Are You Actually Looking for Venture Capital?
Updated: Aug 24, 2021
I hear a lot of people say they want to raise VC money but…sometimes they’re actually looking for friends and family or angel investors. Or sometimes early-stage founders try to pitch private equity firms.
These terms aren’t interchangeable—and these are very different types of investors. I often see this lead to confusion on both sides, so let's take a minute to clarify.
First, “VC” stands for “venture capital” and refers to a firm that has raised one or more funds (pools of money) with the specific purpose of investing in a bunch of startups. But not all investor money comes from VCs. Here’s the general landscape:
Friends, family, and fools
Incubators, accelerators, etc.
Rewards and equity crowdfunding
Venture capital firms
Let’s walk through each, but first let’s talk about portfolio theory. Professional investors estimate that every ten companies they invest will have seven failures, two moderate outcomes, and a single home run. That tenth one—the home run—will make up for all the other losses in the portfolio.
Since no one knows which startup will succeed, it’s important to invest in all ten in order to make a profit. It helps if you choose each investment carefully, and if you help each company as much as you can. That being said, VCs are expecting some of their investments to simply not work out.
Amateur investors only invest in one or two companies, and are therefore way more likely to lose all of their money. They're also likely to be more upset if things don't go well.
It's important to get the words right so that you know you're talking to the type of investors who's most likely to be interested at your stage.
1. Friends, Family, and Fools
This is exactly what it sounds like. You may just have an idea, and you probably don’t have much revenue and/or user growth (“traction”). These are people who believe in you personally and are willing to risk a bit of capital.
These investors may or may not be sophisticated. Keep in mind that they probably have money precisely because they don’t like throwing it away. I like to make sure that I can actually pay these people back if things don’t work out, because money stress can sour relationships.
2. Incubators and Accelerators
These are boot camps for startups that include training and strategy from people who’ve done it before. They may or may not provide funding. They often take an equity stake (although sometimes they don’t). These may be structured 12-week programs—or arrangements where you can work out of a space and receive support indefinitely.
You’ll receive mentoring sessions, introductions to investors, and a ton of networking opportunities. You’ll also be invited—and sometimes required—to work out of a shared space.
3. Rewards and Equity Crowdfunding
Rewards crowdfunding refers the Kickstarter and Indiegogo business model, where people pre-buy your product and maybe some perks or bonuses. There's no stock ownership in rewards crowdfunding (only rewards).
Equity crowdfunding mean that you're selling shares of your company to investors. Popular projects are able to find a diverse pool of shareholders this way. One drawback is that startups miss out on having a single experienced investor who can help coach the founders.
When we raised our $2M Series A, for example, a partner from the VC firm joined our board. This was a guy who had built his own company, taken it public, and helped many other startups during his 10-year VC career. He helped us navigate ups and down on our way to being acquired—and we probably couldn't have done it without him.
If you want to do equity crowdfunding, consider also finding a lead investor for part of the raise. This can give you the best of both worlds.
The most successful crowdfunding campaigns—both rewards and equity—bring their own eager mailing list and often have a few "whales" ready to place large orders in the first few minutes. This drives momentum and builds buzz, which draws in strangers from across the Internet.
4. Angel investors
Professional angels invest small amounts of money in a bunch of different companies. They are using the same portfolio theory as the VC firms (at least 10 carefully selected startups), but with lower dollar amounts—because they're investing their own money vs. raising pools of other people's money like VCs do.
An angel's initial investment gives her a seat at the table for future funding rounds at successful companies. She may or may not join the board or help coach the founders.
Smart angels will also keep some “dry powder” that they can use to buy more of the winners in later rounds. For both angel investors and VCs, they may actually make most of their money this way. For example, Andreessen Horowitz invested $10M in Clubhouse's Series A and then invested another $100M in their Series B—because they saw they had a winner.
5. Venture Capital Firms
VCs are firms made up of successful entrepreneurs who mostly invest other people's money plus a bit of their own. They also understand portfolio theory. They look at a ton of pitches but only make a few investments, partially because they want to be involved in the startups they work with.
