New Venture Financing
It Isn’t Really about How Great Your Idea Is
Startup Toolkit Partner
Columnist on Entrepreneurial Finance, Dr. Rao is a nationally acclaimed practitioner, advisor, author and communicator on new business development, business growth and financing businesses and ventures. He combines real-world experience in financing over 450 firms and managing five companies as the V.P. (now director) of one of the U.S.’ largest development finance institutions with advising governments (including the U.S. government), Fortune 1000 companies and entrepreneurs in new business development and financing.
You are an entrepreneur faced with a troubling question: How do I get venture capital? Before you answer that question, consider another one that should be more important — should you bootstrap? In his book, Dileep Rao profiles 28 entreprenuers who built great companies from scratch. Think carefully before divvying up your equity.
So you’ve hit on a great business concept for a new venture. You’ve even drafted a solid business plan, with input from academics and savvy business people. You’ve evaluated the market and you know this is going to work.
The one challenge you don’t yet have answers to is: where do we get the money that it’s going to take to launch this business and keep it running until sales are actually producing good cash flow? We have marketing expenses, travel costs, equipment to buy, operating space to lease — and we founders will need to eat and pay rent. Until customers start paying, where will the money come from to cover all those expenses?
Look, if it were easy — if, say, you could go to a local bank and they would loan you a big pot of cash — everyone would be an entrepreneur. But it’s not easy. The fact is that others just won’t see the sure thing that you see when you look at your business plan. And for early stage ventures, it’s the perceived risk that it won’t play out successfully that makes it hard to find investors willing to write you a check. So a big strategic priority for you will be to reduce the perceived risk of failure. And you don’t do that by talking about how much success you’re going to have. You do it by demonstrating how successful your business can be. That is, you get started. When you’re making sales — when customers are paying you for what you have to offer, and more customers are showing up today than yesterday — investors will start paying attention.
Here’s a take on what that’s all about: Why There Will Always Be a Financing Shortage. This article and others we will reference below are from Dileep Rao, Ph.D, whose full bio you can see to the right. In his articles on forbes.com, Dr. Rao focuses on helping entrepreneurs succeed without venture capital (VC) funding.
Valuing Your Startup
Before you start asking people to give you money in exchange for equity or even just as a loan, spend some time thinking about the valuation of your business — how much the business is worth. You can’t just come up with a number without any reasoning behind it as valuation relates to what someone would be willing to pay for the company. Discussing this with advisers, such as your tax professional and attorney, can be a good place to start. They may even recommend that you seek the services of a professional appraiser, especially if you get to a point of wanting to sell equity to sophisticated investors. Figuring out the valuation in advance and having explanations about it will help you in your negotiations with any potential investors, including friends and family. For more information on ways to think about valuation as it relates to equity compensation, see the Equity Compensation section of this Toolkit.
How to Fund Your Startup
From reading the news, one can get the impression that all you need to do is pay a call on your friendly neighborhood VC firm, and they will write you a soul-satisfying big check. VC funding, however, is very unlikely to be available to you (for an insightful perspective on this, see Building Better Entrepreneurs: Why Venture Capital Isn’t The First Step To Developing Successful Startups). And even if you could get it, you’d want to think twice before accepting it (see Five Questions You Should Answer before Seeking Venture Capital).
If VC funding is off the table, how else can a startup access some cash to get running and keep running until it is financially self-sufficient? Let’s take a look at the variety of ways you can finance your business, and some of the pros and cons of each.
Self-Financing or Bootstrapping
Most entrepreneurs make significant personal investments in the launch of their venture — not only in the form of cash from their own savings, but also by foregoing salary for their work and by using their home as their company work space. But the necessary personal commitment often goes well beyond that. Entrepreneurs frequently pursue every available personal loan option, including credit cards, personal loans, and home equity loans (see below for more on loans). Outsiders generally will view the fact that you have a real stake in your business as a prerequisite before they will be prepared to invest. The reality is that, when starting a business, you can expect that you will be funding it on your own as much as you can. One important benefit of doing this is that you maintain control over your business. That should be reality check #1 for every startup entrepreneur: investors are going to demand significant say in what the business will do as a prerequisite to their investment.
Still, even after selling your car, maxing out your credit cards, and more, few people will have the financial resources to fund their business entirely on their own. So what other funding sources may be available?
Friends and Family
When you are still in the early stages of your business, getting funding from your friends and family may be your most viable option. They know you well and are likely to be willing to give you the money without asking too much in return (both in terms of expected monetary gain and management control over the business). However, if your friends and family are not sophisticated investors, they may not have realistic expectations about how the business will progress and what sort of financial payoff they are likely to see. A risk of using friends and family to fund your new venture, then, is that it can make holiday meals less pleasant if your business isn’t doing well. Also, if you later want to look to outside investors for additional financing, your existing equity investors (i.e., your friends and family) may not be seen as welcome partners by the professional investors you may want to court.
