Posts
A typical start up goes through several rounds of funding. Each round requires that you raise enough money to get into the next round of funding. Few startups get the funding process right. Some startups are overfunded, while others are underfunded. It is obviously in the best interest of founders to understand the mechanism of funding and the thought processes that investors go through before they decide to fund a start up business.
Sources of startup funding:
a) Family and Friends
Family and Friends are the sources of funding for most startup businesses. Most founders graduate from university, borrow money from their parents and friends, lets assume $10,000 and they start a business which with the help of the borrowed funds makes it past the 12 month mark. There are advantages and disadvantages to borrowing money from friends and family. An advantage worth mentioning is that friends and family are easy to find because you already know them, therefore making it easier to borrow money for funding. However, there are disadvantages too. Firstly, your friends and family may not be as connected as angel investors might be. Secondly, you will be mixing your business life with your personal life, and thirdly, friends and family may not be accredited investors either.
The SEC defines an accredited investor as someone with over $1,000,000 in liquid assets or an income of over $200,000 a year.
b) Consulting
Another way to fund a startup is to get a job. The best sort of job is a consulting project in which you can build whatever software you wanted to sell as a startup. Then you can gradually transform yourself from a consulting company into a product company, and have your clients pay your development expenses.
This is a good plan for someone with kids, because it takes most of the risk out of starting a startup. There never has to be a time when you have no revenues. Risk and reward are usually proportionate, however: you should expect a plan that cuts the risk of starting a startup also to cut the average return. In this case, you trade decreased financial risk for increased risk that your company won't succeed as a startup.
c) Angel Investors
Angels are individuals who are rich. The word applies to individual investors generally. When dealing with angel investors, sometimes its worth noting that contacts can be more important than the money itself. You can do whatever you want with money from consulting or friends and family. With angels we're now talking about venture funding proper, so it's time to introduce the concept of exit strategy. Investors will only consider companies that have an exit strategy and the reason for this that they expect the founders to sell the company or go public so that they can get their money back along with some returns.
This is not as selfish as it sounds. There are few large, private technology companies. Those that don't fail all seem to get bought or go public. The reason is that employees are investors too—of their time—and they want just as much to be able to cash out. If your competitors offer employees stock options that might make them rich, while you make it clear you plan to stay private, your competitors will get the best people. So the principle of an "exit" is not just something forced on startups by investors, but part of what it means to be a startup.
Another important concept that should be noted is valuation! When a person pays money for the shares of a company, it gives the company a certain monetary value. For example, if someone pays $30,000 for a 20% share of a company, it means that that company is in theory worth $600,000.
d) Seed Funding Firms
Seed firms are like angels in that they invest relatively small amounts at early stages, but like VCs in that they're companies that do it as a business, rather than individuals making occasional investments on the side. According to the National Association of Business Incubators, there are about 800 incubators in the US. What is an incubator? Because seed firms are companies rather than individual people, reaching them is easier than reaching angels. Just go to their web site and send them an email. The importance of personal introductions varies, but is less than with angels or VCs. The fact that seed firms are companies also means the investment process is more standardized. (This is generally true with angel groups too.) Seed firms will probably have set deal terms they use for every startup they fund. The fact that the deal terms are standard doesn't mean they're favorable to you, but if other startups have signed the same agreements and things went well for them, it's a sign the terms are reasonable. Seed firms differ from angels and VCs in that they invest exclusively in the earliest phases—often when the company is still just an idea. Angels and even VC firms occasionally do this, but they also invest at later stages.
The problems are different in the early stages. For example, in the first couple months a startup may completely redefine their idea. So seed investors usually care less about the idea than the people. This is true of all venture funding, but especially so in the seed stage.
Like VCs, one of the advantages of seed firms is the advice they offer. But because seed firms operate in an earlier phase, they need to offer different kinds of advice. For example, a seed firm should be able to give advice about how to approach VCs, which VCs obviously don't need to do; whereas VCs should be able to give advice about how to hire an "executive team," which is not an issue in the seed stage
e) Venture Capital Funds
Venture capitalists invest other peoples money and they invest large sums of it. The word "venture capitalist" is sometimes used loosely for any venture investor, but there is a sharp difference between VCs and other investors: VC firms are organized as funds, much like hedge funds or mutual funds. The fund managers, who are called "general partners," get about 2% of the fund annually as a management fee, plus about 20% of the fund's gains. There is a very sharp dropoff in performance among VC firms, because in the VC business both success and failure are self-perpetuating. When an investment scores spectacularly, as Google did for Kleiner and Sequoia, it generates a lot of good publicity for the VCs. And many founders prefer to take money from successful VC firms, because of the legitimacy it confers. Hence a vicious (for the losers) cycle: VC firms that have been doing badly will only get the deals the bigger fish have rejected, causing them to continue to do badly. In a sense, the lower-tier VC firms are a bargain for founders. They may not be quite as smart or as well connected as the big-name firms, but they are much hungrier for deals. This means you should be able to get better terms from them.
