Financing Your Emerging Company

After exhausting personal resources, entrepreneurs often turn to friends and family for (usually) small-ish amounts of early capital. No surprise here, and done right (and particularly if the deal ultimately works) often no harm, either financial or relationship-wise.

For most entrepreneurs, doing it right starts with two key rules: (i) don’t take capital from a friend or family member if it will seriously impact their financial security if they don’t get it back; and (ii) make sure the friend or family member providing the capital knows that there is a very good chance they won’t get any of it back. Violating one or both of these rules has ruined a lot of important personal and family relationships when start-up dreams don’t pan out, and friends and family find themselves wondering what happened to their capital.

The next big challenge with friends and family capital is making sure the terms (express, implied, and assumed by both sides) are (i) well-understood by everyone involved, and (ii) do not put up any obstacles to raising downstream capital from sophisticated investors. That usually means preparing a written document. If the money is a gift (best case, you can always find a way to say thank you down the road), say so. If it is a personal loan, ditto. If the funder expects something specific, like a piece of the business, nail down exactly which piece. 

As to deal terms for friends and family, a few pointers. You can give anyone pretty much any piece of your business you want for whatever price. At this point, if you own all the company, it’s yours alone to give. But, under no circumstance give someone any sort of “evergreen” ownership stake. That is, don’t give anyone X% ownership that is not subject to dilution as future investors buy stakes in the company. This is almost always a deal breaker for downstream investors. Don’t give them a right to participate in future financings – or, at least, don’t give them a right to purchase more than say, 20%, of any future financing, preferably limited to the immediate next round. And, do not give them any rights to block any future financings.

Friends and family can be a great source of very early capital. The keys are making sure everyone knows and appreciates all of the terms; that everyone knows that there is a very good chance the capital will never be returned; and that the terms do not get in the way of future capital raises.

The next step on the financing ladder after friends and family is often “angel” financing. Angels range from wealthy individuals who have no clue about building a high impact start-up, but like to think they know more than you (very dumb money), to very sophisticated folks with lots of good experience investing in, and perhaps even building, successful high impact businesses (very smart money). They run both in packs and as lone wolves. Unlike VCs, they primarily invest their own money as opposed to managing money for other folks. However, in recent years, so-called “Angel Funds” or “Super Angels” have emerged that are managed by a small group of angels on behalf of a larger group of mostly angel investors.

Because angels come in so many shapes and sizes, it is very hard to generalize about working with them. Working with the least sophisticated and experienced angels is a lot like working with unsophisticated and unexperienced friends and family investors. On the other hand, deep-pocketed, well-connected, experienced angels often bring as much to the table (including value-add besides capital) as a good venture capitalist brings. Two things to remember in all angel deals: first, stick with rich (“accredited” per the relevant securities laws) angels; second, as with friends and family, make sure everyone understands the terms of the deal, and that those terms do not unduly complicate your ability to raise future rounds of financing from other investors.

Venture capital funds have been the primary source funding high impact entrepreneurship for more than 50 years. The typical venture capital fund consists of a pool of capital provided by investors, generically referred to as LPs, managed by a small team of investment professionals – the people known as the venture capitalists. Sometimes a venture fund has only a single investor, typically a corporation (e.g. Google) or a wealthy family (e.g. the Pritzker family). Venture funds often specialize in particular technologies (e.g. blockchain); particular industries (e.g. fintech); particular geographies (e.g. the Midwest); or particular stages (e.g. early stage). Some “families” of funds mix and match various strategies and are often managed by different teams of VCs within the broader fund group.

Whatever their particular makeup, today’s VCs invest mostly as they did in the past. They buy ownership (equity) stakes in portfolio companies in the form of convertible preferred stock. This is stock with a variety of preferences (voting rights, dividend rights, rights to the proceeds of any sale of the business, etc) that also has a conversion feature that can be exercised by the holder, or in some cases, (critically a qualifying IPO of the business,) by the business.

Is venture Capital financing right for your business? If you need millions of dollars in capital, and you don’t have any cheaper alternatives (venture financing makes even junk debt capital look cheap), and you are willing to take on what amounts to a partner in your business, who is going to be very interested in how your company is managed and have some serious rights to impact that, venture capital could be right for you. But, look very carefully before you leap. For more on working with venture capital investors, see Venture Best’s “Entrepreneurs’ Guide to Venture Capital Financing”.