Still, seeking investment from friends and family can be very useful. They are likely to be more patient and flexible, and less demanding, than arms-length financial investors. You just need to make sure you set expectations about roles (no, their $20,000 investment doesn’t mean they will have a seat on your board of directors) and financial return (the investment represents a risk, and their money could be lost) up front. Then, keep your investors informed about the business in a professional way that treats the business as a business rather than as a side conversation when you are also dealing with personal matters.
It may surprise you that the federal government is paying attention to little startup ventures like yours. In fact, the federal government’s Small Business Innovation Research (SBIR) program can be a tremendously valuable source of funding for some new ventures — particularly those that are formed around the pursuit of a technological innovation. Known as “America’s seed fund,” the SBIR program supports small business innovation in the U.S. through awards for Research and Development (R&D) initiatives with potential for commercialization (see SBIR.gov). Funding is made available through numerous federal agencies, with each participating agency committing 2.8 percent of its R&D budget to SBIR and administering its own program in terms of the award process. Initial grants “to establish the technical merit, feasibility, and commercial potential of the proposed R/R&D efforts” are made (after a competitive application process) in amounts up to $150,000. If the result of that initial work is positive, further awards of up to $1,000,000 may be made to continue the work toward commercializing the technology. One of the benefits of the SBIR grants, of course, is that they don’t require you to share ownership or share income. These awards do, however, typically have significant reporting requirements in order to ensure that you use the funding as intended. Additional federal resources may be available and the federal government’s Business.USA.gov Portal can help you find them. The Access Financing wizard asks about your business’s geography, purpose, ownership, and industry in order to provide you with a list of financing programs that may be appropriate for your business.
Business Accelerators and Incubators
Business accelerators like Y Combinator and TechStars offer funding in exchange for equity (directly or through a convertible note) as well as some sort of program involving mentors, advice, and other resources intended to help the startup be more successful. These groups are like angel investors in that they are often funded by a collection of individuals with a specific area of expertise who want to make relatively small equity investments in startups and also take steps to help the companies in their portfolio to succeed. The biggest difference is that the accelerators usually have a specific time period (for example three to six months) during which a startup is part of their program, though the startup often continues to have access to some resources after that period.
You also may hear the term incubator. Sometimes it’s meant as something similar to an accelerator in that equity is involved in the process. The major distinction between accelerators and incubators is that accelerators tend to focus on accelerating a business that is already in existence, whereas incubators generally focus more on looking at an idea, determining if and how the idea could be turned into a business, and then, potentially, getting the business launched.
However, some incubators and accelerators act more as advisors without asking for equity in return. Two examples of this group are San Diego-based incubator EvoNexus and the Rady School of Management’s StartR Accelerator (which is for companies involving Rady students and alumni).
While some of us think of banks simply as a place that provides checking accounts, in fact, banks are primarily in the business of making loans to businesses. That’s how they generate most of their income. So they want to lend.
Still, they aren’t foolish. Banks will lend only if they are confident that they will be paid back. In early stages of business formation — before a company is generating significant sales revenue from customers — a venture is unlikely to offer the kind of credit risk that will satisfy a bank. In those circumstances, a bank will make a loan only if the entrepreneur provides a personal guarantee. Thus, the loan may take the form of a home equity loan or other type of facility for which your personal assets are pledged. After all, banks have two classic requirements that a borrower must meet: 1) does it appear that they will have the cash flow needed to reliably repay the loan (plus interest) on the expected schedule; and 2) can the borrower post an acceptable form of collateral to protect the bank in the event that the borrower’s cash flow dries up? An early stage venture is unlikely to meet either of these requirements. In fact, some banks won’t even accept applications for business loans unless the business has been in existence for at least two years.
Banks really come into play as a source of growth financing only after you have moved into a stage in which you have actual paying customers to whom you are selling a product or service (thus representing a stream of cash flow). At that point, there are many providers (not just what we think of as banks) that can offer you a variety of financing options, such as loans and lines of credit, including those based on assets and inventory. The U.S. Small Business Administration (SBA) offers programs to help small businesses get loans, including by providing loan guarantees that improve the chances of a bank lending to a new business, and can help businesses to find a lender (visit See What SBA Offers for more information). Regardless of the way you get the loan, you may be required to provide a personal guarantee.
Individuals who invest in early-stage businesses are sometimes referred to as angel investors. As distinguished from VC firms, which operate as incorporated businesses, angel investors are individuals who often have had success with their own businesses and now want to invest in startups, especially in areas in which the investors have some expertise. Typically the amount they are willing to invest is smaller than a venture capital firm or private equity firm might invest, but they may offer some benefits in terms of the expertise they have or other relationships in the community. Angel investors will, of course, expect a significant return on their investment (after a few years), and may want a fair amount of equity and potentially other kinds of involvement in your business as a condition of their investment.