Better how? The most obvious is valuation: they'll take less of your company. But as well as money, there's power. I think founders will increasingly be able to stay on as CEO, and on terms that will make it fairly hard to fire them later
Because VCs invest large amounts, the money comes with more restrictions. Most only come into effect if the company gets into trouble. For example, VCs generally write it into the deal that in any sale, they get their investment back first. So if the company gets sold at a low price, the founders could get nothing. Some VCs now require that in any sale they get 4x their investment back before the common stock holders (that is, you) get anything, but this is an abuse that should be resisted
Sources of startup funding:
a) Family and Friends
Family and Friends are the sources of funding for most startup businesses. Most founders graduate from university, borrow money from their parents and friends, lets assume $10,000 and they start a business which with the help of the borrowed funds makes it past the 12 month mark. There are advantages and disadvantages to borrowing money from friends and family. An advantage worth mentioning is that friends and family are easy to find because you already know them, therefore making it easier to borrow money for funding. However, there are disadvantages too. Firstly, your friends and family may not be as connected as angel investors might be. Secondly, you will be mixing your business life with your personal life, and thirdly, friends and family may not be accredited investors either.
The SEC defines an accredited investor as someone with over $1,000,000 in liquid assets or an income of over $200,000 a year.
b) Consulting
Another way to fund a startup is to get a job. The best sort of job is a consulting project in which you can build whatever software you wanted to sell as a startup. Then you can gradually transform yourself from a consulting company into a product company, and have your clients pay your development expenses.
This is a good plan for someone with kids, because it takes most of the risk out of starting a startup. There never has to be a time when you have no revenues. Risk and reward are usually proportionate, however: you should expect a plan that cuts the risk of starting a startup also to cut the average return. In this case, you trade decreased financial risk for increased risk that your company won't succeed as a startup.
c) Angel Investors
Angels are individuals who are rich. The word applies to individual investors generally. When dealing with angel investors, sometimes its worth noting that contacts can be more important than the money itself. You can do whatever you want with money from consulting or friends and family. With angels we're now talking about venture funding proper, so it's time to introduce the concept of exit strategy. Investors will only consider companies that have an exit strategy and the reason for this that they expect the founders to sell the company or go public so that they can get their money back along with some returns.
This is not as selfish as it sounds. There are few large, private technology companies. Those that don't fail all seem to get bought or go public. The reason is that employees are investors too—of their time—and they want just as much to be able to cash out. If your competitors offer employees stock options that might make them rich, while you make it clear you plan to stay private, your competitors will get the best people. So the principle of an "exit" is not just something forced on startups by investors, but part of what it means to be a startup.
Another important concept that should be noted is valuation! When a person pays money for the shares of a company, it gives the company a certain monetary value. For example, if someone pays $30,000 for a 20% share of a company, it means that that company is in theory worth $600,000.
d) Seed Funding Firms
Seed firms are like angels in that they invest relatively small amounts at early stages, but like VCs in that they're companies that do it as a business, rather than individuals making occasional investments on the side. According to the National Association of Business Incubators, there are about 800 incubators in the US. What is an incubator? Because seed firms are companies rather than individual people, reaching them is easier than reaching angels. Just go to their web site and send them an email. The importance of personal introductions varies, but is less than with angels or VCs. The fact that seed firms are companies also means the investment process is more standardized. (This is generally true with angel groups too.) Seed firms will probably have set deal terms they use for every startup they fund. The fact that the deal terms are standard doesn't mean they're favorable to you, but if other startups have signed the same agreements and things went well for them, it's a sign the terms are reasonable. Seed firms differ from angels and VCs in that they invest exclusively in the earliest phases—often when the company is still just an idea. Angels and even VC firms occasionally do this, but they also invest at later stages.
The problems are different in the early stages. For example, in the first couple months a startup may completely redefine their idea. So seed investors usually care less about the idea than the people. This is true of all venture funding, but especially so in the seed stage.
Like VCs, one of the advantages of seed firms is the advice they offer. But because seed firms operate in an earlier phase, they need to offer different kinds of advice. For example, a seed firm should be able to give advice about how to approach VCs, which VCs obviously don't need to do; whereas VCs should be able to give advice about how to hire an "executive team," which is not an issue in the seed stage
e) Venture Capital Funds
Venture capitalists invest other peoples money and they invest large sums of it. The word "venture capitalist" is sometimes used loosely for any venture investor, but there is a sharp difference between VCs and other investors: VC firms are organized as funds, much like hedge funds or mutual funds. The fund managers, who are called "general partners," get about 2% of the fund annually as a management fee, plus about 20% of the fund's gains. There is a very sharp dropoff in performance among VC firms, because in the VC business both success and failure are self-perpetuating. When an investment scores spectacularly, as Google did for Kleiner and Sequoia, it generates a lot of good publicity for the VCs. And many founders prefer to take money from successful VC firms, because of the legitimacy it confers. Hence a vicious (for the losers) cycle: VC firms that have been doing badly will only get the deals the bigger fish have rejected, causing them to continue to do badly. In a sense, the lower-tier VC firms are a bargain for founders. They may not be quite as smart or as well connected as the big-name firms, but they are much hungrier for deals. This means you should be able to get better terms from them.
Better how? The most obvious is valuation: they'll take less of your company. But as well as money, there's power. I think founders will increasingly be able to stay on as CEO, and on terms that will make it fairly hard to fire them later
Because VCs invest large amounts, the money comes with more restrictions. Most only come into effect if the company gets into trouble. For example, VCs generally write it into the deal that in any sale, they get their investment back first. So if the company gets sold at a low price, the founders could get nothing. Some VCs now require that in any sale they get 4x their investment back before the common stock holders (that is, you) get anything, but this is an abuse that should be resisted
No comments:
Post a Comment