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More in the 50 Questions Series50 questions: Where do VCs get their money from | How does the structure of the VC industry impact investment strategy? | 50 questions: How does a VC estimate market size? |
What exactly is an “investor”?
In my conversations with entrepreneurs, I have discovered time and again that there is confusion over the term “investor”.
So to kick off this series of 50 questions you should ask when raising venture capital, written jointly with Nic Brisbourne of DFJ Esprit, I thought I’d start by taking an even bigger step back and asking what is an investor in the first place.
An investor invests
invest – verb, transitive apply or use (money), especially for profit
An investor puts money behind an idea, a project or a company with the hope of making a financial return. The problem facing entrepreneurs is that there as many different types of investors as there are investors.
Actually, it’s not quite as bad as that, but there is a wide spectrum. To understand that, let’s take a very quick dive into the concept of risk/reward.
The risk/reward trade-off
The concept should be familiar to anyone who has ever taken a punt at the bookies. Bet on a horse at 100 to 1 and you’re likely to lose everything. Bet on the odds-on favourite and you’re likely to get something back. But the return is low and, for some people, not worth the bother.
Most professional investors are investing other people’s money, so they cannot be cavalier about placing everything on one throw of the dice. So they expect an appropriate level of reward for the risk they are taking.
To take some extremes:
- A bank that lends your business money doesn’t get any upside if you turn out to be the next Google. They just get their money back, plus interest. They are not terribly interested in your massive growth prospects; they want to make sure that they will definitely get their money back and that you won’t go bankrupt on the way. The return they are looking for is 1x, plus interest.
- Early stage venture capitalists like Kleiner Perkins or Sequoia Capital aren’t interested in safe bets. Their business model is to invest in companies that are swinging for the benches. They are looking for companies that are going all out to create or dominate a sector, or both. The problem with aiming for home runs is that you leave yourself very exposed. This style of venture capitalist expects many of its investments to go bust, but some to become the next Amazon, Google, Electronic Arts or Zynga. The return they are looking for is 5-10x.
- In the middle of the risk spectrum, you might find a private equity house that aims to invest £25m minimum in each transaction. They will be looking for profitable companies with predictable cashflows that can take substantial debt on its books to improve the returns for the private equity house. The return they are looking for is 3-5x.
These examples are obvious, but let me give you some others:
- An angel who wants to invest up to £500,000 in up to ten early stage businesses, but is not hoping for home runs. He expects companies to aim for a balance of risk and reward (although angel funding is often the riskiest of all, so many angels actually want home-run potential as well).
- A venture firm funded by the family money of an overseas billionaire, investing in projects that the billionaire finds interesting.
All of these, and more, exist in every investment hub in the world.
Know your investor
As we continue through our series, we will start to help you think about what questions to ask a VC when you are interviewing them to offer them the opportunity to invest in you. (I meant what I said there: never forget that a VC needs to invest just as much as you need capital. Raising money is a two-way interview).
We’ll talk about the source of their money, the lifetime of their fund, their investment horizon and capabilities, their exit expectations and their structure.
But for now, just remember that there is no such things as a “standard” investor. All investors are different, and it behooves all entrepreneurs to spend some time finding out exactly what makes your potential investor tick.
Hungry for more? Go to the 50 questions homepage for more insights into venture capital.