Venture capital is about the most expensive kind of capital you can get on the right side of the law. Early stage venture capital investors typically only invest in deals where they are confident that if the deal really works, as maybe one or two of every early stage venture deal does on average, they will get back at least $10 for every $1 dollar they invested. Given all of the deals that don’t work, and the many expenses of running a venture fund, achieving that 10x+ return on a small number of deals is the only way for the VCs to give their LPs a 3-4x return on their investments in the venture fund. Every deal must offer that 10x+ potential. That, more or less, is the reality, if not the hype, of the venture capital investing business.

When an investor lends money to a company in exchange for the company agreeing to pay back the investor in the future, and the deal includes terms where either party can, in certain circumstances, convert the payback obligation into shares of the company’s stock, you have a Convertible Debt transaction. Historically, and still sometimes today, convertible debt is used to “bridge” a company (for example, to cover a payroll) to a projected closing of a larger financing in the near future. More often in today’s world, when an entrepreneur and investor talk about a Convertible Debt deal, they are talking about a financing to bridge a company to a hoped for, yet undefined, financing sometime in the future.

There are two big reasons for doing a Convertible Debt round. First, it allows the parties to sidestep what is often the stickiest deal point, which is how much the company is worth when the money is invested. Instead, the parties agree that the valuation will be whatever the valuation turns out to be in the future financing, assuming it happens, with some discount on conversion (often 20%) to account for the extra risk the investor is taking by investing before that financing is really nailed down. Second, even relatively fancy Convertible Debt deals with all the bells and whistles are usually much simpler and cheaper to put together and document than a Convertible Preferred Stock venture capital round.

Is Convertible Debt something you should consider? By all means, if what you need is a relatively small (relative to the soon-anticipated “real” round of financing) and the capital you are getting is enough to accomplish whatever milestone is needed to make that “real” round actually come together.  Convertible Debt is probably most common in angel rounds intended to bridge the company to a venture round. The biggest danger is “building a bridge to nowhere,” aka “pier financing,” where the money may keep the lights on but doesn’t really get the company far enough down the road to make the planned follow-through on "real" financing happen. The temptation to pile one round of Convertible Debt on to another over and over has made life very difficult for many companies. For more on the many nuances of Convertible Debt deals, see our blog on the topic.

Free money is the holy grail of start-up financing. “Investors” who don’t want any financial return (private and public research grants, for example) or offer low interest rates, and publicly subsidized loans (for example economic development organizations) provide a lot of start-up capital in the United States. The federal government’s Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) grant programs provide almost $1 billion each year to small and emerging firms, many of them backed by angel and venture capital investors.

Many of these “free” and “cheap” capital sources are important for many emerging companies. Make no mistake, they are never really free, and the cheap ones are never as cheap as the list price. Entrepreneurs considering applying for these kinds of capital need to think about the less obvious costs of these sources of capital. These include (i) potential for delays in funding projects, all the more for programs (like SBIR/STTR programs) where the time from application to approval, and from approval to financing, can stretch into a year or more; (ii) potential for applying for something today that, by the time you get the money, will no longer be as high on your list of priorities (or on it at all); (iii) the opportunity cost of applying for this money, that is, the time-scarce resources spent chasing relatively small amounts of funds; and (iv) the costs of complying with the terms of grants and low-interest loans, which can be pretty high (after all, tax dollars and public officials are often involved). One plus of these programs is that they have signaling value to other investors. (Meaning that getting approval for this kind of money sends a signal to VCs and other private-sector investors that your business or technology is validated.) In our experience, however, the signaling value often is not nearly as potent as expected.

Should you pursue free/cheap, non-dilutive financing options? The answer is almost always situation-specific, and depends on a cool analysis of costs that are not always obvious as the benefits. When they do make sense, they can be very attractive options. But they don’t often make as much sense as they may at first seem to. To learn more, visit our blog on this topic.

While figuring out how founder stock should vest is important to the founders themselves, it is also a topic VCs are very interested in. VCs almost always insist that the founders subject at least a good chunk of their stock to “vesting” requirements as a condition of investment. Sometimes, the vesting schedule the founders have already agreed to is good enough, and indeed, how a future VC might look at those vesting provisions is something the founders should consider when they figure out that schedule. But oftentimes the VC wants a different, longer vesting schedule. That might not seem fair, but you need to understand the VCs' point of view. They are investing in your company for a bunch of reasons, a big one almost always being your team. And so they want to make sure the team, or at least the part of it they care about the most, has every incentive to stick around. From their perspective, a founder who will lose a good chunk of their stock if they leave has a good incentive indeed not to leave.

