Investors and their Incentives

It is incredibly important to understand the incentives of investors when you are raising money. This used to be fairly easy – you raised money from Venture Capitalists who wanted to see a big return on their investment. The best of these investors were incredibly focused on doing the one thing they did well: investing in technology companies.

The world looks different now. There are a lot of different types of startup investors, each with a different approach to investing and different incentives for doing so. While they’d all prefer not to lose money, the differences in how their incentives and expectations are structured are critical in understanding how to decide whether or not to work with them, how to negotiate with them, and how to interact with them over the lifetime of your relationship.

Below, I’ve tried to highlight the key motivations and structures of each of the investors you are likely to encounter. While I haven’t attempted to catalogue all the ways in which the incentives of investors influence their behavior – sometimes to the detriment of the startup founders – this should work as a starting point to think through those issues.

One big incentive difference that I’ve chosen not to address here is preferred vs. common shareholders. That creates a whole other set of questions that is out of scope. Assume the investors below will hold preferred shares.

VC Firm
The classic startup investor that is primarily working to achieve returns for the funds they’ve raised from a set of Limited Partners. The partners at these funds are usually paid in two ways: they earn a % of the funds that they’ve raised and they earn a % of the return they make on the total fund from which they invest in you. These firms generally raise further funds based on the performance of earlier investments.

While investors make money off their management fees (the % of what they’ve raised), the big pay outs only happen when they return a multiple of the total capital raised. Because of how concentrated venture returns are, VCs generally invest only in deals which they believe will return all or most of their returns.

Angel [1]
Usually a wealthy individual who invests their own money in startups. Sometimes these are people that made money through their own startups. Sometimes they are coming from different industries, and sometimes they inherited their wealth. It can be useful to know which category of angel you are talking to.

Angels have become hugely important to early stage startups as the number of companies have grown beyond the financing ability of traditional funds. More importantly, the wide distribution of Angels has materially decreased the access barrier which founders face when raising capital.

There are a lot of different incentives at play for Angels. While many of them are hoping for huge financial returns, many also want to be able to brag about having invested in a hugely successful startup. What’s strange is that Angels often just want to brag about investing in startups, regardless of the success of those companies. Investing in startups has become a badge of pride in a lot of circles.

Though most angels invest as a part time activity, there is a wide range in the amount of time and effort they devote to investing. Knowing that they have other things on their minds should change how you approach and interact with them. You also need to understand how experienced they are, the size at which they invest, and how much time and energy they’ll actually spend on their investing.

At one end of this spectrum, you’ll find angels who are essentially small seed funds. They invest significant amounts of money in startups, and do so frequently. In the best case, these investors have a deep understanding of the companies in which they invest and can be incredibly helpful. These investors understand that they are likely to lose all their committed capital, understand the standard terms and instruments through which startups raise money, and are generally low maintenance.

At the other end of this spectrum, you’ll find small, inexperienced investors who just want to invest in startups wherever they find them. These investors will put a small number of small checks into whatever company they can get into. Because they are unfamiliar with how startups work, they are often hard to deal with and incredibly focused on the risk of losing their principal. These are investors you should avoid unless you absolutely need them.

Accelerator
Accelerators are, for the most part, a subset of VC firms where there are professional investors who raise funds from outside parties to invest in startups. They usually fund more companies than classic VC firms, and do so in batches. Similarly to a VC, most accelerators need to demonstrate return to investors to continue to raise funds.

Accelerators also have a non-financial incentive – they need breakout successes to prove that they are providing operational help to companies and actually “accelerating them.”

Syndicate

Syndicates come in a number of different flavors, but are generally groups of angels who come together to invest in a single deal. Usually, these syndicates have a lead who will be your main point of contact. This lead usually puts money at risk for a return and gets some sort of performance fee for the other funds that they bring into the deal.

Watch out for syndicates where the syndicate runner is taking a management fee on funds raised and is encouraging you to raise more money than you think is wise. Also, be careful with syndicates since you don’t know ahead of time who will invest in your company, and might find that one of the investors is a direct competitor who just wants some privileged information.

Crowdfunder
Any and all comers on the internet who pre-order an unbuilt item in the hopes that it will some day get built and be cool/solve a problem. They’re not expecting financial return, but do want regular updates on what’s going on with the project and when they can expect delivery. Hiding problems is a lot worse than transparently failing to deliver.