Best Options for Funding for Startups
The dictionary definition of a startup is simply a newly established business. The motivations to start a business can be incredibly nuanced, but three basic categories exist wealth accumulation, personal achievement, and helping others.
To grow and scale up a business startup we need huge funding investment. In this blog, we explore 20+ Best Options for raising money or Funding for Startups in 2019.
The Modern Startup
The term startup has been co-opted by the media, entrepreneurs, and technology investors to mean a newly formed business in industries related to technology and the Internet that is intended to grow very quickly.
They aim to do so by developing innovative products and/or services that often replace, reinvent (“disrupt”), or improve upon traditional ways of life and commerce as they existed before the explosion of personal computing and the Internet.
Paul Graham, a renowned computer programmer, entrepreneur, and venture capitalist transcribed his thoughts on startups. To him, the most important characteristic of a startup is growth, in that the startup is designed specifically to grow rapidly.
The fundamental difference between a startup and traditional business, according to Graham, is that not only do startups “make something lots of people want,” which traditional businesses do as well.
The trait of innovative reach can be seen in most startup companies. Unlike your local community center, for example, Facebook is a hub that connects all of the worlds.
Startups Are Fickle
The upside of startups is that this new reach allows for the potential to grow and scale up a business quickly if the product or service is done right. The downside of this reach is that it now has to compete with the entire Internet, which potentially has hundreds of thousands of businesses potentially doing the same thing.
In fact, by their nature, startups are fickle. Most of them fail—an overwhelming majority of them within the first few years.
The unique advantage a startup has is that the rapid progression of technology has yet to show signs of a significant slowdown. This constant progress allows doors to be opened that were unimaginable a few years previous.
However, peering into the future is almost akin to trying to predict the future— most people get it wrong. This is why initiating a startup can be incredibly difficult. If you’re joining the industry because you think it will guarantee you wealth, you couldn’t be more wrong.
For every Google or Facebook, there are tens of thousands of failed companies that were often started by people just as smart and driven as the Google and Facebook founders.
The journey of starting a technology company can be fraught with hardships, surprises, and failures. However, the companies that battle through these challenges and continue to grow over time are the ones that change the world.
Funding Option 1 for Startups:
Bootstrapping, Debt, and Grants
Bootstrapping is the term for launching a self-financed company. The founders still incorporate, but rather than accepting investments from outsiders, they use their personal savings to fund early development. This is how most people fund their MPVs because it’s pretty tough to raise outside cash for an idea on a napkin.
Bootstrapping a hardware startup can be extremely challenging, due to the capital- and time-intensive nature of building a physical product. It’s difficult to iterate cheaply at any point in the hardware development cycle. Manufacturing problems, design flaws, wasted materials, and the risk of recall is particularly stressful when cash is in short supply.
At the same time, the design or prototype stage is also the period during which funding from an angel or institutional investors is hardest to come by. As a result, many entrepreneurs fund their startup by drawing on their own savings.
Others choose to take on debt, particularly if they believe that there is a clear path to revenue. Since many banks will not write loans for startups, this often takes the form of credit card debt or a personal loan.
Some US-based founders who commit a certain amount of personal capital to their new company might qualify for a Small Business Association (SBA) loan.
The Small Business Administration site offers several different programs, so it’s worth a look to see if you meet the various criteria. The Loan and Grant search tool might help you uncover programs that can help you.
The federally funded Small Business Innovation Research (SBIR) program offers another option: grants for small companies based in the US. The purpose of the program is to support early-stage technological innovation or research and development work. Well-known tech companies such as Symantec, Qualcomm, and iRobot received early SBIR funding.
The SBIR program consists of three stages, which are broken down according to criteria designed to gauge the technological feasibility of an idea and the progress of the company over time.
Typically a feasibility study, the first phase is designed to verify that an idea or new technology is feasible and has commercial potential and that the team is capable of executing well.
A Phase I grant traditionally provides up to $150,000 over a six-month period, though the exact amount may vary according to the budget of the specific federal agency backing it.
In this phase, the technology and approach vetted in Phase I is further refined and a prototype is developed. A Phase II award is contingent upon meeting success metrics during Phase I. It has a funding cap of $1 million over a period of up to two years.
