In the process of starting a business, if entrepreneurs try to obtain investment from investors (including individual and institutional investors) and gain recognition from the capital market, they must first have a clear understanding of the capital market and various investors. Different types of investors have different investment priorities or inclinations, and the main difference lies in the industry, enterprise, enterprise-scale, or development stage of the enterprise. Having an understanding of investors is conducive to finding the “right” investors when funding, and improving the quality and efficiency of the funds. This article compares and analyzes three main types of investors in the asset market: Angel Investment (AI), Venture Capital (VC), and Private Equity (PE), to help entrepreneurs judge the investment tendencies and preferences of potential investors.
The conceptual distinction between the three types of investors
1 – Angel Investment (AI)
Angel Investment, or AI for short, generally refers to the first investment that a startup company receives as an angel investment. Angel investors, as their name suggests, are like “angels”, they don’t seem to care if your business succeeds or fails. Aside from providing start-up capital for entrepreneurs, angel round investment also enables them to gain trust and support, encourage them to take the first step, and make their ideas a reality.
The main characteristics of angel investing are as follows:
1- The amount invested by angel investors is relatively small, the funds are often one-time investments, and venture companies are not subject to very stringent reviews. Usually, angel investing is made by one person and is a catch-all. It’s based on subjective judgment or determined by personal preferences or dislikes.
2- Angel investors are the most promising sources of funding for start-ups since many of them are entrepreneurs themselves.
3. Angel investors are not necessarily millionaires or high-income successful people. Many angel investors may be your relatives, friends, company partners, suppliers, or anyone willing to invest in the company.
4. Angel investors can contribute not only funds, but also network resources, and if they are well-known individuals, can also boost the startup’s reputation.
2 – Venture Capital (VC)
Venture Capital, or venture capital, also translated as venture capital, primarily refers to a financing technique that provides financial support to start-up companies in return for equity. The National Venture Capital Association defines venture capital as “a type of equity capital invested by professional financiers into emerging, rapidly growing, and potentially competitive enterprises.” At present, the well-known venture capital institutions in the Chinese market are DCM Investments, China IDG Investments, Northern Lights Ventures, Morningside Capital, Sequoia Capital, Capital Today, Matrix Partners China, etc.
VC has the following characteristics:
1. Most of the investment targets are small and medium-sized enterprises in the start-up stage, and most of them are high-tech enterprises.
2. Venture capital is generally invested through equity investments. This usually accounts for about 30% of the equity of the invested company, and does not require controlling rights, nor does it require any guarantee or mortgage.
3. Investment decision-making is based on a highly specialized and procedural basis, and generally requires procedures such as legal due diligence, financial due diligence, value assessment, and model prediction.
4. Venture capitalists generally actively participate in the operation and management of the invested company and provide value-added services; venture capitalists generally also meet the financing needs of the invested company at various stages of development in the future.
3 – Private Equity Investment (PE)
PE (Private Equity), also known as a private equity investment in Chinese, refers to the equity investment in private companies, that is, non-listed companies, in the form of private equity. Or management buybacks, etc., to sell shares for a profit. The more famous PEs are Temasek, MBK, CITIC Capital, Softbank, PAG, etc.
The three typical characteristics of PE are:
1. PE fundraising is private and extensive. The funds for PE investment are mainly raised from a small number of institutional investors or individuals through non-public means, and their sales and redemptions are privately negotiated with investors.
2. The investment targets of PE are unlisted companies with development potential, and the criteria for selecting projects are to be able to bring high investment returns through the listing.
3. Integrate equity funding and management support. Since the purpose of PE investment is to obtain excess investment returns through the listing, PE investment will not only bring investment to the enterprise but also provide management support for management.