What does all this come down to in practice, in terms of how much stock a founder might have to put “at risk” in a vesting schedule? There are a lot of factors, including how long the founder has been toiling away at the time of the investment; how much value the founder has contributed during that time; how much future value the founder is expected to contribute; and over how much time will that future value be contributed. That said, a very common vesting schedule would put 1/3 to 2/3 of the founders' stock in the vesting schedule, with equal monthly reductions in the invested amount over the 12-36 months after the investment.

Most high impact start-ups want their employees, and often directors and consultants, to have “sweat equity” in the success of the business. That is, they want to motivate these individuals by promising a particular benefit if and when the company ultimately creates and realizes a lot of shareholder value. In our experience, a good equity incentive plan is an important company asset: a tool that management can use to make sure employees are as committed to making the company succeed as is practical.

If a good equity incentive plan is a critical part of the capital structure, what does it look like in practice? Some of the key points are summarized below.

In most cases, equity incentives are set aside in a “pool” of common stock that can be granted at the discretion of the Board in the form of shares or options to acquire shares, usually at “fair market value,” which is usually some fraction of the price paid by investors for their convertible preferred shares. 

An incentive “pool” for a start-up could be anywhere from a few percentage points of the total equity of the company to 30 percent or more, all depending on what the company’s management and the investors think will be needed in the future to attract the right employees at the right time. The pool is often “topped off” at future rounds of financing, as expectations about the company’s future needs change.

The “pool” is, in terms of the valuation of the company at a financing, considered part of the “pre-money” valuation – that is, the valuation of the company before the investment. That's because the prospective investors consider the pool an important asset of the company, and is part of the “whole package” that they are buying. For example, suppose two founders both own 40% of a start-up and they set aside 20% for the pool. If an investor offered a “pre-money” valuation of $2 million, and to invest $2 million after such a deal was done, the “post-money” valuation would be $4 million; the investor would own 50% of the company; each founder would own 20%; and the pool would account for 10%. Life is what it is – even when it’s not fair.

Just as founders typically will have some vesting schedule for their shares, future grants of equity to employees and such will also have vesting schedules. A very common schedule for employees is a one year “cliff” where, on the first anniversary of employment, 25% of the equity incentive vests, followed by equal monthly vesting for the following 36 months. Note that while the “vesting start date” is often the employment date, it can be set for some earlier (or even later) date.

Finally, there are a lot of legal and tax niceties about equity incentive plans – details that are both consequential and in some cases, counter-intuitive. Things like “83(b) elections,” “409(a) valuation,” “ISOs and NQs,” and “accelerated vesting provisions” tied to specific corporate events. Getting them wrong can have detrimental effects on founders, investors, and employees alike. So make sure you get them right.

Pretty much every entrepreneur’s nightmare includes being ousted from their company by their investors. “Founder redeployment” is indeed a nightmare many unfortunate entrepreneurs have lived through. For example, Steve Jobs was once demoted and then kicked out of Apple.

One way to make sure you aren’t one of those unfortunates kicked aside by your investors is to not to let investors have any rights to do that. Like the Uber guy. Oh, that’s right, he set up his shop that way and still got the boot. Or like Mark Zuckerberg at Facebook, who keeps all, or at least a controlling share, of the voting stock to himself.

Reality check time. Zuckerberg-like control depends on a combination of Zuckerberg-like investor credibility and dumb investors. Either extreme might get you there, but you don’t have to go very far from either extreme to find yourself in the vast middle ground where your investors will have meaningful control over your future role at what you are likely to think of as "your" company long after it is just sort of "your" company.

So what about retaining 51% voting control, that works, right? No, it doesn’t. At least not with VCs or other sophisticated investors, who almost always invest on terms that include substantial rights to veto various corporate decisions, put people (usually by round two or three, a majority) on the board of directors, and special voting rights. The fact is, a VC syndicate with a 20% interest can and often does have a lot of control of your business, including what happens to you.

The good news is, if you know what you’re doing, or have counsel to help you figure it out, you can negotiate around the edges of “standard” deal terms to substantially mitigate the amount of control your investors would otherwise have. At the end of the day, make no mistake: when you bring VCs or other sophisticated investors into your company, you are bringing in partners, not just investors. Partners with big egos, substantial capital at risk, and interests that are not totally aligned with yours (and usually drift further apart over time). Take investment guru Andy Grove’s advice and be realistic, and be a bit paranoid. And get, listen to, and carefully process the advice of experienced counsel.