Over the past few years, I have helped raise nearly $25 million dollars for Shoutlet. So it’s no surprise that several new entrepreneurs ask me about the process of obtaining Venture Capital funding. I’ve learned some very valuable lessons throughout the process, and I’m hoping that this post will help you examine all of your available options before you consider funding.
First, only take funding if you need it. It sounds like an obvious statement, but too many startups go out for funding just because they think they have to. I suggest to do whatever you can to self fund your startup before accepting funding.
Second, the days of funding an “idea” are over. Naive startups believe that you can simply come up with a good idea, get it funded, quit your day job and then start taking salary. Those types of funding events have not happened since the Clinton era. No investor funds an “idea” anymore. Venture Capitalist look for proven business models now. They only want to invest in a “sure thing.” My suggestion is to borrow and beg to get your idea to a prototype, sell some of it into the marketplace, then go for funding once you able to prove that it can scale.
A famous CEO told me once, “The second you take funding, you can never go back. Your business will be all about growing top line revenue and you’ll soon find yourself needing more funding to sustain your growth.” He was right. Once you accept funding, you work for your Board of Directors and shareholders, and you have an obligation to do what’s best for the company, with or without you there. I suggest examining all other options before going for funding.
Consider this story from my friend and fellow entrepreneur Jack Phan. He’s an entrepreneur that did it both with and without funding. I’ve asked Jack to share his story:
“In 1997, I was involved with an early Internet startup in Portland, Ore during the dot-com boom of the 90s called Handyman Online. By 1998, our technology for online lead generation, matching and lead distribution systems proved so successful that we were growing beyond our capacity and had to expand offices and take on more overhead. By 1999, we had raised nearly $26 million dollars in funding, hired a new CEO, opened nearly 30 physical offices nationwide and grew our headcount to 300+ employees. We spent several million dollars to hire a consulting firm to do an overhaul of our technology infrastructure, complete hardware upgrade and bring in enterprise level software to support a large business.
By 2000, we had given up control, burning through cash at a faster rate than we could grow revenues, and by spring of 2001, during the dot-com meltdown, we needed the next round of funding but our investors had all fled. The more money we raised, it appeared the more money we would need to keep growing and chase profitability. Eventually, we sold our assets to our biggest competitor and walked away with nothing.
However, it didn’t take long before we were back at it. By September of 2001, we had started a new company called ReliableRemodeler.com and vowed to grow this company with our own resources and not give up our equity if we didn’t have to. The goal was simple; grow with our own resources, build a solid team, wear as many hats as we could manage and try to double our revenues each year while maintaining control of our company.
By 2007, we landed #187 on Inc. 500’s Fastest Growing Private Companies by achieving more than 1100% growth. The offers started to come in and by February of 2008, we successfully sold our business to a Bay Area company in the lead generation space for all cash. Our patience, hard work and dedication finally paid off. We probably could have grown faster had we taken on investor money like the first business but we would have given up control, equity and would have had to sell our business for at least 10 times what we sold it for just to achieve the same personal financial exit.
My advice is have a good business model first, take money only if you have to, do your job as an entrepreneur to add value, work your butt off, and build a business that can be self sustaining for a long time. In the end, your hard work and dedication will pay off.”
– Jack Phan
Funding Sources (listing by recommended order of priority):
- Pre-sell – If your idea is solid enough, why not try pre-selling it to customers? When I first began Shoutlet, I sold the idea of our platform to clients by showing them a PowerPoint presentation well before it was actually built. I promised prospects a substantial discount and the opportunity to help shape my product roadmap if they ordered in advance. I funded the entire first version of Shoutlet from taking pre-orders.
- Friends and Family – Your own friends and family can be an excellent source of funding. It may surprise you how supportive they can be when you approach them for investment. Most families have a “rich uncle” that is more than willing to help. If you do get funding from family, I would make the process formal. Set a valuation and determine your terms of investment before you take their money. I’ve seen verbal deals lead to lawsuits later, which can be ugly for families. Also be clear about the risks involved in funding a startup.
- Bank Loan – After last year’s financial crisis, getting money from bank institutions is much more difficult than it used to be. I’d recommend a bank loan if you truly have faith that your product or service is going to sell immediately AND if you have collateral to offer the bank (such as your home, car, or 401k account). My advice is to never put yourself into a situation that you can’t unwind. Always make sure that you can pay off the loan even without selling your product or service.