This phase is the commercialization period. It isn’t funded by further SBIR money, but participants are often eligible for other federal funding programs, and occasionally for direct contracts with the US government. It is possible to go right from Phase I to Phase III.
Funding Option 2 for Startups:
Friends and Family
If you’re tapped out on bootstrapping and ineligible for any grants, the most friendly faces you can reach out to for money are your friends and family. They know you and trust you, and you’ve presumably already proven to them that you’re reliable and can do the things you put your mind to. They’ve probably heard you talk excitedly about your idea.
However, most people find it difficult to raise more than a small amount of funding this way. Typically, they’re able to round up an amount in the low six figures at the most.
However, if you’re a first-time entrepreneur looking for funds to build a prototype before getting to that next stage, your best bet is likely a combination of self-funding (bootstrapping) and raising money from friends and family.
Funding Option 3 for Startups:
Angel investors are individuals who invest their own personal capital in early-stage startups. Sometimes a group of individuals invests as part of an angel syndicate, but often they are simply independent investors who have a tech or startup background, have had a successful exit, and/or are independently wealthy.
They typically write checks from $25,000 to $100,000, although some (who are colloquially called super angels) occasionally go up into the $250,000 to $1 million range.
Angels often invest in areas in which they have personal expertise or an extensive network. They can be “just a check,” but many choose to be hands-on investors who actively help their companies grow.
The number of angel investors and angel syndicates has risen quickly over the last 10 years. In 2002, there were approximately 200,000 active angel investors and approximately $15.7 billion in investment dollars.
According to the most recent angel market analysis report, which was in 2013, the number of active angels is 298,800. Capital invested grew to $24.8 billion across 70,730 ventures.
This was an increase of 5.5 percent over 2012. The average size of an angel deal in 2013 was $350,830; average equity received for investment was 12.5 percent, and the average deal valuation was $2.8 million.
Many angels invest through networks such as Golden Seeds and Tech Coast Angels. The annual Halo Report tracks which groups are the most active and can be an excellent resource for identifying investors in your sector or regions.
Because startup investments are considered a risky asset class, SEC regulations require that angel investors meet the legal accreditation standards for individuals.
Currently, an individual investor can meet those standards in one of two ways: either by having a net worth exceeding $1 million (not including the value of her primary residence), or by having income exceeding $200,000 (or $300,000 if combined with a spouse) in each of the two most recent years and a “reasonable expectation” of the same income level in the current year.
THE JOBS ACT
A recent piece of legislation, the JOBS (Jumpstart Our Business Startups) Act, aims to change the requirement that investors in nonpublic companies be accredited.
Under this legislation, nonaccredited individuals will be able to invest in new “emerging growth” ventures via government-registered funding portals called equity crowdfunding sites.
Previously, a private company could have only 500 (accredited) shareholders on its blogs before it was required to meet SEC public reporting and disclosure requirements. The JOBS Act raised that to 2,000, of whom 500 can be non-accredited.
There are caps placed on non-accredited persons investing via crowdfunding sites: the greater of $2,000 or 5 percent of income for people earning up to $100,000 a year, or the lesser of 10 percent or $100,000 for people earning above $100,000/year.
Companies that choose to fundraise in this way will also be responsible for taking “reasonable steps” to verify the status of their investors.
TIP Although the bill was passed in April 2012, at the time of this writing, the SEC is still finalizing the structure of these new rules.
Funding Option 4 for Startups:
For founders who are new to entrepreneurship, finding and connecting with angel investors can seem daunting. One of the best resources for plugging into the angel community is AngelList.
Started in 2010 by Naval Ravikant and Babak Nivi, the site has grown from an email list (the origin of the name) to a comprehensive platform for enabling entrepreneurs to connect with both angels and early institutional investors.
As AngelList’s popularity has continued to grow, it has become one of the first stops that an investor makes when looking into a potential investment or getting a sense of what’s happening in a given sector or region.
The site is designed as a network, and it enables investors and founders alike to showcase themselves.
Founders can create rich company profiles that feature information such as a product video or slide deck; press coverage; traction information; incubators they’ve participated in; quotes from advisors, investors, and customers; and more.
Investors also create profiles, tagging themselves with the sectors they invest in and the check sizes they write and linking themselves to their portfolio company pages.
