Learn about the different sources of startup funding and why each presents a unique set of challenges
So you are thinking about doing a startup and you obviously need money to run it. If you are not really rich you are going to need to raise capital from some flavor of investor. But where should you go for that, and what do all the choices you make about who to get money from imply? Basically, most entrepreneurs use one of three means to raise money in the initial stages of their startup: Friends and Family, Angels, and Venture Capitalists. Let’s cover each in turn and describe who these investors are, how they invest, their process, and the implications of that source on your company’s structure and future.
Friends and Family
As the name implies, the source of capital here are literally the entrepreneur’s friends and family (F&F). A lot of investing ultimately comes down to trust. Trust in the entrepreneur. Trust in his or her team. Trust that the market they say is good and big really is. It makes tons of sense that your friends and family are willing to place a bet on you because they know you well and, of course, trust you implicitly. These folks may do no due diligence at all or do a very cursory amount of it. This round is rarely a priced round, and therefore, rarely an equity round. What this means is that there is not a value stated for the company at this stage (so there is no stated share price) and these investors are not directly buying stock in the company.
One means that is used a lot for F&F is called a SAFE, which stands for Simple Agreement for Future Equity. So an F&F investor is giving you money in return for a SAFE, which is a note (debt) that stipulates at the next round of financing (from what are called qualified investors like Angels or Venture Capitalists), these SAFEs convert into equity at the price set by that round, with a discount of between 10 and 20 percent. The discount is a little extra incentive to participate because the investor gets, say, 10% more stock than the normal investors in that round. That is because these investors took extra risk by investing so early, and their payback is to get extra stock. It is probably obvious but I’ll state it anyway: you can lose friends or good relations with your family if the whole thing goes bust and all the F&F's money is lost. It is a risk/reward situation, but these are not sophisticated or experienced investors; besides, they trust you, so if they lose all their money they are actually surprised and don’t understand how you could have brought them into something this risky. So be careful and try to make sure each investor is clear that they could lose everything they invest.
Angel investors are individuals who have a high net worth and have been investing quite a lot, and are therefore considerably more experienced and sophisticated than F&F investors. Many angels operate on their own so you can only find out about them through trusted intermediaries who know you both. Increasingly however, angels are getting organized into groups. Some angel groups have a hired managing director. Some even have created a fund that members contribute to much like a limited partner in a venture fund. And they tend to do a pretty in-depth job on their due diligence.
An angel group in Boston has a paid managing director, has a fund, and does extensive due diligence. They do not like to be part of an F&F round and they usually don’t want to be part of a Venture round because they feel they get marginalized by the venture firms. But Seed rounds are perfect for Angels and mark a great stepping stone from F&F on the way to an A-round filled with venture investors. A Seed round is a priced round (set either by the lead in the round or by the company), and if there were SAFE notes in a previous financing, usually those will all convert into equity when the Seed round closes. Seed rounds typically do not expect the company is generating any revenue or necessarily has a customer yet. In the case of social media or SaaS companies, the only thing the company can point to is that they are acquiring (free) user accounts at a steady pace.
This is when the rubber hits the road. Finding VCs that are interested at all is hard. You probably have to talk to 10-20 investors to find one willing to invest. This group is a lot more risk averse then they were just a decade ago. They definitely expect at least one solid customer and preferably more like three, and some of those need to be paying you some money. The process of courting a VC is long and involved. Unless what you are pitching—either because of the technology, market, or business model—is not at all a fit for what they like, they will not typically give you a flat no after your meeting with them. They want to keep their options open, or they just hate to hand rejection slips to people. It is best to pointedly ask them if they are seriously considering an investment. You are much more likely to get a straight answer if you ask them a straight question.
Your goal here is to find the lead investor. Doing so changes the entire process. A lead is the one who leads the due diligence. They recruit other investors with an ease you will never achieve as the entrepreneur, and this ideally becomes the syndicate that will represent your A-round. After due diligence comes negotiating terms. You need a very experienced attorney at this point because deal terms are very arcane and seemingly small things can turn into huge big-deal items later. And when I say experienced, I mean experienced specifically in venture financing. This is the most important advice I have in this entire post.
Good luck! This is really hard, but if you get well-financed, you have a great team, the market is ready, and you have a great product or service for that market, it will all be worth it.
The weekly CEO Column features Dover Founder & CEO Jothy Rosenberg’s thoughts on product, industry, community, leadership, and more. Center stage, every Monday. Be sure to subscribe to the Doverlog to never miss a beat, and continue to check in right here on our site!