The difference between the two and three types of investment
Differences in targeted companies
1. Angel investment
Compared with VC and PE, angel investment should be involved in the earliest stage of enterprise development. In many cases, angel investors have already invested capital before the company’s products and business have taken shape. Therefore, angel investors value the target company, rather than angel investors value the entrepreneurial team and the outcomes of the entrepreneurial team. Under the circumstance of the founder’s personal charm, such as personal aura, clear expression, eye-catching work experience, famous school background, etc., another critical consideration is the founder’s understanding of the industry: first, the understanding of the industry’s needs: What are the pain points of the industry? How is the product positioned? Where is the product differentiation? Whether the founder and team can quickly produce products that meet or even exceed user expectations determines the success or failure of entrepreneurship. Secondly, the founder’s understanding of the industry is reflected in the understanding of the development trend of the industry. If the industry is good, the founder is also very good, but if it takes a very long investment cycle to achieve income, investors will hesitate or even give up.
For example, Xu Xiaoping, a real angel, rarely did background checks in his investment career. His most well-known investment logic is that investing is investing in people. He once invested in Chen Ou with US$180,000 (about 1.26 million RMB). The successful listing of Jumei brought a hundredfold return to Xu Xiaoping. According to the shares held by Xu Xiaoping at that time, the market value of Xu Xiaoping’s stock was 300 million US dollars (about 2.1 billion yuan).
2. VC – Venture Capital
The projects invested by VC may be small and medium-sized high-tech enterprises that have just started. The enterprises have begun to take shape, but the business model is not mature enough, and there is still a long way to go before the listing. Most of the investment projects in the Internet industry that you often see belong to VCs. , the main characteristics of such projects are as follows:
(1) Higher risk. Since the main investment target of venture capital is the small and medium-sized high-tech enterprises that have just started, the scale of the enterprises is still relatively small, and there are no fixed assets and funds as collateral guarantees, so the investment risk is very high. If the technology cannot stand the test of the market and cannot be transformed into a formed product, the company is at risk of going bankrupt.
(2) Higher returns. If the invested start-up company grows and increases rapidly in the future, venture capitalists can obtain hundreds or even thousands of times the return on investment. WhatsApp had earlier decided to partner with only one investor, Sequoia Capital, which had invested a total of $60 million in the company and received a massive $3 billion return. The return on investment is 50 times.
(3) The equity liquidity is low. Because VCs have invested at the beginning of the enterprise, the realization of capital must wait until the commercial scale of the enterprise has matured. This realization process will take at least 3-5 years. During this period, the capital invested or held by VCs Equity is basically immobile.
3. PE – Private Equity
PE’s investment targets are mainly non-listed companies with development potential. The company’s ability to go public in the near future and whether the listing can bring high returns are important criteria for PE to choose an investment. Compared with AI and VC, in addition to the same emphasis on the advantages of enterprises, PE investment is more inclined toward late-stage mature enterprises. Taking Alibaba as an example, Softbank invested $20 million in Alibaba in 2000 and then invested an additional $100 million in 2003 (a part of the equity was later purchased by Yahoo for $360 million), and in 2005 $180 million was invested. In 2014, Alibaba was listed in the United States, with a market value of 230 billion US dollars, and Softbank held 32.4% of the shares, valued at 74.5 billion US dollars, equivalent to 267 times MoM (Multiple of Money Invested, equivalent to investment return multiple). At present, SoftBank still holds 25.1% of Alibaba’s shares. Alibaba’s market value as of June 16, 2020, is US$597 billion. Softbank’s Alibaba shares are worth about US$150 billion, plus the 2014-2020 period. About 20-30 billion US dollars are cashed out, and this investment has brought 600+ times MoM to SoftBank.
Differences in the investment’s duration
1. Angel investment
Because angel investment invests in the enterprise at the earliest stage, so his investment period is the longest, and it generally takes 3-7 years from investment to depletion, so it is also called “patient capital”. After the angel investment makes an investment, it cannot get cash in the short term; there is no dividend and no interest. Only after the company succeeds, it can get a profit. A truly long-term investment project may make a considerable profit, or it may be lost due to the failure of the operation, and the failure rate of angel investment is also relatively high. If divided according to the investment stage, angel investment is also called angel round investment.