They’re holding out for the best, so your company needs to be one of them.
One typical misunderstanding, and what prompted me to write this article, is entrepreneurs often think that VCs want to invest in their idea. Maybe. But it’s more likely that they want to invest in your working business that's already growing exponentially. VCs are often interested in startups that are more than just an idea. The more traction you have, the more appealing you'll be to investors.
We can think of startups as having two main phases: a) building the rocket, and b) putting more fuel in the rocket to go farther faster. Building rockets is more risky because lots can go wrong. Think of how many rockets Elon Musk has accidentally destroyed over the past decade.
If you're idea stage—still designing and building your rocket—you may want to talk to friends, family, and fools; accelerators; angel investors; and early-stage VCs.
Many VCs are looking for slightly later stage companies—where they want to add rocket fuel to the engine you’ve already build.
And VCs want to believe that you can hit it big. I asked one of my investors about this and he said:
“I only invest in companies I think can IPO, because that’s the real win for me. If I can’t envision the IPO then I’ll pass. Granted some of my companies get bought, but I’m always thinking IPO from the beginning.”
VCs also expect your company to take multiple rounds of money. For example, a VC fund may raise a $100 million fund but only put $1 million into your series A. If they put the same amount into 9 other companies that's "only" $10 million.
What do they do with the rest of the $90 million?
Let’s say your company goes on to raise a $10 million series B. In this case your VC fund may put in another $5 million and ask you to find other investors for the rest. Your series C may be $30 million, of which they contribute $15 million. So now they’ve put up $21 million of the $41 million you’ve raised.
If they repeat this exercise with their winning companies, they’ll spend the $100 million. But they want to see you succeed with $1 million first—before they give you more money.
They’ll assume you’re one of the seven failures until you prove them wrong.
6. Strategic Investors
This is money from larger businesses who are interested in your technology or customer base. Strategic investors are a double-edged sword. On the plus side they can give your business a turbo boost. On the negative side they have an agenda, often want a seat on the board, and can therefore try to steer your company in a way that's beneficial for their corporate strategy. This is especially difficult early in your startup's lifecycle. Later, once you have momentum, it's easier to stick to your guns.
When we were pitching for one of my companies we almost took money from a video conferencing provider (this was long before Zoom) rather than VCs. They wanted a way to share presentations over the Web and we were doing exciting stuff.
It was our first round, so we decided to wait before bringing on strategic investors. We took the VC money instead.
7. Private Equity
These are later-stage investors who want to take over successful businesses. They are looking for cash flow, and you'll hear them say things like, "We want to see at least $2 million in EBITDA."
They usually provide an exit where entrepreneurs take money off of the table. In return, the private equity firm takes a controlling interest and does fun things with the balance sheet like piling on debt in order to pay themselves. Founders are okay with this because they get to put a big chunk of money in their bank accounts while still retaining a minority interest.
I sometimes see early-stage founders pitching private equity (PE) firms—which is usually confusing for everyone. It doesn't help that PE firms don't always clearly label themselves. Instead they'll say things like "We invest in mid-market companies" and "Growth equity solutions" that mean nothing to first-time founders.
One main takeaway is that VC firms are very different than PE firms. They aren't interchangeable.
So that’s the investor landscape. Now you know who to reach out to when you're raising money for your startup.
It may take a while to learn who your target investors are and where to find them. Different investors focus on specific industries, company sizes, geographic areas, etc.
You'll probably pitch the wrong investors at first—and that's fine. It's always great practice, plus you can learn something from everyone.
Just to set your expectations, we pitched 40 investors and they all said no. This went on for months...and then all of a sudden three investors said yes at the same time.
It wasn't because we got lucky. Instead, it was because we kept practicing our pitch and improving our business. We also figured out the right type of investors to target.
Good luck out there!
Join my free Q&A session if you have questions or want further guidance.
Mike Lingle is obsessed with helping founders grow their businesses. He's a serial entrepreneur, mentor, and executive in residence at Babson College and Founder Institute. Check out Rocket Pro Forma if you want to quickly create your financial projections.