Syndicates are a type of investment that sits at the intersection of angel investing and crowdfunding. (However, the older, more common use of this term is to refer to multiple venture capital firms that jointly invest in one company in the same round of financing.) Syndicates permit accredited investors to invest in businesses through the direction of a lead investor who is compensated for the work based on “deal carry,” which is another way of referring to carried interest, defined as the share of profits in an investment that a manager gets in excess of the pro rata value of his or her investment. The platform through which the syndicate is created (such as AngelList) may be compensated as well.
This is the newest category of funding available to new ventures. Under the now-existing system, you can get strangers to provide money for the development of your business in exchange for some sort of reward such as an early, working version of your product or other item of value such as a signed copy of your movie’s script. Funding this way is far from a sure thing, however. Unless you can generate some “viral buzz,” crowdfunding campaigns are unlikely to receive all the funding they seek. The key seems to be a good story that drives traffic to the selected platform, such as Kickstarter or Indiegogo.
The bigger news in this area is that a new era of crowdfunding for startup ventures is upon us. Effective as of April 27, 2016, regulations issued by the U.S. Securities and Exchange Commission (see SEC Adopts Rules to Permit Crowdfunding) permit the offering and sale of “securities” (meaning shares of company stock or bonds) through crowdfunding, subject to certain limitations (which focus on the financial experience of the potential investor and the maximum dollar amount of any allowed investments). These rules make it possible to finance a new venture by selling shares of the company’s stock over the Internet.
Strategic Corporate Investors
Some large companies will invest in startups that are doing things in which they are interested and may even invest at a higher valuation due to their interest in your technology that goes beyond just the absolute growth of the business and financial return. An investor like this — commonly referred to as a strategic investor — receives better access, including a potential right to make the first offer in the event of a future sale, to new technologies that further the company’s own objectives.
The clear upside of the relationship is that an investment from a well-respected company can make it more likely that customers will buy your product or services or that other investors will be interested in funding your business. You also may be able to access resources from the strategic investor, such as facilities or expertise. However, one of the big challenges with strategic investors is that their goals may not be aligned with yours, which could make it difficult to make changes to the business that will further the long-term health of the business but slow down development of the technology that is most relevant to the strategic investor. Therefore, you need to be very clear in any agreement with your strategic investors about what kind of input they have into the business, including what power, if any, they have to limit future funding decisions.
Venture Capital and Private Equity
There are private and public-private kinds of VC. The SBA licenses some private investment funds through its Small Business Investment Company (SBIC) Program; this public-private partnership potentially enables small businesses to meet their needs through a combination of private equity (PE) investments and debt that is government guaranteed and of relatively low cost.
However, for all private VC, the return the investor will want is likely higher than any other type of funding. In addition, VC investors will want the greatest degree of control over company management — to the point that they may demand that the venture’s founder step down as CEO, to be replaced by someone brought in by the VC firm. There can be some benefits to VC, of course; the amounts they are willing to invest are typically higher than other sources, and they may be able to offer you connections to other resources and expertise via their network of businesses. And sometimes the fact that a big-name VC firm has invested in you will attract good publicity and other investors. Still, they will expect a lot of the venture’s equity and may have provisions that allow them to participate in an even greater way in the upside of your business. They also typically have a certain period after which they will want a “liquidity event,” meaning that they will demand to take your firm public (through an initial public offering) or sell your business, so that they can cash in their equity investment in your business. An important lesson that every startup entrepreneur should know: if you do end up dealing with a VC firm, the way to get better negotiating leverage is to build your company as long as possible without them — delay turning to the VC until your company has already proven that it is succeeding. That’s when you will have multiple suitors and can play them off to get better terms — meaning more money for a smaller percentage of your equity. Dileep Rao has done the research and clearly explains the rationale: How to Make Venture Capital More Productive?
In addition to a conventional loan or an equity investment, financing for a new venture can sometimes be structured as “convertible debt” (also referred to as a convertible note). Often angel and venture capital investors (discussed in more detail below) will be the source of convertible debt funding. It may offer you a way to get additional funding before you are ready to explicitly give away equity, as convertible notes typically function more like loans in the beginning and then later, the terms of the note can result in the note converting into equity. In this way an entity can participate more fully in the success of your business after they lend you money.
Classes of Stock
Classes of stock represent an important consideration related to outside funding — should you choose to consider this path. Sophisticated investors may want to have greater rights when they invest in your business than earlier investors have and to issue more than one class of stock (common stock versus common and preferred stock), your business will need to become a C corporation.
Individuals within finance sometimes categorize the funding process into different stages but the terms for the stages — and what falls within each stage — can vary. The key for every stage, no matter what you call it, is to remember that what you are doing is running a business and to treat everything you do that way, from how you manage your paperwork to how you treat your investors, employees, suppliers, and customers.