Fundraising for Startups 101

Starting a business is hard, and entrepreneurs say that one of the biggest obstacles to starting a business is fundraising.  In our practice as well, one of the most common questions we’re asked by startups is: “Where do I go to get funded?”  To alleviate some of the difficulty, here is a basic overview of the various ways that emerging businesses can seek financing. 

Cost vs. Control: When choosing between, say, seeking venture capital versus going to friends and family, you should consider how much control of your company you have to give up, and how much it will cost (in terms of time and dollars) to raise the amount of money you need.  The answers to these fundamental questions will go a long way in helping you decide which route to take.

• Bootstrapping / Consulting – Fund it yourself.  You could fund your business either with your own cash (from inheritance, savings, etc.) or debt (credit card, home mortgage, etc.), or through revenues from consulting services.  Bootstrapping or consulting results in founders giving up the least amount of control (possibly zero) and leaves the business with the greatest amount of freedom to change course.  However, consulting leaves the founder(s) with limited free time and a reduced ability to scale the business.  Also, bootstrapping can also lead to personal liability and risk for the founder(s), especially if their personal assets are at risk (e.g. credit card debt, home mortgage, 401(k), etc.).

• Friends and Family – Ask your network for cash.  Friends and family financing rounds are very common, and can be in the form of equity (common or preferred stock) or debt (convertible or non-convertible promissory notes).  In either case, entrepreneurs can receive small amounts of money from many people in their network without ceding very much control of the company and at minimal cost.  The primary downside is that having too many small investors can be a burden when it comes time to raise money in future rounds or in an “exit event” such as selling the company.  To minimize this downside, friends and family rounds should be limited to a small number of investors.  In addition, federal and state securities laws may restrict the issuance of stock or debt to friends and family investors in many cases, and therefore founders are cautioned to retain experienced securities counsel to assist with these types of financings.  Click here and here for additional information on friends and family rounds.

• Business Plan Competitions – Win cash and valuable prizes at local events.  Local business plan competitions offer the opportunity for quick cash (some competitions have first place cash awards of up to $100,000) and sometimes free or discounted services from advisors (law firms, CPAs, etc.) and vendors (hosting services, etc.).  Business plan competitions also provide opportunities to test your ideas, receive advice, hone your skills, and network in an efficient, friendly and organized manner.  Click here for a website devoted to helping you find a business plan competition in your area.

• Accelerators / Incubators – Go to Startup School.  Accelerators like TechStars, 9Mile Labs and 500 Startups, and Incubators like SURF Incubator, Founder’s Co-op and Ycombinator offer training programs, mentoring, office space, and (sometimes) cash to startups in the high tech industries (and some incubators are opening up for other industries as well, such as design and consumer products).  Entering into an accelerator or incubator program is a significant commitment, so may not work for every startup.  Here is a list of incubators around the world, put together by the innovative startup platform Startup Weekend, which is itself a mini-incubator crammed into one weekend of startup mania.

• Crowdfunding – Ask the world for cash.  There are three main flavors of crowdfunding.  In all three cases, the idea is to raise a small amount of money from a large number of investors over the internet.

  • “Traditional” Crowdfunding – Websites like Kickstarter, Indiegogo and Rockethub allow individuals, companies and nonprofit organizations to raise money by soliciting “backers,” who generally consist of people who are interested in supporting a particular project or idea.  Backers contribute funds without receiving any equity in return.  Instead, they get the opportunity to participate in the venture, and often receive a “token” such as a gift, recognition or product.

  • “Equity” Crowdfunding (Accredited Investors) – Equity crowdfunding involves the issuance of debt or equity securities to a (typically) wide pool of investors.  Given federal and state securities laws, equity crowdfunding has been legally impossible until very recently, when the passage of the JOBS Act enabled equity crowdfunding to become a reality, initially for “accredited” (i.e., wealthy) investors.  In the past year, a number of equity crowdfunding platforms have emerged that permit emerging companies to market and sell debt and equity securities to accredited investors under certain circumstances.  Some examples of these platforms include AngelList, FundingPost, CircleUp, Fundable and many others.

