Investors face uncertainty. They have less information about opportunities than entrepreneurs. Uncertainty and information asymmetry creates problems in financing new companies.
One way to give evidence you are committed to the business is simply investing your own money. This demonstrates confidence in opportunity. An advantage of this – owner is able to retain most if it’s equity. Downside is, however, most people don’t have enough money.
Covenants are restrictions on entrepreneur’s actions. For example: the founder is not allowed to purchase or sell, issue or buy back shares without investor’s permission. Mandatory redemption rights give investors they investments back anytime. Convertible securities (a form of financial instrument) convert preferred shares that get treatment in liquidation, into common stocks at investor’s option. Forfeiture and anti-dilution provision allows investor to take a portion of ownership if venture fails to meet agreed milestones. Control rights decide how to use venture’s assets. Long-vesting periods limits entrepreneur’s ability to cash out investments. They cannot leave without investor’s permission or retain much ownership if they leave.
Investors specialise by industry or stage of development of the venture. Small investments in early life of the business and large investments in later stage. Specialisation helps contracts among suppliers, customers and technical experts who help to evaluate ventures that they are planning to back and ensure that ventures are on the right track once they have invested in them. Investors learn key success factors at particular stage of firm’s life. This information makes them able to assist and monitor new firms.
It is much easier to get involved in regular updates and step into day-to-day operations, this is the reason why investors may localise in particular geographies. It is also easier for them to pick up right companies to invest in. They develop networks of sources of information about good start-ups and trusted contacts.
Investors also reduce risk by inviting other investors to join them in making investments. Diversified risk put less pressure, as well as benefits with different experience and knowledge.
Baron, R. and Shane, S., 2007. Entrepreneurship: A process perspective. Nelson Education.