- Angel Funding – Often you can obtain funding from high net worth individuals in your hometown. These people can often be found by networking with lawyers, bankers, accountants. Be sure that the individual is an accredited investor. There are certain rules you need to follow to stay out of legal trouble when going the Angel route. Often Angels invest in the individual, not necessarily the company. It’s much easier to get Angel investors than it is to go out for Venture Capital funding.
- Venture Capital – Venture Capital money is the toughest to get. The folks that run these firms are often Harvard or Stanford educated with several years of experience in funding and selling companies. They receive hundreds of business plans per month, and only jump on the ones that completely align with their firm’s investment criteria. To obtain Venture Capital, you often have to already be generating revenue with a proven business model. Venture Capitalist invest in the company, not the individual. They want to see how you can scale your company and give them a ten times multiple on their investment. To pitch a Venture Firm, I recommend having two pieces to your pitch: 1) A PowerPoint presentation that can tell your story in less than 10 slides and 2) An Excel sheet that proves your revenue model. Note: VCs think in bullet points. Be clear, concise, and to the point. You can visit the National Venture Capital Association for information on Venture Capital. Also, it may be helpful to download a Term Sheet so that you can see in advance what your investment terms might look like. In addition, be sure to check out The Funded to see how well your potential Venture Capital investors are rated by other entrepreneurs.
- Crowdfunding – Kickstarter gained significant attention as a way to get funding for your new product or service through the internet. Crowdfunding allows inventors to list their idea on a popular website in an effort to raise funds before the idea goes to market. Often several hundred (or thousand) people will invest or pre-order your product before you build it. I’ve found this process to be very effective for product (not as good for services) that you want test the market before you go bigger.
Types of Investment Instruments (Definitions from Wikipedia):
- Preferred Stock – Preferred shareholders have priority over common stockholders on earnings and assets in the event of liquidation and they have a fixed dividend (paid before common stockholders). I’ve seen almost all Venture Capital deals use Preferred Stock. Basically, they get their back before you do. They also get nifty little add-ons like dividends and participation rights (extra ways of squeezing cash out).
- Common Stock – The type of stock most often used for investment. If your legal structure is currently a Limited Liability Company, you might have to change it to a C Corporation to begin selling Common Stock. Most Angel investors are fine buying Common Stock as it’s the same type of ownership you would have an the entrepreneur. One of the only ways for an entrepreneur to get Preferred Stock is if you put a significant amount of your own cash into the company.
- Warrants – A warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiry date. Warrants and options are similar in that the two contractual financial instruments allow the holder special rights to buy securities. Both are discretionary and have expiration dates. The word warrant simply means to “endow with the right,” which is only slightly different from the meaning of option.
- Debentures – A debenture is a document that either creates a debt or acknowledges it, and it is a debt without collateral. In corporate finance, the term is used for a medium- to long-term debt instrument used by large companies to borrow money. Basically, it’s give companies that opportunity to borrow money from investors instead of going to a bank.
- Stock Options – A call option on the common stock of a company, granted by the company to an employee as part of the employee’s remuneration package. The objective is to give employees an incentive to behave in ways that will boost the company’s stock price. If the company’s stock market price rises above the call price, the employee could exercise the option, pay the exercise price and would be issued with ordinary shares in the company. The employee would experience a direct financial benefit of the difference between the market and the exercise prices. If the market price falls below the stock exercise price at the time near expiration, the employee is not obligated to exercise the option, in which case the option will lapse. Restrictions on the option, such as vesting and non-transferring, attempt to align the holder’s interest with those of the business shareholders.
- Phantom Stock – A form of compensation where a company promises to pay cash at some future date, in an amount equal to the market value of a number of shares of its stock. Sometimes companies prefer to use Phantom Stock for its employees because it gives them similar benefits to Stock Options, but without voting rights. Additionally, Phantom Stock doesn’t need to be purchased at a later date like Options do, so there is no money out of pocket. However, Phantom Stock is often taxed like a cash bonus, so employees cannot take advantage of long-term capital gain tax discounts like they can with Options.
So, where do you start? That’s a good question. You have planted the seeds, and now it’s time to develop the roots of your company with a strong management team. Once you set a solid foundation in place, your company will flourish. Investors bet on your teams as much as they do your company, so select your branches wisely.
Remember at the end of the day it’s all about control. Even though Facebook has raised several rounds of capital, Mark Zuckerberg still controls all of the votes for Facebook. If you position yourself correctly, you can do the same.
I hope you found this post helpful as you consider raising capital. Let me know if you have any questions or need any additional advice for your own funding process.