AngelList emails the profiles of suggested companies to targeted investors, who can reach out and get an introduction to the founders.
Users can also browse one another’s profiles and follow one another’s activity, discover trending startups, source talent or support staff (e.g., attorneys), and much more. It is a thriving community and a valuable resource.
It’s important to create a polished presence for your company. A top-notch profile can attract the attention of the AngelList team, which may feature you. With enough attention, you may become a trending startup.
In either of these cases, your startup will be emailed out to hundreds of investors and potentially showcased on the site’s front page.
In anticipation of the JOBS Act rules being finalized (see “The JOBS Act” on page 197), AngelList has recently made it possible to raise money directly on its platform. Startups that have a lead angel (someone who has committed a minimum of $100,000) are eligible to close out the rest of their round via a self-syndicate: they post the raise to the platform itself.
Angel investors can form syndicates as well. They commit to investing a certain amount of capital in a specific number of deals per year. Other accredited investors (“backers”) can join a syndicate, committing to invest alongside the lead.
This lets founders potentially receive a much larger investment through a connection with a single angel. For more information about how syndicates work, see AngelList’s Help page.
One of the most daunting things for many new entrepreneurs is the prospect of reaching out to investors and establishing a network ahead of a raise. Since AngelList’s launch in 2010, the team has worked hard to make that process easier. Ash Fontana, product manager, shared a few tips on how best to leverage the platform.
Using AngelList properly means being willing to put yourself out there, in several ways:
Give the market as much information as possible.
Create a detailed profile and think about how to make it the best possible public representation of your startup, almost like a landing page. Use the tagging system to make sure you will show up in searches by industry sector or geographical region. For hardware products, in particular, add lots of images of people using the product to your profile.
If you have units already in production, add some video! Videos help convey a sense that the product is real. AngelList proactively features the best profiles on the site, emailing them out to investors. In order to be considered, an information-rich company page is a must.
Use AngelList like a social network.
That’s how it’s architected. This requires an investment of time on your part. Just as you build up LinkedIn and Twitter contacts and relationships over time, you have to put some effort into building connections on AngelList.
Check in daily, and monitor your feed to see what people are doing or investing in. Add investors and advisors to your company profile as you bring them on. Update with important news, and have friends and followers share the updates so that you appear in their connections’ news feeds.
It’s natural to feel somewhat nervous about reaching out to investors, whether in person or online. It’s important to remember that they’re on AngelList because they are looking to fund companies.
So get out there: request introductions, follow founders and investors, and message all of the people you can message…provided, of course, that you have reason to believe that they’re interested in your space (investors also tag their profiles with their interests).
The time to join AngelList isn’t just before you want to start fundraising; it’s when you’re comfortable announcing yourself as a company. So get on there, build a great profile, and start forming relationships as soon as you’re ready to publicly acknowledge that you’re a company. Then, when you’re ready to fundraise, flip on the Fundraising switch on your profile.
Once you’re actively raising, you might want to update your profile with information specifically geared to investor questions. Add some details about your manufacturing process and relationships if you’re raising more than a small seed round; investors want to know that you’re on top of this. Share pre-sale numbers, signs of traction, and established customer relationships.
The typical process of successfully raising around involves reaching out to many investors. The best way to do that is to be authentic. Keep the first note simple, and be sure to include exactly why you think that a specific investor is a fit for your particular startup.
Once you’ve made a connection with an investor who decides to write you a check, that signal often leads others to follow. One of AngelList’s offerings, Invest Online, helps to facilitate this on the platform itself. Companies that have a demonstrated commitment of $100,000 from an AngelList investor are eligible to fundraise online.
Companies participating in the program are emailed out to the broader AngelList community. It’s a great way to find sources of capital outside of your network, and it generally takes less outreach effort.
AngelList Syndicates are another, relatively new, way to fill out around. Well-known angels and seed investors form syndicates on the platform—mini-funds, in a sense, seeded with their own capital but filled out with money from smaller investors.
This means that an individual angel who ordinarily would have written a $25,000 check has a bigger group behind him and can conceivably now contribute a much bigger amount, in the hundreds of thousands of dollars. Reaching out to these investors is a bit like approaching a fund.
