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.

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.”

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.

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.

Family and Friends
While your friends and family are probably hoping to get a huge return from their investment, they’re more likely motivated by wanting you to get a chance to succeed and be happy. They are unlikely to try to negotiate terms, though in contrast you will feel the worst for losing their money. Take money from them if you need it and only after making sure they fully and completely understand that they are likely to lose anything they give you. You also need to be okay with losing all of the money someone you care about gives you. If you don’t think this is true, don’t take money from them because it will likely hurt your relationship.

Family office
These are the private investment vehicles for super high net worth individuals and families. Whereas some individuals invest their own money as angels, those that get to a certain scale often employ staffs of portfolio managers and investment professionals. There are many different structures here. Some family offices are structured like single limited parter hedge funds with a high tolerance for risk, and others are structured more conservatively. Whatever the risk tolerance, the staffs of family offices generally get carry on their investments as well as salary, which introduces some of the incentive dynamics present at VCs.

Generally, these entities are very concerned with not losing their principal. Whereas a VC fund that loses an entire fund will have a hard time raising other funds, a family office that loses all its principal has no recourse for more funds. Generally, if you get an investment from a family office, it will come from a small portion of a portion of an overall investment portfolio.

Corporate investor (direct)
There are a lot of corporations that like to talk about investing in startups. Some of them actually do this, and some do not. When an investment comes directly from the company's balance sheet at the direction of a particular business line, the corporation is usually looking for strategic value from the investment. Most of these companies know that investing in startups is unlikely to change the valuation of the investor.[2]

This means they either want an inside edge to acquire you at some point, or believe that investing in you will help improve their bottom line. They may want to prevent you from selling to competitors in the same space, and may have other confusing and onerous ideas. This is because their incentives are different that those of most startups - they are more concerned with how you can help them than with how they can help you get gigantic.

Corporate investor (venture arm)
While corporate venture arms have some of the misaligned incentives of direct corporates, they generally have a mandate to generate financial returns for the company's balance sheet. This means they act more like VCs, and are typically more conversant with how startups work.

Governments have many reasons for investing in startups. There are many government grants available in various countries that are designed to promote startups as way to increase job growth. There are also government agencies with their own venture funds, generally designed to fund technology that will help the government in the long run.

University endowment
University endowments are similar to family offices, but they represent an endowment. They are designed to produce returns to fund the university over time. These entities do not generally invest in early stage companies except in conjunction with a fund with whom they have a strong relationship.

Seed fund
Seed funds are VC funds that write smaller checks at early stages of companies. They usually have the same incentives and structures.

Hedge fund
Hedge funds are largely unrestricted pools of capital. Traditionally, these were focused on public market investments, though in the last few years have started investing in startups. Generally, they invest in later stages and are looking for returns on capital as they have LPs and similar incentive structures to VC funds.

Mutual fund
These are large pools of capital run by portfolio managers. They don't have LPs, rather they have large groups of retail investors who buy shares in the funds, which capital they can then deploy. These funds only invest in late stage startups, because they need to deploy a lot of capital to have any kind of impact at the portfolio level. These managers are paid based on performance, and often have reporting requirements that cause them to publish their internal marks for private companies. This has caused a lot of consternation lately as Fidelity has been publishing widely oscillating valuations for a number of companies like Dropbox.

Sovereign wealth fund
These are the largest pools of capital in the world, and are essentially very large family offices for entire countries. These funds are large enough to invest in any and all asset classes that the managers believe will produce a return on investment. Like mutual funds, these funds rarely invest directly in startups - they are more likely to invest in funds that do.

In the last few years, however, a number of them have begun to invest directly in startups. While the managers of these funds are generally paid on a performance basis, there are a lot of other complicated incentives in place at certain funds deriving from political requirements. These are pretty hard to parse.

[1] I don't actually love the term Angel as it seems insufficiently precise given the wide range of investors to whom it applies. While it would probably make sense to find other terms for subgroups, the key thing to know is that. Maybe we'll try to rename them down the road.
[2] Yahoo's investment in Alibaba is a rare exception to this rule.

Thanks to Paul Buchheit, Geoff Ralston, Daniel Gackle, and Dalton Caldwell for your help writing this.