Formal and informal investors: A blessing or a curse?23.07.2014 10:53
Inspired by the OECD report “Financing SMEs and Entrepreneurs 2014”* the Start-up Monitor analyzed the investor types of 102 startups represented in the Start-up Monitor’s database with regards to the average revenue growth rate. We focused especially on the differences between informal (founder, family, friends) or formal investors (Venture Capital, Business Angels etc.).
Obtaining adequate access to capital is one of the biggest challenges for entrepreneurs. Lack of track record, small size, and the ambiguous future often limit external funding. Hence, start-up financing typically comes from the founder themselves, family, and friends (GEM, 2006). A recent article published on Forbes estimates that currently 95% of the money raised by start-ups comes from founders, family or friends. Capital funding provided by both type of investors usually differs in their amount and stage of investment: informal investors tend to have limited resources available and usually support new ventures in their early stage, whereas formal investors are likely to provide higher investments for later stage start-ups.
These different types of investors may also vary in providing nonﬁnancial resources that can substantially inﬂuence the performance of start-ups (Hsu, 2006). A critical factor for start-ups to be successful is accessing complementary assets such as entrepreneurial experience, consulting services, network contacts and reputation. These additional nonfinancial benefits are likely to be provided by formal rather than informal investors. But formal investors have also their drawbacks. With a contractually regulated involvement, the founders are no longer allowed to be the “masters in their own house”.
However, only little restriction of control is expected with informal investors. Family and friends are patient investors, meaning that they often offer low or no interest rates and more flexible repayment terms. This independence might be one beneficial aspect of informal investors. But founding with friends or family is also a high-risk proposition: The danger of losing personal living expenses and the moral debt toward friends and family is omnipresent.
What about the investors of Swiss Star-ups? The analysis shows that start-ups in which informal investors are the major sources of financing have a higher average revenue growth rate (4.23%) than those with a majority of formal investors (1.92%). The average revenue growth rate of these two groups is significantly different from each other – whereby the average revenue growth rate is higher when the majority of company investors consist of informal rather than formal investors.
This analysis indicates that start-ups with informal investors as a major source of financing are likely to be an advantage for the start-up revenue growth. One explanation for this result might be the aforementioned independence from investors. Independent founders have the possibility to act more flexible, faster and with less coordination costs than entrepreneurs dependent on formal investors. As already explained, an additional reason for the positive effect of informal investor on revenue growth might be the favorable terms and conditions for capital granted by family and friends. When does informal or formal investor exactly adds value for new ventures? This is one of the questions the Start-up Monitor Team intends to research on in future projects.
*The OECD report “Financing SMEs and Entrepreneurs 2014”
About "Swiss Start-up Monitor"
The Swiss Start-up Monitor is a joined research initiative of the University of St.Gallen, ETH Zurich and University of Basel supported by the Commission of Technology and Innovation (CTI), Gebert Rüf Stiftung and AVINA Stiftung. The main goal is to build up an exclusive panel of Swiss start-ups in order to foster entrepreneurship on a micro- and on a macro-economic level. This aim will be achieved by collecting and analyzing data of Swiss start-ups on an aggregate and anonymous level, providing high data security and user controllability at any time. The recent sample size is 1500 in the public directory and 376 in the private area for registered user.