More than a third of the investors on the AngelList platform are institutional investors, from VC and seed funds. It’s more than a place to find your first $100,000.
And as a startup itself, AngelList is constantly launching new features to facilitate connections and access to capital. Be sure to check out the AngelList blog for the latest tools to help you get out there and raise money.
Hardware is a particularly popular category on AngelList, and it attracts a lot of investor interest. “It’s always good to get some pre-sales on Kickstarter or elsewhere, and then go on AngelList to raise an equity round,”
Ash says. “This is a common and successful strategy; investors see it as validated demand. But ultimately, at the angel stage, it’s about the people and the product.”
Funding Option 5 for Startups:
Venture capitalists are professional investors who provide capital to young, high-growth-potential companies. A majority of the capital comes from outside investors (limited partners, or LPs) and is pooled in an investment vehicle called a fund.
Because the life cycle of a fund is typically 10 years, venture capitalists target investments that will achieve a return for them within this time frame. Generally speaking, they expect to lose or break even on most of the investments in a given fund but earn outsized returns on a few.
Raising a venture capital round is hard work, particularly for a hardware company. Historically, many venture investors have avoided hardware because of the high cost to bring a product to market, the difficulty of rapid iteration, and the challenge of vetting market demand prior to product release.
As discussed earlier in this blog, those concerns have been somewhat mitigated recently, and an increasing number of institutional investors are putting money into hardware startups.
It’s difficult to get exact stats on the flow of money into hardware startups, but data from DJX VentureSource indicates an increasing amount of investment dollars in the sector: in 2012, $442 million was invested into hardware startups. By 2013, that number had nearly doubled, to $848 million.
Even though more checks are being written, fundraising can still be a long slog. Many entrepreneurs on both the hardware and software side will tell you that fundraising becomes their full-time job for several months until they manage to close around.
Since you’d probably like to minimize that phase and get back to product-building, let’s go over some best practices for successfully closing deals with institutional investors.
Funding Option 6 for Startups:
It’s difficult to overemphasize the need to choose your target investors carefully. It’s important to know what value-add you’d like your ideal investor to provide.
Venture investment is a long-term partnership, so it’s important to find people who will be able to help you grow. A first venture capital raise should be used to help you scale and find product-market fit.
In the short term, you need partners who can help you reach the milestones you’re raising money to hit. If you haven’t yet gotten to market, for example, you might want an investor who’s helped other portfolio companies navigate the manufacturing process.
If you’re selling something into a niche channel (say, a health tech device), you might want to find investors who can help you with connections into hospitals, or who have navigated an FDA approval process. Money is money; the value-add of investors is in the extent to which they can help you grow your company.
The fundraising process is similar to sales: you’re selling a vision. Start by building out a fundraising pipeline. Identify a set of investors you want to target and set up a spreadsheet or customer relationship management (CRM) system to keep track of contact dates, feedback, and requests for follow-ups or additional information.
How do you identify investors and populate the pipeline? Do your research and be selective. To find the investors for you, read news articles, industry publications, and blogs focused on your sector to discover who the active participants are.
Check Angel List’s investor profiles; most VCs on the platform have tagged themselves with relevant sectors or geographic areas that fit their investment theses.
CrunchBase and Quora are also good resources. CrunchBase releases monthly database dumps as Excel files. Get in there and sort by sector and date, and see what funding events are happening in hardware and who’s participating. If you’d like to hear more about an investor’s process or what she is like to work with, reach out to connections in the portfolio.
Not all venture capital funds are the same. Some don’t invest in hardware at all. Some, especially smaller funds, won’t touch certain sectors with large up-front capital requirements or significant risks (e.g., health-care devices requiring FDA approval).
Be aware that most VCs won’t fund companies that are potentially competitive with their existing investments because this can create conflicts of interest. Fortunately, most VC firms’ websites include a portfolio page, so you can get a sense of what the firm looks for.
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Funding Option 7 for Startups:
After you’ve identified the investors who are the best fit for your company, it’s time to reach out for a meeting. The ideal way to do that is to find a mutual connection who can send a warm introduction.
LinkedIn is a great place to discover how specific investors are connected to you through your personal network. Entrepreneur friends who have founded or work at one of the VC’s portfolio companies are another great way in.
