The almighty dollar is a tool for creation and destruction. From concept to execution, how money comes in and how money goes out is at the forefront of every entrepreneur’s conscious. For both Fortune 500 companies and startups, understanding the key features of different sources of capital is critical to successfully funding a company.
Companies can raise capital in either of two ways: debt, or equity. Debt is when a company borrows money and has an obligation to pay money back over time with interest, e.g., a loan. Equity is when money is invested into the company in exchange for ownership rights, e.g., founders investing their own money in a startup. Early-stage companies rarely raise money by incurring debt because it is unclear whether or not the company will be able to pay back any borrowed money (the exception being convertible notes which will be discussed in a separate blog post). With this in mind, it is critical for owners of early-stage startups to know where they can find sources of equity funding, in addition to their own investment. Here are some of the most common sources of equity funding to get your company up and running.
Sources of Equity Capital
1. Friends and Family
Friends, family, and professional networks of founders are common grounds for early-stage sources of pre-seed and seed financing. When founders seek capital from these sources most or all of the investors in the business have some close personal connection to the founders for better or for worse. On one hand, close personal connections can allow for greater flexibility in negotiations, lower equity stakes and the potential for investors to become trusted advisors in the startup. On the other hand, close personal connections can bring about unnecessary conflicts due to personal matters, unwarranted requests for higher equity stakes from inexperienced investors and the untimely loss of personal connections as a result of unsuccessful ventures. Friends and family rounds can range from $1,000 to $150,000 – sometimes reaching $300,000 and more. However, don’t be tricked by the label of “Friends and Family” – you still need to treat these people as legitimate passive investors. These people are still entitled to certain rights depending on the type of the instrument used to raise funds (SAFE, Convertible Note, or Series Seed Preferred Stock) and they must still comply with federal and state securities laws. Hence, seeking the guidance of an experienced startup attorney is always a great idea when navigating these complex regulatory waters.
2. Incubators and Accelerators
Incubators and Accelerators are a great way to transform ideas into businesses. Both programs provide capital, operating resources, help with management and valuable networks to help businesses grow. Some incubators look more like accelerators and some accelerators look more like incubators understand more of the difference between the two here. The goal of an accelerator program is to help a business do roughly two years of business building in just a few months. Accelerators are intense 3-6-month commitments which require startups to give up 4-6% equity in exchange for typically $10,000 to over $120,000 in seed money, in-depth training and access to a valuable network of investors, financial advisors, successful startup executives and industry experts. One of the most well-known accelerators in the industry, Techstars, accepts around 1-3% of startups for its program each year and contributes $20,000 in exchange for 6% equity of the company until the company raises a priced equity financing of $250,000 or more. Incubators rarely require equity but will grant you space and supportive services to help your startup grow.
Crowdfunding involves a type of social platform on the internet to attract a large number of people to each invest relatively small amounts to reach fundraising goals. Crowdfunding platforms are registered with the SEC and allow entrepreneurs to pitch their business ideas, generate public interest, and reach a specific community of investors or people willing to support their ideas with relatively little cost. With crowdfunding, entrepreneurs are not forced to use traditional methods of capital markets and venture capital fundraising. Entrepreneurs can focus on a specific community of people in the crowdfunding sphere and access the traditional methods of fundraising at a later time when their idea has gained more traction. But raising funds through crowdfunding is not easy. The crowdfunding market is competitive, and the funds raised through crowdfunding cannot exceed $1.07 million in any rolling 12-month period. And even if you succeed in raising the maximum $1.07 million, which is not an easy thing to do, it can result in a messy cap table with numerous minority stockholders and future VC’s might not like that.
