This week’s blog continues on the topic how to finance your startup. On May 6th we posted a blog about SAFE financing and our new guest blogger explains the principles behind five common ways to get your company funded. There are several options available and we encourage you to think seriously about alternatives and options before you zero in on one or two. Each has advantages and disadvantages, so any given one may not be available or attractive to you and it’s always a question of what you qualify for, and what you are willing to give up, to turn your dream idea into a viable business. It’s important that the founders and senior executives understand the laws and regulations surrounding fundraising and should always be in contact with counsel before signing the fundraising methods discussed in this week’s post. While it adds to the costs by working with an attorney it might save the business from massive fines or other violations eventually. Experience counsel can also guide startups through other types of financing transactions not discussed in this blog such as funding from strategic corporate partners.
The different ways to get your company funded
You have a great idea for your start-up and you’ve recruited talented people interested in helping you turn your dreams into a successful business. While you can probably bankroll some expenses out of your own bank account and/or credit cards, you know that at some point your startup will need additional funding to continue on with its operations. You may be like many entrepreneurs hoping to get venture capital, or “VC”, funding since it brings instant credibility for your company and increases the chances of success. However, while the thought of a VC fund investing in your company may sound good, it may be too optimistic and not necessarily the best decision for you or the company. It used to be that a “typical” startup will go through a financing evolution that begins with funding from “friends and family”, continues with investment by angel investors or angel funds, and then, if all goes well, a coveted “Series A round” with VCs. For many companies, this is still the preferred path, but founders also should be aware of interesting funding alternatives such as crowdfunding and initial coin offerings (“ICOs”). Understanding each type of funding and the considerations of each are crucial for a start-up business before embarking on a fundraising effort.
Friends and Family
Fundraising through operating the business is the best way to fund, however, at beginning stages of the business life cycle the company is usually funded by the founders’ savings or contacting their friends and family for contributions. This is an excellent way to keep the business funded at the early stages. It’s crucial for the business to not rely on friendly handshakes or promises but rather get adequate documentation in place for every dollar coming into the business. Without following the necessary processes and documentation this could complicate matters down the line regarding compliance with federal and state securities laws.
Angel Investors
Angel investors are an attractive option for fundraising because they usually come with experience and tend to be more aligned with management compared to VCs. They will almost always be accredited investors, individuals with minimum net worth of $1 million and annual income of $200,000, satisfying federal securities laws exemptions. Being individual investors who bring their own entrepreneurial expertise with them can provide valuable experience to a start-up business. Angels invest their own money compared to VC’s which invest from pool of other investors, a situation that causes VC to have a shorter time span on their investments and patience often less than angel investors. If the start-up fails, the angel investor loses all their own money meaning an angel is personally vested in the success of the business. These types of investors will typically contribute between $25,000 and $100,000 in a company while not pushing the company as aggressively as seen in other methods of fundraising regarding the deal and creating an exit within a relatively short while. Angels are typically easier on a start-up regarding terms, such as not requiring a board seat or additional rights. An angle will become a more “passive investor” in management while being a brand ambassador advocating for the company.
An important caution for dealing with angel investors is to be alert for red-flags that an angel may be “fishing”. An angel might be more interested in the information they can get from you than they are in actually investing. If the investor is more interested in the business model, market and technology than they are in the valuation, rights and preferences it’s possible that they are fishing. And be cautious if the investor has invested in a competitor or they know more about your business than you do.
Venture Capital
Venture capital may be considered the “Holy Grail” of the start-up company’s life. There is a common belief that if a company gets funded by a VC firm that they’ve made it and are guaranteed to succeed. VCs have become successful by betting on winners, but that doesn’t mean that you have hit easy street when VCs offer you money. Many experienced start-up advisors think that taking money from a VC really should be a company’s last resort after they’ve exhausted all of their other means of fundraising. Comparatively to angel investors, VCs will be looking to make a substantially larger investment to the start-up. VCs can contribute a start-up but they could require terms that prove to be too burdensome for the startup at a stage of development. Founders should be ready for their exit from the company not long after a VC gets involved. After a couple rounds of preferred financing with VC’s the founders should expect on losing control. VC’s will typically require liquidation preferences and redemption rights as a part of the terms sheet. If a VC fears they will not be seeing the returns on their investments they may jump ship cutting their losses and forcing the sale of the company. An investment by a VC comes with high expectations. What could easily result in a massive payday for the founders could as easily result in loss of control and seeing their company sold off before they see the company through to where they had originally intended.
On the positive side, VCs have an expertise in the field that could be beneficial to the business; however, they also come with extensive due diligence periods and possibly unattainable standards. A founder must think long and hard before going down the path of VC financing.
Crowd Funding
Used to be that start-up investing was only for the rich and connected; however, crowdfunding has brought new and hot ideas to the retail investor if the founders think this is a good path to follow. There are two methods of crowdfunding that start-up businesses may seek to utilize to fundraise. The first is donation-based crowdfunding efforts where businesses seek donations on websites like Kickstarter. This is a method that may intrigue younger businesses still testing their model or product. The second method of crowdfunding is equity crowdfunding. Equity crowdfunding has gained steam as an option after the Jumpstart Our Business Startups Act (JOBS Act) which allows a company to raise up to $1 million from the public through a broker-dealer or registered funding portal. A private company may sell up to $1 million of securities in a 12-month period and not be required to register the sale of the securities with the SEC. However, the individuals that access to the portal must be highly monitored. The business can raise money through crowdfunding but the individuals investing must meet income requirements and can only invest up to a specific amount based on their annual income or net worth. Individuals with an annual income or net worth of less than $107,000 can only invest the greatest of 5% of their annual income or net worth or $2,200. For those who make greater than $107,000, they can invest up to 10% of annual income or net worth (whichever is lesser) but not to exceed a total amount of $107,000. Crowdfunding might be an option for some but there are considerations that most may find dissuading. For example, angel investors and VCs may be reluctant to invest in a company that already has a large number of unaccredited investors. In addition, if the crowdfunding offering fizzles the founders may not recover from the setback regardless of how they change their business model.
ICOs
While an ICO may not be a viable alternative for most start-ups, it is the “now” topic in technology. ICOs are tremendously expensive and outrageously complicated to properly perform requiring extreme consideration before performing any token generating event. An ICO is a community supported crowd sale of a cryptocurrency token issued by a company. ICO “tokens” or “coins” are digital coupons used by new cryptocurrency start-ups to raise funds for their operations, with most companies only accepting convertible virtual currencies in exchange for these tokens. While ICOs are new, complex, and greatly misunderstood they provide excellent opportunity for funding in an exciting new area if correctly managed and implemented. An ICO is an enticing option for modern day start-ups because it allows the company to create liquidity and grow the company without giving up equity in the company. The implication of securities laws is a very realistic outcome from performing an ICO and a company seeking to raise funds through this means must take extreme precaution before moving forward with any token sales.