If you don’t have a strong network yet, don’t be discouraged. Creating your own warm relationships with investors is much easier than many founders think. If you have a particular reason to want to raise from someone, you probably are interested in his advice just as much as money. So, ask for it. Reach out over email or Twitter.
Ask for a coffee or a quick call, and specify that you’d like to hear his take on a problem or space. It’s important to be specific in your ask. Just saying you’d “like to talk” leaves the investor wondering if you’re beating around the bush about fundraising.
As a relationship develops, there are more meetings, calls, or email updates—more dots. Eventually, the investor can draw a line connecting these dots, see the path the company has taken to date, and predict where it might go in the future.
The truth is, it’s rare for an investor to write a check to a founding team that she has just met, or that comes with no validation through a personal connection.
Sometimes, it’s easiest to establish a relationship with an institutional investor who isn’t a partner at the fund.
Analysts and associates might not have check-writing power, but it’s their job to meet interesting entrepreneurs, and they are more likely to have time for a coffee and feedback session than a partner might be.
While some Silicon Valley conventional wisdom will tell you not to waste your time with junior investors, their incentives are aligned with yours. They want to bring good companies in to pitch the partnership as much as you want to be in there pitching.
Associates will often help guide a founder through the process and advocate for their favorite startups in the firm’s weekly meeting.
It might mean a few extra meetings before you get to the partners, though, so if you’re truly short on time or about to close around, it isn’t rude to make that clear.
While there are many approaches to establishing a relationship, sending a 30-page deck to the blind-submissions email address (e.g., email@example.com) is not one of them. Those email addresses are rarely checked because investors receive hundreds of emails to their “real” email accounts on any given day.
If you have no connections at all to an investor whom you want to talk to (and no way to make them), try to at least discover his direct contact information. Many institutional investors are also on AngelList, so you can reach out to them via the platform’s Messages service.
TELLING A STORY
Once you’ve landed the meeting, it’s time to tell your story. A good pitch is a story about a problem and a solution. It’s a narrative that weaves together both your existing progress and your future vision.
If you have a prototype or demo, craft the flow of your story around showing it off. Showing is always better than telling.
The best pitches touch on the following things:
What is the customer pain point you’re trying to solve? Be specific. What is it about the problem that has appealed to you on such a deep level that you’re willing to devote years of your life to solve it?
What is your fix for the pain point you’ve just articulated to the investor? The solution doesn’t have to be absolutely innovative; it’s fine to be building a better mousetrap, as long as you’re able to articulate specifically why your mousetrap is better. Are you competing on price, on features, or on something else entirely?
Why is your team the best possible group of people to be solving this problem? Do you have a background or personal experience in the space? The founding team is the most important criterion for many VCs. Ideas often change, so investors back solid people in who inspire confidence.
If you have previously built a company or successfully launched a product, be sure to emphasize that. Even if it’s not relevant to the specific space you’re working in now, VCs like to back founders who have demonstrated an ability to execute. If you’re a first-time founder, focus on professional accomplishments and the milestones you’ve already hit on the product you’re pitching.
The addressable market
Who are the people suffering from the problem that your widget is solving? How many of them are out there? What percentage is likely to pay for your product? Many founders find this difficult to quantify, but it’s important to understand the economics of the space you want to sell into.
You have to be able to make a compelling case for why your market is big enough to be appealing to an investor. Do your homework here, and be honest.
There is a difference between total market (e.g., all of the teachers in the country) and addressable market (e.g., the teachers working in school districts with a budget capable of buying your awesome new ed-tech device).
There are many products out there, hardware or software, that are beautifully designed and in demand by some group of people.
But if there aren’t a lot of potential buyers as well (the SOM is small), VCs are going to be hesitant to back your company. You might hear the term “lifestyle business,” or “not venture-fundable,” in their feedback to you.
This means that your idea is good enough that some people will undoubtedly buy it, and you might earn a nice living from it, but it’s probably not going to grow into a billion-dollar company capable of generating the returns that venture investors are looking for.
You might be asked, “Are you a product or a platform?” This is the investor’s way of asking if he’s going to be backing the one widget you are currently producing, or if there is a vision for a stable of products.
Will you be content making a single connection can opener, or are you striving to be the next Oxo? This is of particular concern for startups that don’t have a software component.