4. Angel Investors or Angel Investor Groups
Angel investors are a rapidly growing part of startup private equity markets. Angel investors are a collective class of roughly 300,000 high-net-worth individuals in the United States who are willing to invest their own money into risky startup ventures. Their motives for investing may range from a passion for a specific industry, professional interest, or a more traditional return on investment. In any event, angel investors collectively inject over $1 billion dollars quarterly in US startups. The average size of contributions per investors may vary, but a successful seed round can reach up to $1 million, especially if it is led by an angel investor group. Angel investor groups are collaborative angel networks that share information about potential investment opportunities for other angels. In addition to individual investors and groups, super angels are well known, full-time investors that often have their own investment funds. Here is a list of some of the top angels around Los Angeles: Talmadge O’Neill, Mihir Bhanot, Anthony Saleh, Clark Landry, Jim Brandt, Ashton Kutcher – Tech Coast Angels, 12 Angels, Angel Vision Investors. These investors are more sophisticated than friends and family investors and often have their own lawyers and accountants. So, it is critical to be prepared for their due diligence requests, conduct your own due diligence, and have your startup’s legal structure and financial statements in order. Not hiring an attorney to assist you with fundraising, risks the loss of potential capital and reputation, advice and other ancillary benefits to be gained from an angel investment.
5. Micro-Venture Capital Firms
Micro-venture capital firms (“Micro-VCs”) are institutional investors that specialize in early stage financing. Institutional investors like Micro-VCs invest using funds pooled together by LPs like pension funds, corporations, wealthy individuals, or governments looking to stimulate the startup ecosystem. Micro-VCs often have access to large funds but are very careful with where they choose to invest and so fewer deals are made each year. Here is a list of some of the top Micro-VC’s around Los Angeles: Arena Ventures, Canyon Creek Capital, Mucker Capital, Noname Ventures, Wavemaker Partners. The size of early seed rounds led by Micro-VCs may well be in the hundreds of thousands or even millions of dollars and are a sign of a rare success in early startups. This said, founders should be careful not to give up more control and economic rights than necessary in exchange for a Micro-VC investment. Of course, dilution of the founders is inevitable in priced rounds, and you should be prepared to lose full control over your board of directors. But founders must fully understand the ramifications of dilution and that there are no hidden provisions in VC term sheets that can cost you your job as the CEO or a board member of your own startup. This is why it is critical for startups to work with an attorney that can bring both parties together and verify that both parties are on the same page regarding the terms of the investment and how to protect against future problems.
6. Strategic or Corporate VCs
Strategic or corporate VCs are typically subsidiaries of large corporations like Intel, Google, and SBI. Corporate VCs use corporate funds to invest in external private companies. The sole purpose of these strategic or corporate VCs is to invest within their core businesses to achieve financial or strategic returns, e.g., capture technologies that may be important to their business, or acquire critical in-house expertise. Here is a list of some of the most active strategic or corporate VC’s this past year: Google ventures, Salesforce Ventures, Intel Capital, Baidu Ventures, Legend Capital, SBI Investment, Alexandria Venture Investments.
7. Investment Bankers and Mergers & Acquisitions
Investment bankers, brokers, or financial advisers can assist founders connect with financing sources. But, investment bankers are primarily concerned with providing growth capital to relatively mature companies looking to expand, restructure operations or enter new markets. Investment bankers also tend to be intermediaries for private placement of securities. In other words, investment bankers can help you sell securities to funds and other investors. But be warned, regulatory issues and banking fees are usually associated with intermediaries like investment bankers. Read more here. A merger or acquisition with a company rich in cash can be a viable source of capital. But any merger or acquisition triggers a myriad of legal, structural and tax issues that must be evaluated carefully before making any decisions. For early-stage startups, we recommend waiting a couple of years before selling the company to achieve a higher valuation rather than selling your potentially great idea at a much lower valuation.
Raising capital from any of the sources mentioned above is a great way to potentially grow your business. But with that growth comes a multitude of legal issues from proper due diligence and compliance with securities laws to tax considerations and corporate governance structures. The almighty dollar is a tool for creation but without proper legal counseling it can be a tool for destruction.
If you need help with your questions about funding your business, feel free to schedule a consultation with an attorney using this link or calling our office at 323.543.4453.
By Ryan Urban, Loyola Law School