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Small business expansion eventually accelerates to the point where you need financing to support new demand while maintaining the high standards of your brand. If you are ready to take your company to the next level but find yourself asking “How do investors work,” “Do investors own the company,” or “How much do investors make,” then it’s probably time to educate yourself about how business investors work and the level of influence they have.

How do investors work?

If you’re wondering what investors do, the answer varies dramatically from one opportunity to the next. Most startups who want outside funding to grow their business pursue angel investors. These wealthy individuals put their own money into companies in exchange for a share of profits. Angel investors often enter the picture in the early stages of business growth because they see potential in or have a personal connection with the brand or owner. 

You will want to look for an angel investor who is an accredited investor. To be an accredited investor, an individual must have a net worth exceeding $1 million or earnings of $200,000 or more per year for at least the past two years ($300,000 for those who file taxes as a married couple).

In contrast, venture capitalists and private equity investors are professional investors who work for institutional investment funds. Companies typically don’t seek venture capital or private equity funding until they are past the initial startup scaling phase. Venture capital firms typically invest in younger companies that lack the resources to scale operations and generate significant profits. Private equity investors, on the other hand, tend to invest in more mature companies and use proven leadership skills and industry expertise to improve business performance over time.

Choosing the right partner

Before seeking an investor for your business, clearly define your objectives for this type of partnership. Are you looking for a silent benefactor who will step aside in exchange for future returns, or do you want an investor who can guide you through the process of scaling your business successfully? 

Even if you don’t plan to offer possible investors a majority stake, you should make sure their values align with your vision for your company. Having a shared mission in mind can reduce the likelihood of conflicts with your investors. Always consider any potential investor a potential partner, not just a source of funding. 

Ideally, an investor should have the resources and connections to help your company grow in strategic ways. Examples include access to talent, customer relationships, partnerships, and industry knowledge and expertise. Look for a track record and extensive experience in your niche or a closely-related area. If your growth plan involves pivoting to a related sector, look for an investor who can forge that transition.

What to expect from a business investor

The level of influence held by investors in business varies depending on the percentage of shares they purchase and the terms agreed to by both parties. Majority control of a business requires retaining at least 50% of its shares, although investors with lower stakes can still potentially influence the company’s direction through methods such as:

• Exclusivity agreements
• Composition of the board of directors
• Buy-sell agreements / Rights of first refusal
• Veto rights on dividends payments, liquidation, company reorganization, etc.

Investors who control less than half the company’s shares are called minority owners and can be either active (have a say in business operations) or passive (simply provide funding). According to the Corporate Finance Institute, active investors generally hold 20% to 50%+ of the company’s value, while passive owners typically hold less than 20%.

What do investors get in return? They are able to participate in the increase in the business’s value over time. Let’s say you have an investor who offers $5 million in return for a 10% stake in your business. This transaction assumes you have a business valuation of $50 million. If your business doubles in value, that same 10% stake will be worth $10 million.

However, it shouldn’t be all about the money. As a savvy business owner, consider seeking an investor who wants more than financial returns. As an active partner in growing your company and realizing its success, the right investor should be a rich source of professional connections and relationships, operational knowledge and improvements, vendor and supplier partnerships, and other non-monetary necessities for scaling your business.

Understanding what to offer investors in a small business requires an understanding of expectations in this space. For example, most angel investors typically target at least a 3-10x return on their investment within three to five years. As mentioned previously, angel investors target high-risk, high-reward investments. As the investor’s risk appetite decreases, so do the expected returns for investors. Venture capital firms and private equity firms that invest in less risky businesses are generally compensated with lower returns.

Alternatives to outside investors

Growing your business with a loan or line of credit lets you retain full control while accessing the funds you need to support expansion. It also provides an opportunity to build a solid company credit history with predictable results as long as you can make payments as agreed. 

However, interest payments can be costly, especially for a new business. If you have limited business credit, you may need to place personal collateral at risk. Loans are best for short-term rather than long-term financing needs. 

Some business owners decide to seek investments from friends and family members to avoid losing control to an external investment firm or individual. If you consider this strategy, put all terms and conditions in writing just as you would with an outside investor to avoid misunderstandings that could damage the relationship. You should also clarify whether your loved one will take an active role in managing the business and what that will entail.

Crowdfunding platforms are a popular way to fund new products and services, especially if you have a large audience and network already. On sites such as Kickstarter, your company can solicit donations from interested individuals in exchange for a token of gratitude. For example, if you want to offer an upgraded version of a best-selling item, you could send the finished product as a free gift to those who donate.

The best scaling solution for your small business will depend on your financial circumstances, business expertise, and goals. Exploring the process of working with investors as well as alternatives can provide insight regarding the next steps for your thriving company.

References:

https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-investor-influence

https://www.inc.com/tony-tjan/5-tips-for-choosing-an-investor.html

https://www.business.com/articles/angel-investors-vs-venture-capitalists/

https://www.sba.gov/business-guide/plan-your-business/fund-your-business