There are so many confusing terms out there to define equity investors that I thought it would be helpful to put a little Six Minute Strategy around the problem. This blog topic turned into quite a long one so I have split it into three parts and these will be published successively, the second part on Friday 23rd September 2011 and the third part on Monday 26th September. As a follow up, on Friday 30th September, I will turn the problem round and give you an A-Z (in the form of 26 questions) of how to identify which investors are right for your business.
I have taken six base categories to work from
- My own 6MS classification
- Venture Capital
- Special Situations
The Six Minute Strategist Classification
I use a broad number of categories to screen investors so my six categories in this group are rather broad and deliberately so. I am trying here to create large groups which I can further refine. It is also part of my email and networking strategy (more about that in another post another time).
Note: in my contacts classification the F is the sixth of six classifications and covers the financial investor community.
My categories are:
F1 – Early Stage: these investors are typically referred to as Venture Capitalists (“VC”) (as opposed to Private Equity (“PE”)). Don’t be mistaken, for the most part they have the same attitude for risk – very little. In the US, the VC market is far more vibrant and the most successful firms are characterised by a long track record and staffed by many who have been successful (often serial) entrepreneurs themselves. They typically like to come in as the first “institutional” investor after seed and angel investors have eliminated some of the product related risk. Typically, they will not invest pre-revenue.
F2 – Mid Market: these investors are firmly in the PE camp. The mid market is defined by deal size and it is this primarily that separates them from the VC end of the market. These investors are looking for established businesses with strong management on whom to work their financial alchemy. The types of deals they do will be dealt with below but the enterprise value of the companies they look at can range from £10 to £100m. This is broadly the same in the US although the deal size range is probably larger.
F3 – Large Deals: this is not primarily my market, although I would be delighted if a significant opportunity came along. These PE boys play in the big league of syndicated leveraged buyouts. The deal sizes range from £100m upwards and can reach billions of pounds. It is important to know who these players are so that you don’t confuse them with we mere mortals. Offering a £10m buyout to one of these guys just tells them you don’t know the market. The flip side of the coin here is that as many of these financial gentlemen make exceedingly large amounts of money, they are sometimes prepared to make private early stage investments of a few hundred thousand (although the terms will probably be tough) and can therefore individually some times be regarded as F5 investors (see below).
F4: Small Deals: These investors are still primarily PE investors but investing in the £2m-£20m deal size and writing equity checks of around £2-£10 million. In the UK they often raise their money through VCTs and like to take advantage of the EIS (Enterprise Investment Schemes) to get tax breaks for their investors. Many of these firms will accept minority equity positions but will nearly always protect this with shareholders agreements which give them de facto majority rights over a broad range of issues. Investee companies should also look carefully at the maturity/exit/sale rights of their equity instruments as these often have additional premia attached to them. As a rule of thumb is is always worth working out how these investors make their returns.
F5 – HNW (High Net Worth): These investors might also be called Angel investors. Typically they are successful (for which read wealthy) people, often but not always successful entrepreneurs. Many of them take a portfolio approach and if you are lucky will also bring their experience to the table to help your business develop. This is not blind money and if things start to go wrong, expect them to step in to protect their investment. A good rule of thumb for these investors is what ever your valuation or funding round, they like to get between a quarter and a third of the enlarged equity in return for their risk capital. This is not cheap money.
F6: Special Situations: This is not just a catch all grouping. These investors are seeking opportunities to take advantage of difficult or unusual circumstances (often distressed companies or successful companies short of capital) to make their return. The often use complex structures and share classes to protect their downside and negotiate hard for as much of the upside too. By definition, they are seeking situations where their capital is badly needed and where their negotiating position is strong.
This then is my classification. However, when reading the investors’ websites you will often see a wide range of different terms used. I will now try to explain these in a little more detail.
The second major category looks at the investors who invest in early stage deals. It should be stressed here that these investors are all looking to put money into the companies and not to see any of it going out to earlier investors or founders.
Seed: Seed investors are those who come in right at the beginning. They sometimes referred to as Friends and Family (literally at this stage the only people who will put money into your brilliant idea!). Sometimes the category is referred to as Friends Families and Fools. These investors understand that this money is REAL risk capital and very often they do not get it back. As often, the business plan requires additional funding and they end up suffering significant dilution. It is worth considering, if Uncle Jim really can’t afford to lose the £50k he is offering you, why jeopardise future family reunions by taking his money.
Start Up: this term is sometimes used by VCs who want to invest in early deals. As mentioned above, they seldom (but not never) invest pre-revenue and often will make very encouraging comments and tell you to come back to them when you have achieved some significant milestones (for which read sales).
Angels: These investors are covered largely under the HNW category above. Essentially they differ from Friends and Family as they are neither Friends nor Family. Their investment size is typically in hundreds of thousands where as the former are in the tens of thousands range.
Other Early Stage: this is VC-speak for post-revenue investors who might really be trying to steal into the Series A space (more of that below). At this stage investors are moving away from product risk (is there a market for the product?) to market risk (can the product be sold into a large enough market to make the business profitable).
Venture Capital: or VC. These investors are “institutional” in the sense that they are normally professional investment firms (or offices of High Net Worths or wealth families). They employ professionals to vet deals and make the investments and therefore have a more cautious (and less proprietary) approach to deal risk. If you are investing your own money you might decide you want to back the founder and make a subjective judgement on this basis. These investors are not likely to take this approach. You may expect their term sheets to contain a considerable amount of tricky to understand downside protection clauses (which you really do need to understand and often cross out!).
Development: this is another catch all term for investors seeking to invest in growth companies. Often minority investors, they are likely to be post revenue investors seeking high growth (lower risk from slightly more mature businesses) investments. Normally institutional rather than private individuals.
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