It can be difficult to build community engagement and brand loyalty around a single simple physical product. If that’s all you’re personally interested in making, that’s fine.
But it’s going to be difficult to convince an institutional investor that a product line consisting of one type of mousetrap is going to sell enough units to produce venture-caliber returns. A well-articulated game plan for how you will become the next Oxo is much more compelling.
Your traction and revenue
If you have any existing traction, get it out there, front and center. Investors love traction. If you are a hardware company with a software component, share your engagement numbers and relevant software metrics.
Share preorder or sales data. Mailing list signup counts. The number of Kickstarter or Indiegogo backers you have, and the total dollars raised.
Enterprise company letters of intent (LOI). Any data that you have that can indicate to an investor that there is a demand for your product. Most early-stage investors aren’t looking for some specific magic number of orders or amount of revenue; they care about trends over time.
The funding ask
Why are you asking this investor for $3 million? What does that $3 million get you? Be specific. Is it for hires, or marketing, or manufacturing? While most seed-stage investors ignore the financial projections of early-stage software companies, the hardware is a different beast.
Certain things need to be paid for: salaries, manufacturing, warehousing, shipping, etc. Don’t forget about rent, legal costs, certification costs, and marketing.
It’s important to have a clearly articulated estimate of what your costs will look like, particularly if you’re asking for money to go to market for the first time.
This doesn’t have to be anything fancy, but it should convey how the dollar value that you’re asking for gets you from point A to point B. The investor wants to see you asking for an amount of money that can plausibly give you 18 months of runway.
Every startup has competition. Period. You might argue that your device is the very first of its kind to be conceived, but few problems are new, so your competition is whatever people are currently doing to overcome this difficulty.
If they’re doing nothing, then your competition is people not thinking this problem is important enough to bother spending money on your solution.
Be honest about your competition, because the investor is going to do her own competitive research as well. If you’ve conspicuously neglected to mention your closest competitor, you will seem either dishonest or uninformed about your market.
Many founders like to draw a feature matrix if they’re competing on features, or a quadrant visualization if they’re competing on multiple factors.
Typically, each of the sections just discussed gets one, maybe two, slides. There are many great blog posts describing how to design an optimal slide deck.
One of our favorites is Guy Kawasaki’s “The 10/20/30 Rule of PowerPoint” (10 slides, 20-minute presentation, no font smaller than 30 points). You can also hit Slideshare, where many startups share their presentations.
TIP Do note that a deck that you send out is different from a deck that you present in person. You don’t want to be reading your slides to the VC in an in-person meeting…and you don’t want to send a minimalist deck with one word per slide to an investor over email.
If you’re building something that is truly new, such as innovative technology, be prepared for investors who don’t understand what you’re doing. VCs are great generalists, but you might find that few have had professional experience in your area.
Being able to convey why what you’re doing is important to nonexperts is a valuable skill. You’re selling your concept to the VC now, but you will have to sell the product to customers or explain it to the press eventually.
Visuals or nontechnical diagrams in the deck are a great way to make things more comprehensible. An appendix is a great way to ensure that you have all of the information you need to answer the most common questions, while still adhering to the 10/20/30 rule.
If your pitch goes well and the VC partnership is excited, most will begin the process of doing due diligence. This phase takes anywhere from a few days (if the VC already knows the market well) to a few weeks (if the investor wants to do some in-depth research or customer interviews).
The purpose of due diligence is to answer the “Who, What, When, Where, and Why” questions around a particular opportunity. At an early-stage fund, due diligence comprises market research, competitive research, and founder reference checks.
The investor will examine the drivers underlying the market you’re targeting. If you’re working on a health-tech device, this will likely include the regulatory environment.
Competitive research typically takes the form of understanding who the entrenched big players are, and also doing a search for other startups in the space, to see how your offering compares.
Founder reference checks will start with the names that you provide to the VC, but they will likely also include “back door” checks of people you and the investor have in common, or other names that your references provide.
Customer validation phone calls are quite common, particularly if you’re a B2B company. The VC will ask to see your cap table.
Finally, if you already have revenue and are doing a first venture raise later in the game, a thorough examination of financials will also be part of due diligence.
