Raising Money for a Startup

Most startup ventures need to raise money, if only to support the entrepreneurs until the venture creates appreciable cash flow. Besides salary, funds are needed to purchase supplies or initial inventory, to do pre-launch marketing, to outfit a laboratory or office, to travel to potential customers, clients, or investors, and so forth.

I use the table below in my course. The dollar amounts and the time durations will vary greatly depending on the product. The numbers in the table correspond to a business that will manufacture a piece of hardware. Software development is much faster-one could almost replace "yrs" (years) by "mths" (months) and be reasonably accurate. The dollar amounts though are about the same for software and hardware projects. This table, and the numbers, originally came from a successful entrepreneur, Frank Wezniak, who started and built an electronic instrumentation company called Biomation.

$200K	$1M-$10M	$10M-$20M	$10M-20M
Relatives, friends, Ex-entrepreneur, self angels	VC#1	VC#2	Financial Company (Insurance Co.)
5-10 yrs	3-5 yrs	2-3 yrs	1 or 2 yrs
Very Important	Very Important	Less Important	Minimal
100%	20%-40%	25%-40%	25%-30%
2 or 3	3 or 4	Full Team	Company
Idea and business plan	Prototype	Working Prototype	Revenue

In the table above the abbreviation "VC" means Venture Capitalist. Some venture capitalists specialize in early stage entrepreneurial enterprises. These are denoted by "VC#1". Others, "VC#2", do latter stage deals.

The information in the table should be clarified. The first column shows that a seed stage enterprise might have 2 or 3 people involved. They will need about $200,000, written "$200K". The usual sources of funds for ventures at this stage are relatives, close friends, one's own savings and credit cards. More than one entrepreneur has mentioned the two well-known early stage investors Ms. Visa and Mr. Mastercharge. "Angel" investors are often successful entrepreneurs that are investing their own money, partly because they want the excitement and satisfaction of starting a new company or social service organization. If the product is hardware, a seed stage investor usually does not expect to receive her/his money back for 5 to 10 years. The same period applies in the case of pharmaceutical or medical devices companies, which have to be concerned with FDA approval. Software companies normally succeed or fail in a much shorter time-a year, perhaps. An angel investor almost always expects to be heavily involved in the project, giving advice and encouragement, perhaps as often as two days a month. Seed investors expect their initial investment will be returned100% annually; of course, they do not expect a return the first year or so but they do hope typically to receive after 5 years a return of 5 times (or more) their original investment. An example of how the value of the investment might increase is given below. Such a high return is needed because most startup companies do not earn significantly for investors, another example is shown below. Because an angel investor cannot predict how a particular venture will turn out they often are involved with several at a time. The table also shows that a common source for mezzanine financing is insurance companies or other financial institutions, including college endowment fund. These institutions invest most of their funds conservatively but often allocate a small percentage to higher risk/higher payoff investments.

The bottom two rows on the table show the growth of the organization and the progress of the idea into a product. Startups typically begin with two or three people who come up with an idea. They need funds to buy supplies, have a place to develop their idea, and (probably most important) support themselves so they do not have to hold a "day job". The culmination of the Startup stage is a convincing business plan. A solid business plan can be used to get money from early stage venture capitalists. Venture capitalists may be investing their own funds or they may be investing on behalf of others-people who do not have to time or inclination to search out promising new ventures. Often a venture capitalist will suggest that the people proposing the idea seek out an experienced business person to work with them-the expression "designated adult" is sometimes used. Such an experienced person may be one of the first hires after a company receives money from an early stage V. C.

