Foundations of New Venture Finance 265try. In its early days, family funds financed the future. Matthew offers this tip to other
entrepreneurs employing family resources: “When you are dealing with family investors,
it should be clearly defined which family members are actively involved in the business
and which are involved only financially. To avoid confusion or misunderstandings,
everything should be documented the same way any other financial relationship would
be.”^10
At the beginning of the business, the risk is highest, and start-up equity carries with
it the highest risk of total loss. Therefore, it also carries the highest returns if the busi-
ness is successful. These initial investments are equity from the point of view of the firm,
although the actual sums may have been borrowed. For example, an investor can bor-
row against the value of his home (and incur or increase the mortgage) to make an equi-
ty investment in the new venture. Equity from the owners, the top managers, friends,
and relatives is called inside equity because it is generally believed that these investors
will vote their stock in agreement with the company “insiders.”
Outside Equity. Investors who have no personal relationship with the venture are called
outside equity investors. Outside equity comes from three sources: private investors,
venture capital, and public offerings.
Private investors, sometimes called angels, are wealthy individuals interested in the
high-risk/high-reward opportunities offered by new venture creation. Private investors
are, in fact, the largest single source of funds for new firms.^11 Wealthy investors exist in
all communities and all cities in the developed world. The best way to reach these peo-
ple is through personal introduction by acquaintances or associates: lawyers, account-
ants, consultants, and others in the economic network of a community.
A new development in angel investing is the creation of angel trade groups with
names like “Indiana AngelNet” and “Central New York Angels.” The groups meet to
discuss investment strategy and to hear entrepreneurs make their pitches. Most have
Web sites and a few have full-time staffs. There is even a national organization called the
Angel Capital Association whose goal is to raise the visibility of angel investing and help
investors benchmark practices and adopt innovations.^12
Wealthy investors will want to see a business plan or offering memorandum.
Obtaining expert legal counsel in this process is crucial. Many securities laws, both state
and federal, regulate the sale and distribution of stock.^13 Failure to comply with these
laws and regulations can enable the investor to sue the entrepreneur for recovery of his
or her investment if the company goes broke.
The main advantages of obtaining early financing from wealthy investors is their rela-
tive accessibility and the size of the investment pool. Also, these individuals may be in a
position to lend their positive reputations to the venture when additional funds are need-
ed.
There are also disadvantages. Many wealthy people made their money in the profes-
sions or inherited it. They may lack the business expertise to advise the entrepreneur
wisely. Even when wealthy investors are businesspeople, they may have made their
money in different types of business or long ago under different conditions.
A second disadvantage is their inability to continue investing in the future—even rich
people have limits. The usual range of investments from wealthy individuals is $10,000