are all sorts of private equity funds, from those that do small deals at or below $5 million invested to those that manage multi-billion dollar deals. In each case, they are looking for existing assets that could be better positioned with outside capital.

Working with a private equity fund will require a great deal of preparation and diligence, to say the least. At the point in which private equity gets involved, the finances of the business will be the central component, so the founder knowing the numbers inside and out will be critical since private equity is less focused on the vision and more focused on the numbers, that may not necessarily align with the business growth.

Advantages and disadvantages of working with private investors

First, it's important to acknowledge that raising capital is a difficult, demoralizing, and long process — that sometimes ends with no payout. So before raising capital, founders should spend a good amount of time and energy asking themselves whether they really need to raise capital. If the answer is yes, they should also explore raising all types of capital, things apart from equity financing, from potential investors with private investments to financial institutions, including financing options like small business administration loans.

With that said, here are the advantages and disadvantages of raising the three main financing options of private investment that a startup would likely seek.

a. Friends and family

Advantages of working with friends and family

The biggest advantage of raising money from private investors like friends and family lies in the fact that a founder already has an established, trusting relationship with these people. That means they're easier to get a meeting with, more inclined to say “yes,” and are more likely to be flexible with their expectations and timeline.

The structure of the investment will also likely be simpler than the structure of an investment obtained through more formal means. Founders borrowing from friends and family don't have to worry about long, complicated applications like they would with large financial institutions.

Disadvantages of working with friends and family

However, despite those advantages, there are many reasons why an entrepreneur may not want to invest with friends and family members and focus more on traditional financing options like equity financing, or even looking into small business administration loans.

The number one reason? Introducing large sums of money into a relationship that was previously entirely personal has the potential to ruin that relationship.

That's a particularly big risk if a startup fails — as most do — and investors lose all of their investment. It's important for founders (and small business owners) to be very clear about the potential for loss when accepting business funding and investment money from friends and family.

Friends and family members also may not be able to add value to a company in the same way that more formal, established private investors can.

Venture capitalists, for example, typically invest in startups in fields that they are familiar with. Having that kind of knowledge on board is a huge advantage for any new company looking for private funding.

b. Angel investors

Advantages of working with angel investors

One big advantage of working with angel investors is the fact that they are often more willing to take a bigger risk than traditional financial institutions, like banks.

Additionally, while the angel investor is taking a bigger risk than a bank might, the founder is taking a smaller risk, as private funding from angel investments typically doesn't have to be paid back if the startup fails.

As angel investors are typically experienced business people with many years of success already behind them, they bring a lot of knowledge to a startup that can boost the speed of growth.

Many startup founders are learning everything from scratch, so having that kind of knowledge on the team is a huge advantage.

Disadvantages of working with angel investors

The primary disadvantage of working with angel investors is that founders give up some control of their company when they take on this type of private investment.

Angel investors are purchasing a stake in the startup and will expect a certain amount of involvement and say as the company moves forward.

The exact details of how much say the angel investor gets in exchange for their investment should be outlined in the term sheet.

c. Venture capitalists

Advantages of working with venture capitalists

Similar to angel investors, private investors such as venture capitalists also come to the table with a lot of business and institutional knowledge.

They're also well-connected with other businesses that may help a new startup, professionals that a startup might want to take on, and — obviously — other potential investors.

Disadvantages of working with venture capitalists

Also similar to angel investors, part of what venture capitalists want in return for their investment is equity in a startup.

That means that a founder gives up part of their ownership when they bring on venture capital.

Depending on the deal, a VC may even end up with a majority share — more than 50 percent ownership — of a startup. That means the founder (or small businesses) essentially lose management control of their company.

Where to find private investors

Finding private investors depends on the type of investor a startup is looking for.

We're not going to go over family and friends, because that's obvious, and we're also not going to go over private equity, for all of the reasons outlines above.

But let's take a look at the other two main types of private investors.

Where to find angel investors.

The first place most people recommend finding angel investors is through a founder's own network. Personal connections are always a good move when a person is asking someone to invest a lot of money and trust.

However, not everyone has networks that include very wealthy individuals — or even friends of very wealthy individuals.

In that case, there are a few resources available.

Websites for accessing angel investors:

• Angel Capital Association

• AngelList

• Angel Investment Network

• Funding Post

• Gust

Angel investor events:

Another way to connect with angel investors in person is at investment events.

Many of these events take place in the Bay Area, which makes sense — Silicon Valley is still the hub of tech startups.

But if a founder can't travel to San Francisco, it's worth searching “angel investor events” and the region a startup is located in for events closer to home. However, it may be necessary to travel to a nearby city.

Where to find venture capitalists.

The first step to finding venture capital is to make a smart introduction to the venture capital firm the founder is interested in meeting. Venture capitalists rely heavily on trusted connections to vet deals.

Founders shouldn't try to contact as many people as possible; they should try to find venture capital firms that are the best possible fit for their deal.

The more closely aligned the founder is with the needs of the venture firm, the more likely they'll find venture capital firms willing to write them a check.

Founders should do extensive research both online and through existing networks ahead of time in order to determine what types of investments a firm makes, as well as whether or not they have any connections with that firm.

Every pitch to a venture capital firm starts with an introduction to one of the private investors at the firm. It helps to know the exact profile of a venture capitalist to know which level of introduction makes sense.

Typically it starts with an introduction to an associate and then founders can work their way up to the full partnership.

How to get private investors to commit

Getting a commitment from a private investor relies on the strength of a founder's pitch. But the pitch process starts long before a founder finds themselves standing in front of the investor with a pitch deck with cold outreach, and networking opportunities through personal or business connections.

The initial approach is slightly different for angel investors and venture capitalists. Simply put, venture capitalists are in the business of funding companies — angel investors are not.