It is important for entrepreneurs to maintain the confidence of the angel investors and early stage venture capitalists they deal with. Investors form a fairly close-knit community and discuss the projects and entrepreneurs they are working with. Especially in the second stage, few venture capital firms want to finance a whole deal so a team of investors is needed. If an entrepreneur has a poor reputation other investors will not want to join the team. The entrepreneur should select an angel or first stage investor who is widely connected in the investment world, who can give advice about other investors and make introductions

After the Mezzanine stage shown companies have reached maturity. Some companies simply continue to operate as private ventures, paying the investors off in dividends from the cash flow generated. Often though investors want their money back as soon as possible-so the investors can reinvest it in other startups. Investors get their money back generally by selling the equity they have in the company. The equity becomes marketable, "liquid", if the startup does an Initial Public Offering-IPO-or if the company merges with another company. An IPO is exactly what it sounds-the company offers its stock to the general public for the first time. The Securities and Exchange Commission has stringent regulations for IPO's, aimed to protect possible buyers of the stock, so an entrepreneur would contract with an investment banking firm to manage the IPO. Once an IPO has been completed the original investors can sell their stock on the open market. Another to way for companies to make their equity liquid is to be acquired by another company, one that has already gone public. Part of the acquisition agreement would be an exchange of stock-each share of the startup company is exchanged for a certain number of shares of the acquiring company. Once the acquisition is completed, investors can sell the shares in the acquiring company. The word "merger" is also used to describe the acquisition process, especially when the two companies are approximately the same size. The acquisition process is complicated so the two parties would nearly always both contract with investment bankers for guidance.

Being acquired or going public is not always in the best interest of the entrepreneur. It is a complicated and somewhat expensive process. Managing a publicly held company is more difficult than managing one privately held; for one thing management has no control over who owns the stock of a publicly owned company and must answer to the requests of major stockholders. These major stockholders may be less sympathetic than the original investors. Publicly held companies must meet certain legal requirements. The passage of the Sarbanes-Oxley Act a few years ago has increased these restrictions and therefore increased the administrative costs of running a publicly held company. An IPO or merger does benefit the entrepreneur financially; at the time of an IPO or an acquisition the entrepreneur will most likely own a significant percentage of the equity. When the equity is liquid the entrepreneur can sell part of her or his holdings and gain cash. In practice this sale cannot be done for 6 months or so after an IPO; the time is called the "lockup period"; its purpose is to let the stock price stabilize. Often it is the investors who pressure the entrepreneur to make their investor liquid-the entrepreneur benefits by choosing early investors who will be patient. The way the investors can sell their equity is called the "exit strategy" and is often indicated in the business plan.

A hypothetical, and optimistic, example that illustrates the financial implications of the sequence of investments, will be given next. For simplicity we assume a single entrepreneur. In the seed stage the angel investor put in $200,000 and was given 25% of the equity. The startup prospered and an early stage venture capitalist was willing to invest $1,500,000 for 15% of the total equity. The total value of the company then is $10,000,000. Note that the angel investor's share is now worth $2,500,000 and the entrepreneur's share is worth $6,000,000. The company continues to grow and a second stage V. C. invests another $10,000,000 for 10% of the equity. The value of the company is now $100,000,000 and the entrepreneur's share is worth $50,000,000. The angel investor's share (25%) is $25,000,000-a big increase from the original $200,000 invested. The value of the investment of the early state V.C. has increased 10 times; of course, it will be difficult to convert this value to cash until the company goes public. If the company continues to be promising its value should increase two more times-at the mezzanine stage and when it goes public.

Some other notes may be helpful. An entrepreneur needs to remember that venture capitalists in most cases are investing other people's money; they need to get a timely return on their investment. To maintain the trust of investors-so more money can be raised in later stages-it is important for the entrepreneur to meet milestones. A business plan must look professional to convince an investor to give up her or his money.

To understand why an investor needs a large return on the investment consider typical results for an early stage V. C. The historical record of 10 entrepreneurial ventures might be:

3 Total loss
3 Break-even
3 Profitable-earnings of 8% or so a year
1 Star-earnings of 100% a year

The investors make their money on the big successes, which pay for the ones that are a total loss or just return the amount of the original investment. It does not pay an investor to invest in a project that does not appear to have a big payoff. Banks or the SBA are better sources of capital for lower payoff/lower risk ventures.

If big payoffs are essential for venture capitalists, one might ask how they evaluate a project. They might look at:

Most investors think the People are the most important aspect in deciding whether to do a project-good people can meet the challenge when the inevitable unexpected thing happens.