Understanding the different types of equity investors
In this module, we look at the small but helpful industry of angel investors and venture capitalists in South Africa. In particular, we look at understanding more about what they do, and what they look for to make an investment decision. This information will help you prepare yourself to make an application to these investors.
These investors are really picky about which companies they invest in, as they want to know that their hard earned money is well spent and will earn lots of interest. If you've ever watched the Dragon’s Den TV series, you’ll already have a good idea of how fussy investors can be.
How equity investments work
Angel investors and venture capitalists work in very similar ways, they just invest in different types of companies.
So let’s explore how they work and what they would expect from the small business they invest in:
- They want to make money. Whilst you might be able to convince investors to part with their hard earned cash, never forget that they expect to be paid back and with good interest rates.
- Investors take calculated risks. Unlike banks that have a low tolerance for risk (which is why they are keen for you to provide collateral), venture capitalists and angel investors look for businesses that have the potential for rapid growth. Since they give cash in return for a share of profits, high growth is the only way that they can make a return on their investment. Should you pass the initial screening, investors will conduct a “due diligence” on your company, so you need to have records and financials in place for them to check. Their aim is to get to know your trading and operational history, how cash is managed and understand the full potential of the business.
- They invest for a fixed period of time. When you receive equity funds, the contract will state the duration of the investment and how and when it must be paid back. In general, angel investors (seed funding) like to exit (get their money back together with interest) within 2 to 3 years. Venture capitalists generally invest for a 3 to 5 year period. Private equity for listing purposes are considered to be long term investments but investors are free to sell their shares at any point.
- They own shares in your company. Investing in small businesses is extremely risky. Did you know that more than 80% of small businesses in South Africa fail in the first two years of operation? So, investors are very fussy about which businesses they will invest in and when they give you money they will take a percentage share of your company. The percentage share of the company owned by the investors is determined by the overall value attached to your business. By owning shares in your company they are fully entitled to management feedback. In fact, most investors and particularly angel investors will insist on having seats on your board of directors. That way they get regular feedback on how their money is being spent and have a say in the decision making. Some investors not only sit on the board of directors but become directly involved in mentoring the business owner, however, this is the exception rather than the rule.
- They expect to be paid back. So, you have the money for a fixed period of time and the aim is to use it to grow the business so that you earn enough revenue to be able to buy back the shares from the investor, or receive a second round of funding from new investors that will buy out the first round investors and still leave cash over for expansion. The shareholding agreement sets out the conditions of this exit sale and the expected interest rate that applies. This sounds fine in theory, but sometimes businesses don't grow at the expected rate.
- Angel investors. Angel investors work with you if you are hitting problems. After all, they want to protect their money. If the business still has great opportunities to grow, they may help you find venture capital funds to take the business to the next level. If both of these options fail, then the business will be closed and money lost. Depending on the terms of the investment contract, you may find yourself owing a lot of money, particularly if you have signed personal surety for the loan. If it gets to this point, make sure you have professional help to protect your personal assets as far as possible.
- Venture capitalists (VCs). Like angel investors, venture capitalists would have been monitoring your progress from day one and will try to help you turn things around. If they believe that there is a good chance of improvement, they may elect to extend the term of the loan, if not they may liquidate the company and cut their losses. Either way, seek professional help if things are not going according to plan to make sure you are protected as far as possible.
A key point to remember is that whether you receive angel or venture investment, decide beforehand on the type of involvement in the day-to-day management of the company that the investor can have.
Secondly, identify where it would be useful to have input from a highly experienced entrepreneur. Both these points will help you identify the best investor for your company.
How venture capital funds work
A venture capital firm can have more than one fund, each of which has a limited lifespan.
Each fund could have a specific directive, concentrating on:
- A certain industry sector, such as biotechnology.
- A certain stage of investment.
- A type of business.
A fund will be established and remain open to make new investments for a duration of time (for example two years), after which it will close and no new investments will be made. The fund will then manage those investments to maturity. Venture capital funds will typically want to cash in on their investment after a few years, and very few funds would be willing to hold their investment for longer than five years.
What equity investors look for
The list below shows the key factors that equity investors would be looking for. Realistically companies differ in their ability to perform strongly in all these areas. The bottom line for equity investor decision making is that they need to believe the company is capable of growth and that the presented plans will produce the profits they need in order to exit after a few years.
- Strong entrepreneurial characteristics and a great team: They look for experience, ability to execute, and leadership abilities to adjust to opportunities and threats. Bear in mind that both strong leadership and a strong team are required. You must have this in place, or at least have already identified team members that you can bring on board should you be approved for equity investment.
- Disruptive or innovative products: First prize would be companies with a product or service that is unique and presents a clear value proposition for its customers. They will also look at how the intellectual property is protected and how easy it is for companies to open up in competition. You must have thoroughly researched your competitors and be very clear on your unique selling point, and at least have some idea of how long it will be before competitors catch up to you.
- Large or growing market: The investors want to know that the company has large untapped pools of potential customers. They will be interested to know exactly how each market segment will be acquired, as well as the anticipated rate of growth. In the case of start-ups, you'll need to show exactly why customers will be willing to buy your product or service, and preferably be able to back this up with the results of pilot studies. If you are past the start-up stage and ready for growth, then you will be expected to show that your business has gained traction (that is, a good, strong user base) and how this investment will enable you to expand these markets.
- Existing clients: Angel investors are willing to look at small start-ups so they would not expect the company to have a large client base. Venture capitalists, on the other hand, will want to see the size, quality and value of the existing market.
- Profit potential: This is important because if the company has a high-profit margin and also understands how to grow the business and extend the reach, they will feel more confident that they will be able to realise a return on their investment in future.
- Scalable: Scale means the ability to very rapidly grow and increase margins. If you think about this, service businesses that rely heavily on people to execute/customise work or products that require a long, people-intensive sales cycle, are not good candidates for rapid growth and high margins. Technology companies that create automated products (e.g. mobile apps) are ideally suited to scale.
- Exit: Right at the start the investor will want to know that you understand the importance of the exit and the role it plays in building their business. Most equity investors invest for only a few years and then expect to exit. Obviously, their return on the investment in your company rests on your ability for growth and increasing profits.
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