As a result, most VC firms have a documented process founders should follow in order to guide their approach. In contrast, founders approaching angel investors can follow the process outlined below.

Founders interested only in information about VCs can skip down to the “pitch deck” section.

Be prepared

The time for a founder to get all of these materials together is before they decide to start reaching out to private investors like venture capital firms and angel investors.

The investors are going to assume the founder is ready to go and is well-prepared.

Stalling for weeks to scramble to put materials together after a founder's been requested to pitch is not going to end well, so be prepared.

The elevator pitch (for angel investors and VCs)

The first thing a founder needs to send to angel investors is an elevator pitch. The elevator pitch isn't a sales pitch.

It's a short, well-crafted explanation of the problem a startup solves, how they solve it, and how big of a market there is for that solution. That's it.

Founders don't need to “sell” the angel investor in the introduction. The opportunity should speak for itself.

For more information on email pitches, read “How to Create the Perfect Email Pitch.”

Have a pitch profile ready (for angel investors and VCs)

These days just about everything is done through email, which means just about everything is also available online.

Sending an elevator pitch along with a 20-megabyte PDF document is a surefire way to never even make it past an investor's spam filters.

Instead, founders should send a link to their pitch profile, which is an online profile that explains a little bit about the deal and provides a way for private investors to request more information.

Founders can also create a funding profile on Fundable.com. It only takes a little while and is an easier way to provide a reference back to a company profile than messing with attachments.

The first response (for angel investors)

When and if the angel investor responds to an email, the founder will either get a short “no” or a request for more information.

Most angels will request either an executive summary or a pitch deck which is pretty similar. The angel investor isn't interested in finding out as much information as possible about the deal at this point, just understanding it is a viable business venture and has the potential to deliver a profitable return.

In fact, they are looking to find out as little information about the deal in order to determine whether or not they want to spend more time with this company and its founder.

It's not a good idea to inundate the investor with every last piece of information ever collected for fear of them “not seeing everything.”

They are likely reviewing a dozen other deals at the same time so they couldn't review a tome of knowledge, even if they wanted to (which again, they don't).

Founders should simply let them know that more information is available upon request.

Executive summary (for angel investors and VCs)

The more traditional request from an investor is to ask for an executive summary. Over the past decade, this has become less and less common, with most preferring a pitch deck.

Founders can expect the angel investor to jump to the one section they're most concerned about, read a couple of paragraphs, and then maybe look a little deeper.

They figure the founder will answer most of these questions in the pitch meeting, so they're not going to spend too much time on the documents.

Pitch deck (for angel investors and VCs)

A more likely request is that the founder sends over a pitch deck. A pitch deck will also be required when pitching to venture capitalists.

A pitch deck is essentially a business plan or executive summary spread across 10 to 20 slides in a PowerPoint document.

Here is a breakdown of how to create a pitch deck: How to Create an Eye-Catching Pitch Deck

Investors like pitch decks because they force the entrepreneur to be brief, and hopefully use visuals instead of an endless list of bullet points. The pitch deck is the founder's friend and most trusted ally in the angel investor pitch process.

They'll use it as their main collateral item to get meetings, it will be the focal point of their meetings, and it will be what investors peruse after meetings.

The pitch meeting (for angel investors and VCs)

Once the investor has reviewed the founder's materials and determined they are interested in meeting with the founder, the next step is to arrange a time for a pitch meeting.

For angel investors especially (but for VCs to some degree as well), the pitch meeting is more about the investor liking the founder as a person than it is just pitching the idea.

Founders should take a little bit of time to try to establish some rapport. Investors will more often invest in an entrepreneur they like with an idea they have some reservations about than an idea they like and an entrepreneur they think is a jerk.

During the pitch, the founder will run through their pitch deck and answer questions. The goal isn't to get to the end of the pitch deck in 60 minutes or less.

The goal should be to find an aspect of the business that the investor actually cares about and zero in on that point. If the investor wants to spend 60 minutes talking about the first slide, the founder shouldn't rush them.

There are no points awarded for presenting the 20th slide. Focus on the conversation.

The business plan (for VCs)

Venture capital firms don't actually read business plans, but they sure are glad when founders have one. Business plans aren't really about the document itself — they are about the planning that goes into composing the document.

It's highly unlikely that founders are going to get asked to submit a full business plan to a venture capital firm, but it is likely that they'll be asked all of the hard questions that could be answered in the business plan, so putting one together is a great exercise in preparation.

Luckily, we have Bizplan's business planning software to help you with this step.

The financials (for VCs)

Of all the documents that a founder is going to be expected to be armed with, the financials are the most important.

Most venture capital firms are going to expect a reasonable four-year projection of the income and expenses of the business.

They'll want to know how quickly founders will be able to get the business to break even. They'll want to know what founders intend to use their money for. And of course, they'll want to know how founders intend to give it back to them with a healthy return.

Founders should be prepared to provide an income statement, use of proceeds, and breakeven analysis at the very least.

Due diligence (for VCs)

The last item is kind of a catch-all that we'll call “due diligence.” When the venture capital firm gets more interested in a deal, the next phase of discovery is called due diligence.

During this phase, they will dig into all the details of the business, from financials to the details of how the business model works.

This is where all of the research and support the founder has put together will be put to the test. They're likely going to ask founders to prove how they arrived at the market size they're going after.

Founders may get asked to have their early customers talk to the venture capital firm. Assume the firm is going to do its best to make sure everything the founder said actually checks out.

The goal of the Private Investors' pitch process

The goal of the first few meetings isn't to “close” the private investor, it's to establish a relationship that will naturally lead to a close.

Founders should be themselves. They should represent the opportunity and their passion for business. That is all they need to convince private investors to do a deal.