So, what makes a VC say yes or no? VCs most commonly do a deal because they love the team and they are excited by the problem. Building a product that solves a big, meaningful problem typically means that customers will be drawn to your solution organically (or at least that they will be willing to pay you for it).
Investors say no for a variety of reasons. Many health-related hardware companies find that investors are scared off by the 510(k) approval process. For consumer devices, the “product vs. platform” issue might make a startup seem unlikely to grow into a big enough company to tempt a VC.
Sometimes, the pass is about your stage not aligning with where the investor prefers her investments to be (if this is the case, it makes sense to stay in touch occasionally and reach out again for a future round).
“No” is the most common response by far, so don’t be discouraged if your first few investor meetings don’t lead to checks. If you do get passed on, it’s perfectly reasonable to follow up and ask for feedback as to why.
Strategics for funding
A strategic investor is another type of professional investor worth a separate mention. Strategics typically represent the corporate venture capital or investment arm of a large corporation (e.g., Time Warner Investments or Dell Ventures).
These funds generally invest because of the potential for a mutually beneficial relationship between the big company and the startup.
Sometimes, this takes the form of supporting a potentially complementary product or an experimental technology that might one day help the strategic investor enhance its own product line.
There is often a financial motive: many of these firms specifically focus on areas in which they have deep domain knowledge, so they are likely to have a better-than-average chance at picking a winner. They will often invest alongside traditional VCs.
There are pros and cons to taking money from a corporate venture fund. The strategic partner might add value in the form of technical or business expertise in the industry.
Some will offer access to or advice about marketing channels or management. A big brand publicly signaling interest might also provide a nice PR boost to a young company. Finally, some are simply acting as passive investors, who will provide a source of capital and are likely to follow on in later rounds.
However, on the flip side, there is typically higher personnel turnover in a corporate venture fund, so you might find yourself losing an internal ally and struggling to form a new relationship.
Competitors of your strategic partner might be reluctant to become your customers. Occasionally, the strategic investor might require terms that specifically prevent you from selling your product in their competitors’ distribution channels or retail stores. They might attempt to structure a deal more like a technology license transfer than a real equity investment.
There are also potential concerns about mergers and acquisitions further down the road. You might limit your pool of potential acquirers if one of your investors is a strategic competitor because of the acquiring firm might be hesitant to divulge information about the state of its own business.
A strategic investor with a large ownership stake might have the ability to block a sale. It is important to be sure that long-term strategic partnership intentions and incentives are aligned before accepting corporate venture capital.
Structuring Your Round
When you go out to raise around from angel or institutional investors, you have to decide if you’re going to pursue convertible debt or equity financing.
In a convertible note, an investor makes a debt investment (a loan) that converts to equity in the future, generally when a subsequent equity round has been raised. The note is typically structured with a set time period by which you must convert to equity or repay the loan.
A typical convertible note asks looks something like this: “We are raising $750,000 with a $6 million cap and a 20 percent discount.” The first dollar amount is what the startup is looking to raise. There is often a conversion trigger that applies to future fundraises;
for example, once $1 million in total has been raised, the debt will convert to equity. Otherwise, the note converts when a priced equity round is raised. The discount (20 percent in our example) is a reduction in the price of that theoretical next round, and it is designed to incentivize early investors.
If the company goes on to raise a subsequent Series A equity round at a $10 million valuation, the investor holding the convertible note receives her shares at a 20 percent discount.
So if the stock price during that Series A round is on a dollar a share, his earlier $750,000 debt investment converts to 935,700 shares of stock at 80 cents a share—a 20 per-cent discount in price. An investor entering the Around would get 750,000 shares.
The other piece of the note structure, the cap, is a ceiling that limits the valuation at which the debt can convert to equity, and is designed to align entrepreneur and investor incentives and reward early investors.
Consider the previous example: the cap is $6 million, and the valuation arrived at during the Series A negotiations is $10 million at one dollar a share. The convertible note holder’s $750,000 investment converts as if the company was valued at $6 million: he gets 1,250,000 shares at 60 cents a share ($6 million/$10 million).
Generally, the debt will convert at the lower value of the per-share price as determined by the cap or the discount.
In our example, the best option for investors is the 60-cent price from exercising the cap (not the 80-cent price via the discount). There are many possible intricacies in the terms of convertible notes, including interest rates and liquidation preferences, so make sure you understand what you’re offering.
