If I mention Silicon Valley, what do you think of? Tech? Google? Apple? Billionaires? How about venture capital? Or angel investing?
Venture capital is what made all those companies a reality. Okay, there was some innovation and hard work as well, but, without venture capital, those companies would still be a dream.
So what exactly is a venture capital? What is angel investing? And what is the difference between a venture capitalist vs angel investor?
If there is one thing the investment world likes more than money, it has to be jargon. However, terms such as venture capital, angel investors and seed money are easy to understand if we give them some context and look at some examples.
Angels, VCs (venture capitalists) and seed capital, are all part of the early stage investment arena. Before we dive into the nuts and bolts of the venture capital world, let’s take a step back and look at where this fits into the broader investment world.
Venture capital falls within the realm of private equity, and private equity is any investment in an unlisted company. If you buy shares in a company such as Google or Apple, you are investing in a public company. They are public companies because they are listed on a stock exchange. If on the other hand, you buy a share in any business that is not listed, whether it’s your friend’s Pizza parlor or the latest tech start-up in Silicon Valley – well that is private equity investing.
Let’s follow a hypothetical entrepreneur named Adam. Adam has decided that there’s a need for a social network for novice investors. He wants to build a network where investors can learn about investing, share ideas and join investment clubs.
The idea/seed stage:
Adam starts out by setting up a Facebook page and a basic blog. He reckons that if he can get 100,000 users, his business will be viable.
Adam has enough savings to keep him going for a few months. After that, he can probably borrow a little from friends and family. And then he can max out his credit cards. But what next?
He needs some capital to build enough of a product to test the market. This is called seed money and is used to ‘seed’ the idea. Angel investors are a common source of seed money.
Angel investors are often wealthy investors who have had a successful career or started and sold businesses of their own. They will often bring, not just capital, but experience and a network of contacts to the start-up. Angel investors invest from $30,000 to $500,000 depending on how much potential they see in the idea.
Very often, angel investors invest in businesses that have no tangible value. There is little if any revenue and no real assets. They are therefore investing in the potential of the product and the enthusiasm and experience of the team.
One of the most famous angel investors is Peter Thiel, who invested in Facebook in 2004. Yes, before most of us had heard of Facebook, he invested $500,000 for a 10% stake. He sold most of that stake in 2012 for close to $1 billion.
Adam meets an Angel investor and pitches his business plan. The angel sees potential, and more importantly, is impressed by Adam’s enthusiasm and drive. He agrees to invest $30,000 for a 30% stake in the company.
The goal for the seed stage is to get to the start-up phase, and then raise enough money to get the business off the ground. Adam’s initial combination of a blog and a Facebook page shows promising results. His audience reaches 100,000, and he uses them to do some market research.
He realizes he will need at least $300,000 to build a proper backend so that he can turn his subscribers into members of a network. He also needs money to advertise and reach more potential users.
An amount of $300,000 is too much for an individual investor. What Adam needs now is venture capital.
This beings us to the defining features between an angel investor vs. venture capitalist.
Venture capital funds are partnerships that pool money from more than one investor. They then invest that money in a portfolio of businesses. VCs invest in companies that have some proof of concept in place. There will usually be an alpha product and active users. The business might not even know how it’s going to make money, but it will know that there is demand for its product.
Google followed a typical investment process. Their first funding came from an angel investor who invested $100,000 in 1998. The next round of funding came in 1999 when two VC firms invested a combined $25 million.
For Adam to raise venture capital he needs to show that he is getting traction with his idea. His user growth will be the key number that a VC will want to see. They will also want to know how big the market could be.
The Angel investor introduces Adam to a VC firm, and together they pitch the business. They put together a slick presentation showing that Adam can build an audience and that there is demand from this community for a dedicated social network. The VC partners are impressed and agree to invest $300,000 for 30% of the company.
Once the company is up and running, there may be a few more rounds of financing to accelerate growth. During the growth stage, investment is used to expand the marketing effort and make sure that distribution systems are scalable.
Once a company proves it has a product that people will pay for, it becomes critical to grow market share as fast as possible. Why? Well just imagine if Adam stopped growing the after he had proven the demand for the product. A larger rival such as Yahoo or Google would step in and launch a competitive product. Adam would have done all the hard work, and given them their next big thing on a silver platter.
While the company might have a revenue stream at this stage, it may well not yet be profitable. Some venture capital firms specialize in this later stage of growth. Later stage investing offers lower returns, but with the benefit of lower risk.
Let’s face it, Adam’s investors are in it to make money. And at some point, they will want to cash out. This is the stage where investors and sometimes even the founders want to sell their stake and invest that money in something else. Like a yacht, an early retirement or another venture.
The most common exit strategies are an IPO or a trade sale. IPO stands for ‘initial public offering’ which is what happens when a company lists on an exchange. A trade sale occurs when a business is sold to a larger company in the same industry. Adam’s business might be attractive to Yahoo, Google or even Bloomberg.
Angel and venture capital investing are both types of private equity investments. Private equity funds also specialize in all sorts of other complex activities from leveraged buyouts to distressed debt and mezzanine finance. However, that is all a topic for another post.
Now you know how entrepreneurs access the funding they need to turn those dreams into reality. If you have the next big idea, it’s time to put a pitch together and get an angel investor excited enough to write a check.