Business loans aren't the only option when it comes to raising startup capital. Private investors are also a viable choice. Investors are a particularly helpful option for small business owners who don't have the cash to fund a startup or the credit profile to secure a reasonable loan.
A recent Guidant study found that cash, drawing from a 401(k) retirement plan, and borrowing from friends and family were the most popular ways to raise startup capital.
But friends and family aren't the only private investors at your disposal. Other types of investors are willing to help your business get up and running. Your enterprise's stage and industry will dictate which private investor type is right for you.
Whether you need money to open a dry cleaner or a cloud software company, here's how to find private investors for your small business venture.
What is a private investor?
A private investor is a person or company willing to invest their own money in your business. In exchange for backing your business idea, the investor gets equity or a cut of your sales.
Private investors run the gamut from individuals to venture capitalists. Banks or alternative lenders are not private investors.
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What are the types of private investors?
Private investors tend to specialize in specific stages of your startup. Some only want to invest in early-stage startups, while others go after more established players.
With that in mind, here's a look at the main types of private investors.
- Close friends and family: According to Gudiant's survey, 39% of business owners bootstrap their businesses using savings or a side gig. Once the company gains traction, many look for startup capital. Family and friends are a popular option at this stage because of the built-in trust that's hard to gain from private investors. "It's a natural way for startups to raise money," said Ben Johnston, COO at Kapitus. "A lot of people get passionate about what they are building and tell their friends and family about it."
- Angel investors: Angel investors are high net worth individuals who invest their own money in startups at the early development stage. These investors like to help companies get off the ground and will typically provide support in addition to capital.
- Venture capital: Venture capitalists work for investment firms and use company money to invest in startups. They have less skin in the game than angel investors. Still, they want to see the businesses they invest in thrive, so they usually provide support, networking and consulting along with capital. Some VCs even take seats on the board. VCs typically make longer-term investments in exchange for equity or convertible debt.
- Private equity: Private equity capital is typically reserved for more established organizations with millions of dollars in sales and assets to put up as collateral. If you're looking for startup capital for your small business you won't have much success obtaining funds from a PE firm.
How do private investors work?
Depending on the type of private investor, the process can be informal or formal. A loan from a friend or family member may call for a handshake, while a venture capitalist could require tons of documentation and paperwork.
Either way, the arrangement should be legal and binding, and you should be confident the investor is offering you a good deal. With that in mind, here's how each type of private investor works.
How does friends and family funding work?
Think of friends and family funding as a type of crowdfunding. Select family members and friends invest a small amount of money into your startup. Friends and family may invest in your business interest free, require an equity stake or other monetary reward to give you money.
The arrangements tend to be much less formal than taking out a bank loan, but you should put the agreement in writing. Your contract should lay out all the terms, including the repayment schedule. This precaution will protect both parties if something goes wrong.
How does angel funding work?
Angel investors target early-stage startups because these investors have extra money to invest. They are typically looking for higher returns than they would get from stocks, bonds and other investments.
Angel investors are typically focused on helping entrepreneurs start the business rather than helping it grow. These investors seek company ownership or convertible debt in exchange for the investment. Some angel investors will use crowdfunding platforms to make early-stage investments, while others create angel investor networks to pool their investment capital.
How does venture capital funding work?
Venture capitalists typically invest in startups operating in fast-growing markets and have the potential to be huge. They invest at different stages, sometimes alone or alongside other VCs.
The three main types of VC funding are seed, early stage and late. While VCs have a lot of money to throw around, they tend to invest in only a small number of startups. Getting venture capitalists' attention, as a result, can be challenging.
"For small businesses who aren't high growth, traditional equity investing doesn't make a lot of sense," said Nick Mathews, CEO of MainVest. But if you are planning to grow 100 times over the next five years and want to go public or be sold, VCs will want to hear from you.
What are the pros and cons of using private investors?
Like most things in life, working with private investors has pros and cons. Whether you're accepting money from friends and family or venture capitalists, you have to weigh these pros and cons.
Pros and cons of family and friend investors
Here are some key advantages of working with family and friend investors:
- Your investors already trust you.
- The structure of the deal tends to be simple.
- It's easier to secure financing from loved ones.
These are some disadvantages of working with family and friend investors:
- It could create family strife or ruin a friendship.
- Friends or family members may not be able to add value.
- All of your loved ones' investments could be lost if the business fails.
Pros and cons of angel investors
Here are some benefits to working with angel investors:
- Angel investors are willing to take risks when banks are not.
- They tend to have a lot of experience and are willing to impart it to you.
- You won't have to pay back the money if your business fails.
These are some of the drawbacks:
- The angel investor gets a piece of the business.
- You give up some control of operations.
Pros and cons of VCs
Here are some advantages of working with VCs:
- They tend to invest larger amounts of money.
- They have a lot of experience and institutional knowledge.
- VCs are typically well connected and happy to help you network.
These are some key disadvantages of working with VCs:
- You give up equity in the business.
- VCs have a say in operations, sometimes even seats on the board.
- If you aren't careful, VCs can end up with a majority stake in your company.
How do you find a private investor?
Private investors are everywhere; how you find them depends on the type of funding you want to raise.
- Close friends and family funding: For funding from friends and family, look no further than those closest to you. They likely heard about your idea already and trust you.
- Angel investors: Finding angel investors is a little trickier. The first step should be to tap into your business, social and industry networks. If you come up empty on the uber-rich individual front, there are other avenues to try. There are several angel investor networks, including the Angel Capital Association, AngelList and Angel Investment Network. These operations have websites that connect your startup with angel investors. Many angel investors also use crowdfunding websites to find startups.
- Venture capital: Securing venture capital can be challenging unless you're the next Facebook or Tesla. It's not impossible, but a VC relationship typically starts with an introduction. You can cold call VCs, but you shouldn't do this blindly. VCs specialize in different industries and varying growth stages. They also get a zillion pitches, so do your research before reaching out. "You really need to research what investors are in your space and take a look at what stages they invest in," said Katie Palencsar, investor and global head of Venture Studio at Anthemis. You don't want to waste time targeting a VC that doesn't operate in your industry or at the stage your business is in currently.
How do you pitch to a private investor?
Finding the right private investors is half the battle, but selling your business wins the fight. That's why Palencsar says it's important to have a well-thought-out business pitch at the ready.
"If anyone asks you what you want to do, you better be able to articulate the value proposition, why it's needed in the market, and what it looks like in 30 seconds," she added. "Make sure you really explain why you and your team are the ones to solve the problem."
What are some alternatives to private investors?
Raising capital from private investors takes time and effort, requiring you to put yourself out there and network with prospective investors. If that way of fundraising doesn't appeal to you, there are alternatives.
For example, the U.S. Small Business Administration (SBA) offers loans with long terms and low interest rates. Be aware that applying for an SBA or alternative loan requires a lot of paperwork and can take weeks before you receive funding.
The SBA and other lenders also offer microloans: small business loans of $50,000 or less. They tend to have less stringent requirements than a traditional bank loan.
Private investors are worth considering.
Raising capital is part of life for entrepreneurs, whatever the business. Private investors are a great way to shore up startup capital. You get not only access to cash – usually at favorable terms – but also the guidance and expertise of investors who know what it takes to grow an enterprise. That in and of itself can be priceless.