We often say that the seed round, A round, B round, and C round are all VC venture capital. From a case-by-case perspective, VC investment periods vary, but they are usually withdrawn within 5-10 years due to the period of fundraising and the circumstances of the project itself:
(1) After the duration of the VC partnership agreement expires, the profits need to be distributed to the investors (ie LPs), so it is necessary to withdraw from the invested enterprises one after another. The term of VC is usually 7-10 years, and some include extensions for up to 15 years.
(2) If the invested project is successfully listed or acquired after the lock-up period expires, the venture capital fund can withdraw. Of course, there are also very promising companies that will continue to hold for a period of time. Conversely, if the company is operating badly, the VC will have to continue to hold it, or even request an extension to the LP.
Private equity funds typically have a tenor of 5-8 years. The period setting of private equity funds is divided into investment period, exit period, and extension period. For example, if a fund has a period of 5+2 years, then 5 years is the investment period and 2 years is the exit period; if the fund period is 3+1+1 years, then 3 years is the investment period and 1 year is the exit period. 1 year is an extended period. The extension period is mainly used to continue processing legacy projects that failed to exit the previous year. Depending on the nature of the fund, the investment industry, the investment projects, and the capital market conditions at the time of exit, the duration of the fund is also different.
“Out of the Box services” provided to Startups
In addition to providing funds for entrepreneurs, angel investment, VC, and PE may also provide enterprises with value-added services other than funds.
1. Angel investment
Angel investors can not only bring funds but also bring contacts, experience, materials, venues, labor, etc. to entrepreneurs. If they are well-known personalities, it can also enhance the company’s reputation and credibility.
Angel investment is often a participatory investment. After the investment, angel investors often actively participate in the strategic decision-making and strategic design of the invested company; provide consulting services for the invested company; help the invested company to recruit managers; assist in public relations; design and launch channels, And organize business promotion and so on. However, different angel investors have different attitudes towards post-investment management. Some angel investors actively participate in post-investment management, while others may not care about the management of the enterprise and do not participate too much in the management of the enterprise.
Excellent VCs may help entrepreneurs in the following ways:
(1) Provide strategic direction for entrepreneurs. VCs may hold a seat on the board of directors, discuss the company’s strategic development direction by participating in board meetings and contribute to the company’s strategic development. Based on professional investment capabilities, the company can obtain guidance on some critical decisions, and solve some obstacles encountered during development.
(2) Recruit outstanding talents for the company.
(3) Facilitate transactions, cooperation, etc.
(4) Provide financial and legal guidance.
Generally speaking, the size of the investment amount and the proportion of shares it occupies determine the amount of energy that PE needs to spend in post-investment management. The main purpose of PE is to maximize the value-added of enterprises. Therefore, private equity investors not only invest equity capital but also provide critical value-added services, such as helping management team building and providing information. Support, legal counsel, and other consulting services. Many PE institutions have relatively professional and high-quality personnel, so they can also give many professional opinions on the decision-making of the invested enterprises.
Differences in the exit methods
Different venture capitals have different exit strategies, and even have large differences in exit strategies. The differences in exit strategies have completely different abilities and resources for investors.
1. IPO exit
After the companies invested by VC and PE achieve IPO listing, investment institutions can sell their shares in the secondary market after the lock-up period to realize cash-out. Judging from the current situation, domestic and overseas IPOs are still of important exit channels for investment institutions. Although the importance of IPO as an exit channel seems to be declining from the perspective of the proportion of IPO exit cases in the total number of exits, from the perspective of book rate of return, the status of IPO as the most ideal exit channel for investment institutions remains unchanged.
