Platt Perspective on Business and Technology

Understanding and navigating burn rate: a startup primer – 10: the cash-flow implications of having outside investors – 2

Posted in startups by Timothy Platt on November 6, 2011

This is my tenth installment in a series on resources, cash reserves and cash flow for startups and early stage businesses (see Startups and Early Stage Businesses, postings 67-75) and my second in that to focus on the impact of a decision to bring in outside investors (see Part 9 for the start of this portion of the overall discussion.)

At the end of Part 9 in this series I made note of how startup and early stage business founders and owners tend to think of angel and venture capital investors in terms of increases in available cash they can provide. That is an important piece to the puzzle in understanding these potential stakeholders and participants in a new venture. But I am going to discuss angel and venture capital investors from a wider perspective here, looking at:

• How they do their own due diligence in deciding where to invest,
• How they manage and seek to limit their risk exposure where they do decide to invest, and
• The impact of these processes on the business and its founders and owners when they accept these types of outside investor support.

I want to address these points at least in part by disentangling angel investors and venture capital investors from each other, at least briefly outlining how they both differ and share similarities.

• Angel investors tend to gravitate towards earlier stages in new business development than do venture capitalists, as they both review startups and early stage businesses for potential investment opportunities.
• Angel investors tend to invest smaller amounts of up to perhaps a few hundred thousand dollars in any given business venture. Venture capitalists usually start investing at a minimum that is above the level that an angel investor would commit to as a maximum. Venture capital investors at least by current practice generally start with at least a half million dollars on the table.
• Angel investors are perhaps more likely to invest in the idea or concept that a startup would develop into a unique value proposition. Venture capitalists may focus on specific industries or other specific areas that interest them and in which they have expertise when they make investments (e.g. in a field like biotechnology or green technology, or an arena like social media). But their focus tends to be much more on the investment potential per se and little if any on the dream that the founders would realize.
• Both conduct due diligence research but venture capitalists do much more through and detailed analytical research so as to know what the potential upsides and down-sides are, and what the risk levels would be.
• Venture capitalists seek out more control, and as a means of specifically reducing their investment risks. That can and frequently does mean their putting specific functional experts in place in the business as requirements for their participation, and to help them meet their risk management needs (e.g. such as an early stage business specialist chief financial officer.) Venture capitalists often want board of directors oversight through membership in that body too.
• Venture capitalists invest more and they want more back in return.
• And both, and venture capitalists in particular prefer to get their returns on investment quickly and that places significant constraints on the strategic planning and operational development of any venture they enter into.
• I will add that angel investors might not generally seek to have a direct voice in the planning and development of a venture invested in but venture capitalists do and certainly since the first dot-com bubble burst.
• And angel investors often go in first with venture capital types following, with ventures of interest bringing in two (or more) rounds of outside capital infusion support.

The founders and owners of record of a new venture need to start thinking like the outside investors they would bring in, and with an acute awareness that their impact would have on the venture and its development, and on the level of control they will be able to retain.

• How much and what types of control would have to be relinquished? There, what types of decisions would have to be made co-jointly with these outside investors? And what types of decision, if any, would the founders simply have to turn over to others to make?
• How much potential return from the venture would they have to relinquish, and of that how would it be calculated and for what stages in the business’ development? Would this mean a percentage of revenue brought in as the business starts to bring in revenue, or as it goes cash flow positive and is earning profits? Would it be necessary, at least as some performance benchmark is reached, to pay back one or more fixed amounts as investment dividends?
• What contractually specified time frames are going to be set in place?
• And should a venture’s founders look to obtain outside capital as business development support once, for dealing with some specific challenge, or should they plan in terms of more than one round of such investments? That can mean starting with angel investor participation as noted above, followed by a transition into venture capital investments support. And that can come in more than one round.
• What are the cumulative effects and limitations to founder and owner decision making that all this would impose upon them?

This all has to be thought through in the specific terms of the business venture planned and in how that plan is or is not working. This all has to be thought through with the needs of the founders and owners in mind. This all needs to be though through with specific potential angel and/or venture capital investors in mind and with that based on solid research for identifying those who might be appropriate and interested – and on how best to approach them.

As a final thought here, angel and venture capital investment and participation are often thought of and discussed as a specific category of exit strategy that startup founders and owners can plan and build towards. I am going to turn in my next series installment to specifically discuss exit strategies as they connect into this general topic of resource bases and cash flow.

You can find this and related postings at Startups and Early Stage Businesses.

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