Taking a great idea from concept to company usually requires, among other things, a pile of cash. Questions about how to raise money, how much to raise, and who to raise it from have kept many an entrepreneur up at night. And though the answers differ for every entrepreneur, they usually correlate with the growth phase of his or her startup.
There are plenty of sources of capital for a young company seeking money – among them business loans, seed capital firms, business incubators, or royalty financing arrangements. But the most common investors in early-stage businesses are friends and family, angels, or VC firms.
Which of those three you’re ready for usually depends on how far along you are in the startup lifecycle and how much money you’re looking for. Keep in mind as you consider what you need that you should never, ever execute any fundraising without guidance from your legal counsel.
When your business is just a “grain of sand” idea, it takes funds to turn it into something tangible. If you have substantial financial assets and are willing to place all the risk on your own shoulders, you can fund it yourself to start – but that’s a route that’s led many an aspiring business owner into credit card debt or bankruptcy.
Seeking funding from your friends and family is just as risky, since it places your personal relationships in peril should your concept fail. But accepting that risk is not only a rite of passage for entrepreneurs, it’s a reflection of your commitment to making your business a reality.
Unless your business can be “bootstrapped” – built up quickly enough that you don’t need financing – your friends and family should be the first source you turn to.
That’s because unless you get your company involved with a startup incubator program (which would help you refine your concept and groom you to give your pitch) you likely won’t be prepared to field the tough due diligence questions of experienced angel investors. Most entrepreneurship organizations recommend that businesses raise their first $15,000 or so from friends and family, though many companies raise more.
Since you don’t need to formally file friends and family investments with the SEC, the money you raise early on is yours to use freely. Most entrepreneurs use it to build a solid foundation for the business by creating a viable product prototype (if applicable), crafting a thorough business plan backed by market analysis, and moving forward with product development and sales.
Angels are wealthy individuals – usually accredited investors under the SEC’s definition – who choose to invest in early-stage companies in exchange for equity ownership. They may invest as individuals or as members of a larger angel investment group (a “syndicate”).
Companies typically seek angel funding at a point in their growth when they have refined the business plan and established traction but have little or no revenue coming in. The funds raised in angel investments may be used to produce or enhance the product, execute the marketing or sales strategy, or hire staff.
When you raise funds from angels, you are required to file the fundraise with the SEC. Since you’re likely raising far more money from angels than you would from friends and family – typically hundreds of thousands – you need to be prepared to engage in a formal, regulated transaction before you approach potential investors. Working closely with legal counsel is crucial to navigating your negotiations and filing all necessary paperwork.
Experienced angels – more so than friends and family investors – will enter discussions wanting to know how they’ll potentially be paid back for their investment. You need to prepare yourself to discuss a potential exit strategy, even if selling your business is not part of your short-term plans.
So how do you get angels interested? Cold calling or “cold emailing” syndicates may work for some, but networking with the right individuals – including with other local entrepreneurs in your industry – is more likely to connect you with angels. Nowadays you can conduct that networking online as well as in person, and you can even use funding portals like EarlyShares to solicit investments from accredited investor angels through new exemptions allowed under the JOBS Act.
Venture capital firms are companies that professionally manage funds pooled from groups of individuals, and invest those funds in startups. VC funds are overseen similarly to hedge or mutual funds; dedicated fund managers earn percentage fees, sometimes based on the funds’ performance.
Similarly to angel investor financing, VC funding must be filed with the SEC and is subject to regulatory oversight. A VC investment tends to range between $1 and $3 million and the companies that receive the money use it for a wide variety of purposes. They may build out their technology or infrastructure, expand their operations or product line, launch in new geographies, or execute any number of other initiatives necessary to grow their businesses.
Due to the very high amounts invested by VC firms – and the large returns they hope to receive on their $1 million+ investments – venture capital financing is difficult to come by and not appropriate for every business.
VC firms only consider financing companies that they perceive as having high growth potential (and who have the data to back that up). They also typically engage in lengthy negotiations before investing, demand a large equity stake in exchange for their investments, and expect to have strong oversight of the business’ ongoing decisions after closing the fundraise.
Startups who go after VC funding typically do so later in their lifecycle, when they have an established standing in their industries and major traction behind their business models. But if you see your business as a fit for VC funding, there’s no need to be shy. Many entrepreneurs seek VC money with a so-called “shotgun” approach, contacting as many VC firms as possible and playing the field until they find the right partner.
Check back to the blog for more future ‘Raising Money 101’ posts, including one on the different stages of financing, from Seed to Series C.