The main difference between a convertible note and a priced equity round is that no value is set during the former. Priced equity round math is a bit simpler. Rounds are quoted as “$X invested on $Y Pre” (e.g., $750,000 on a $6 million pre-money valuation).
The post-money valuation, which is what the company is worth following the close of the equity raise, is determined by adding up the pre-money valuation and the amount of investment. In our example, post-money is $6.75 million.
Most institutional investors are looking to maximize their ownership percentage relative to the post-money valuation. Typically, they will target between 10 and 20 percent ownership.
Using our example, the VC’s investment of $750,000 is 11.11 percent of the final $6.75 million company. Valuations are generally based on comparable companies. Historically, VCs have had a bit of an edge in negotiation here, because they see deals daily and are familiar with the closing prices of other deals.
However, industry transparency is increasing. Your banker can likely provide you with a list of deals similar to yours, and Angel List recently launched a Valuation tool that lets entrepreneurs check comparables themselves. Law firm Fenwick & West also offers an annual Seed Financing Survey, which can help you understand market trends.
Hardware companies are often more capital-intensive than software companies, so many choose to raise on a convertible note to avoid discussing valuation until there are more data points (e.g., sales).
It is often faster to raise money via convertible note because a rolling close is possible (i.e., not all capital has to come in at once), legal fees are lower, and you can avoid having to formally convene a board.
However, many venture capitalists feel that investor and entrepreneur incentives are misaligned during a convertible note raise, particularly if there is no cap.
Many institutional investors also believe that their investment is more than just a check, and want to take a board seat and an active role in helping their portfolio companies grow. It is always best to approach an investor with an openness to negotiation, particularly if you believe she’ll be a valuable partner in the long term.
If you’re a growth-stage company (i.e., you’ve already raised a Series A, and you have a steady revenue stream), you might be eligible for a form of financing known as venture debt.
Certain banks will offer venture-backed companies the option to take out a loan for working capital or financing a specific project, typically in exchange for interest and warrants.
The bank will occasionally also want the option to invest in a future equity financing round. If you’re interested in using venture debt to fund a production run, there are helpful financial models online that can enable you to get a better sense of how the cash flows work, and whether it’s a suitable option for your company.
Following are the terms that people working in startups are quite familiar with. They will be referred to later in this blog.
Agile: A method of developing software that emphasizes adaptability, collaboration, and cross-functional teams
Angel investor: An individual who provides the initial capital for a business to start, in exchange for equity/ shares in the company
B2B: A business model in which the target customers are other businesses, rather than individual persons. The opposite of a B2B company is a consumer company.
Bootstrap: bootstrap is to start and grow a company without outside investment.
Equity: Ownership shares in a company, often used to exchange for capital
Growth hacking: A buzzword for marketing with data-driven methodologies
Incubator: Organizations that help to develop early-stage startups by providing initial funding, industry insights, connections with investors, and access to a network of entrepreneurs, usually for a small amount of equity in the company
IPO: An initial public offering. This allows a company to be listed on a public stock exchange. Typically, after an IPO, a company is no longer considered a startup. Investors often hope to make a profit through an IPO of a startup.
MVP: Minimum viable product. This refers to the simplest version of the product, in terms of features, that could satisfy customer needs, built with the goal of soliciting feedback, which enables quick and iterative product development.
Pivot: A change in business strategy, often done to promote better profitability and a more sustainable business model
Product: A term that refers to the product and service that a company sells
SaaS: Software as a service. This is a business model in which software is provided as an on-demand service via the Internet. Most SaaS companies are also B2B companies.
Scope: The information that is explicitly expressed before working on a new project. Specifically, project scope refers to the work that must be completed in order to finish the project. Product scope refers to the planned features and functionalities of a new product.
Unit economics: The net revenue and cost number, expressed on a per-unit basis (per sale, per usage, etc.). It is usually used to measure the business viability and sustainability of a startup.
Valuation: A company’s worth in monetary terms. This is usually determined by assessing the company’s current capital structure, revenue, and future potential.
Venture capital: The money provided to startups that allows them to grow. Capitalization is usually done in series, typically after the initial capital provided by the angel investor or the incubator and after the startup has demonstrated growth traction.