  • “Equity” Crowdfunding (Non-accredited Investors) – The JOBS Act also authorized the issuance of debt and equity securities to larger groups of “non-accredited” investors as well, however the Securities and Exchange Commission, state securities regulators, and self-regulatory organizations like FINRA must still propose and finalize rules and regulations governing several aspects of non-accredited equity crowdfunding before this can be a viable (and legal!) way for startups to raise money.  As of this writing, it is not clear when these rules and regulations will be final, but probably not until 2014 at the earliest.

• Angel Investors – Ask rich people for cash.  Angel investors typically are wealthy individuals who have extra cash and are interested in supporting innovative small businesses, while possibly earning a return on their investment.  There are groups of angel investors throughout the country and around the world, which sometimes pool their resources and hold various kinds of events at which entrepreneurs can pitch groups of several angels at the same time.  Angels often require founders to surrender less control of the company, and tend not to engage in as much negotiation of terms, as compared to Venture Capital investors.  Angel groups like Alliance of Angels and Keiretsu Forum are excellent examples of well-organized Angel groups.  GeekWire has an excellent list of angel groups in the Pacific Northwest.  You can expect angel investors to participate in Equity Crowdfunding for accredited investors (mentioned above) at an increasing rate in the future.

• Venture Capital – Pitch the VCs.  Venture capital funds are managed by professional investment managers on behalf of institutional investors (known as “limited partners” or “LPs”).  The VC’s job is to maximize the return on investment for its LPs by seeking out companies that will produce high returns.  Due to the high-risk nature of the companies in which VCs invest, VCs tend to demand significant ownership and a greater level of control of the company (via board seats, protective provisions, and other voting rights and economic preferences).  In addition, you can expect VC-led equity and debt rounds to involve higher costs, especially legal costs, for the preparation/negotiation of legal documents and the conduct of due diligence.  This website provides a comprehensive list of and filtering and comparison tools for venture capital firms in the United States and around the world.

• Revenue Loans – Share your revenues with your investors.  Once your startup has significant revenues, some investors may be willing to extend capital in return for a share of your future revenues.  These deals (sometimes referred to as “growth capital”) could be favorable alternatives for businesses that do not expect to consummate an “exit” event (M&A or IPO) in the foreseeable future.  Revenue loans are also generally less dilutive to the founders’ ownership and less restrictive in terms of control.  Revenue loans also avoid negotiation over the company’s valuation, and may avoid the constant pressure on the management team to seek an exit event.  Revenue loans may also be more appropriate than angel or VC financing options for companies in non-technology industries.

• Secured Bank or Venture Loans – Give up the store.  Bank and venture loans tend to be secured by the assets and properties of the company’s business, so are typically only appropriate for companies that have significant assets or properties to secure such loans, which startups tend not to have.  That being said, startups should not rule out having conversations with traditional bankers, because there may be viable alternatives to explore.  Many traditional banks (US Bank, Wells Fargo, etc.) and more tech-focused banks like Silicon Valley Bank will be able to make these kinds of loans.

As you can see, there are a number of options for startups who are seeking financing.  Certainly there is no one-size-fits-all path to funding that works in all (or even most) cases, so you should consult with your advisors, mentors and co-founders to determine which route works best for your startup.  In addition, each one of these potential sources of funding could give rise to various different transaction structures (such as preferred equity, convertible debt, etc.), which will be the subject of another post. 

If you would like more information on any of the above options, or to speak with an attorney about possible ways to structure a proposed financing, please contact any member of the Business Group at Summit Law Group:

Andy Shawber (andys@summitlaw.com) – Corporate/Securities

Chris Brown (chrisb@summitlaw.com) – Tax

Derek Ko (derekk@summitlaw.com) – Licensing/IP/Commercial Transactions

Heidi Drivdahl (heidid@summitlaw.com) – Corporate/Securities

Laura Bertin (laurab@summitlaw.com) – Corporate/Securities

Mark Worthington (markw@summitlaw.com) – Corporate/Securities

Mike Erickson (mikee@summitlaw.com) – Corporate/Securities