2. Listing on the New Third Board, Transfer, and Exit
Another important exit method for VC and PE is to exit through the New Third Board (National Equities Exchange and Quotations). to complete the exit. Before 2014, the New Third Board had been in a state of obscurity, and cases of exit through this route were very rare. At the beginning of 2014, the new third board was officially expanded. In August, the new third board officially began to implement the method of market making and transfer, which made the trading activity of the new third board leap forward. Since the second half of 2014, the NEEQ market has become hot, and the number of listings and transaction volume has grown by leaps and bounds. In addition, the stratification of the NEEQ and the advantages of the NEEQ as a potential high-quality target pool for listed companies’ mergers and acquisitions also make VCs and PEs more willing to see their invested companies listed on the NEEQ.
3. M&A exit
The other is that after the invested company is listed, it exits through mergers and acquisitions. Mergers and acquisitions are more commonly used methods for VC and PE. Since 2013, the number and amount of mergers and acquisitions in the A-share market have increased year by year, which has promoted the prosperity of this channel of mergers and acquisitions.
4. Corporate repurchase and exit
Whether it is PE investment or VC investment, most investment agreements will have a repurchase clause. However, the actual treatment of this clause by funds at different stages is very different. PE firms take repurchase provisions seriously by enforcing them; VC firms rarely require enforcement.
Although the terms of the agreement are there, the investment industry also abides by certain industry-established rules. It is normal for a PE firm to ask the major shareholder of the invested company to buy back. Even if an angel investment or venture capital firm actually asks the company’s founder to execute the buyback, it will be considered outrageous.
VC institutions and angels tend to invest based on their willingness to gamble and lose as a default rule. Everyone is willing to gamble and lose, even if the investment fails, as long as the entrepreneurial team does not embezzle and embezzle public funds. Entrepreneurs will likely be frightened to start businesses in this market if VC organizations also force them to buy back. PE institutions are unsure whether a foreign PE investment is part of their foreign PE strategy or more like a debt. In reality, PE funds often implement repurchase clauses in large quantities. Therefore, repurchase has become one of the most effective exit methods for PE institutions.
5. Exit through other equity transfer methods
A company’s equity is transferred from an investment institution to other investors for cash out, such as by way of a private agreement, public listing, or transfer to the regional equity trading center (i.e., the fourth board). Equity transfer exit is a common exit method for angel investors and VCs. Those who opt to exit via equity transfer probably do so because the invested company has no hope of an IPO or because investors aren’t optimistic about the future development prospects of the company, and thus the equity transfer and exit will be conducted in advance before the company goes public. In addition, the average book return multiple of equity transfer exit is also much lower than that of listing and M&A exit.
6. Liquidation Exit
This may be the most unwilling exit method for direct investment institutions because adopting this method means that the project has completely failed, and liquidation is only the last stop-loss measure. As long as you can get your investment back, you are lucky enough. Probably because of this reason, there are very few cases of exit by liquidation. The investor may set repurchase clauses that will require the majority shareholder or the actual controller of the company to take on the repurchase obligation, even if the liquidation will result in the recovery of the principal and corresponding fixed income.
A typical angel investment involves investing in a new project, with many uncertainties, mainly for individual investors, and with a relatively small investment amount. VC venture capital. As soon as the corporate strategy is developed, it is necessary to invest resources to accelerate the growth of the business. Many institutions participate at this time, usually in the form of funds, usually worth tens of millions. PE private equity investments are made in mature companies. At this time, the enterprises have a certain scale and market position. However, some need to be listed, and some need to undergo industrial integration, to reach the next level. Also, different investment institutions may have different preferences and passions. There are some who like to invest in the Internet, others prefer artificial intelligence, and others prefer live broadcasting. Investment is also a two-way “go-to” relationship. Choosing the right investment institution can help entrepreneurs develop their companies in the future.
In practice, there is no strict boundary between the three types of investors, even though many distinctions have been made on various aspects of the three types. When the project is good enough and the market development prospects are impressive enough, angel investors, venture capitalists, and private equity investors will also break through the barriers of differentiation and will be willing to invest a lot of capital in the company’s future success. Additionally, as a company matures, it will attract different investors at different stages, including angel investors, venture capitalists, and private equity firms.