Raising capital at any stage of a company’s growth is challenging and requires creativity and tenacity. However, these hurdles are especially difficult to conquer at the earliest stages of an enterprise’s development. In this article, I’ll discuss where and how to raise capital at the seed level—when you are first organizing your business, or when it is at its earliest stages of growth.
At the seed level, you are looking for capital to acquire the initial resources you need to launch the enterprise, attract and hire employees, conduct research and development, acquire computer systems, and build initial inventory. Although this time in your business is characterized by frustration, struggles, setbacks, and delays, there are many sources of cost-effective seed capital available if you are creative and aggressive in your search and still allow you to maintain control and majority ownership of the business.
Start With Your Own Resources
The combination of your own financial investment and time investment (“sweat equity”) is a prerequisite to obtaining capital from third-party sources. The capital markets expect you to put your own funds at risk before asking others to risk investing in your business. This is often called the “straight-face test” because you are able to look an investor in the eye and demonstrate your own commitment and belief in the potential of the new enterprise. If you have co-founders, all are expected to make this commitment. This is true even if the level of personal investment varies due to differences in the partners’ financial circumstances or the degree to which a particular individual contributes a particular skill, recipe, knowledge, or relationship—the intangible, non-financial aspect of contribution.
Your initial capital may come from savings, 401(k) plan loans (where permitted) or withdrawals, home-equity loans, credit cards, or other sources as set forth below. Of course, this also violates the OPM (Other People’s Money) rule: Wherever possible, use other people’s money to invest in a risk enterprise. However, in the world of new-venture financing, the OPM rule usually goes out the window unless you’re a veteran entrepreneur with an established track record and can demand that others risk their capital without investing your own funds in the enterprise.
Only you can dictate what portion of your life savings you’re willing to risk, and prudence should dictate some level of conservatism, which may vary depending on your immediate cash needs as well as your short-to-medium-term goals and requirements. An individual with limited savings and two children nearing college age should be very careful with his or her savings and may want to reconsider whether this is the right time to launch a business venture at all. Conversely, a young couple with toddlers and one working spouse may decide that this is a perfect time to use their savings to launch a business. They know that they have a steady source of income from the working spouse and plenty of time to replenish their savings if the business venture is unsuccessful.
Family, Friends, and Fools
After exhausting that portion of your life savings and available credit lines to finance the start of your business, the next most likely source of capital usually comes from those who love and trust you—family, friends, and fools. Whether it’s an equity investment or a formal or informal loan, entrepreneurs often turn to old friends and family members, who typically provide capital on the basis of a relationship rather than on the basis of financial rewards.
If your family is anything like mine, however, you may want to reconsider this strategy. You would have to be prepared to provide business-plan updates at family dinners and to be reminded weekly of “who helped you get started.” The benefits of this inexpensive capital may be outweighed by the costs of the family dynamics and by the complex emotions of guilt, despair, and frustration if the business fails and the family investment is lost.
Turning to old friends for money may also be unwise, particularly when the friend is investing in your new business based on trust and can’t really afford to lose the money if things go south. Business loans and investments have ruined a lot of longstanding relationships. The Catch-22, of course, is that if things go very well, then your family and friends wind up arguing with you because you didn’t give them a chance to participate. Again, you know your friends and family and their tolerance for risk, and only you can decide whether it will be advisable or appropriate to approach them for seed and early-stage capital.
If you decide to solicit friends and family as a source of capital, you must be very open and honest about the risks and rewards of the enterprise—and the risks are likely to be much more significant than the rewards in the early stages of the business. Make sure that they know that this is not like investing in the public stock market where public reporting, a track record, and the availability of liquidity protect against downside risk. You should also put the terms of the investment arrangements into writing to formalize the transaction and to avoid confusion about the rights and responsibilities of the parties.
Heaven on Earth – Finding An Angel Investor
Once you’ve demonstrated that your own funds are at risk and you have exhausted your “emotional investors” (family, friends, co-workers, and others who love and trust you), it’s time to begin your quest for an angel. The term “angel” originated on Broadway, where wealthy investors provided funds to aspiring directors to finance the production of a new musical or drama. The motivation for the investment, which included financial reward, was mainly driven by the love for the theater and the chance to develop friendships with aspiring actors, playwrights, and producers. The point was that these investors provided high-risk capital and were motivated by something more than money. Even today, playwrights, artists, producers, and musicians often rely on the altruism of others to advance their projects or careers. Likewise, an aspiring entrepreneur must rely on something other than financial reward as an impetus for the investment. Your focus in meeting and presenting to angels must be on what makes this person motivated to invest more than what IRR will be attractive to their wallet.
Beyond Broadway, angel investing has become a critical source of financing for seed and early-stage companies. From Arthur Rock in the early 1960s, whose angel dollars and capital-formation efforts helped launch companies, such as Intel and Apple Computer, to cashed-out entrepreneurs, such as Lotus founder Mitch Kapor, whose angel investments include RealNetworks and UUNet, to new economy multimillionaires and Internet pioneers like Ted Leonsis of America Online, and the early-stage investors in Google, thousands of modern-day angels have played a key role in the launch, development, and financing of scores of early-stage companies, as well as the mentoring and assistance to thousands of entrepreneurs.
Angels come in different shapes and sizes and often invest for different reasons. Some are motivated by something much larger than financial return—a good thing, since it is hard to convince someone with a net worth of $125 million that your deal will make them rich. There are “checkbook angels,” usually friends, neighbors, and others who typically invest $5,000 to $25,000 on a passive basis hoping to get in early on the next Yahoo!. Then there are “capital-A” angels who typically invest $50,000 to $250,000 on a more active basis and who may insist on some advisory or mentoring role as a condition to their commitment. Finally, there are the “super-angels,” the cashed-out multimillionaires and even billionaires who have the capacity and the guts to invest $500,000 to $2 million in an early-stage enterprise in a deal that may look more like a venture-capital transaction — from a legal paperwork and control perspective – than like a deal made in heaven!
The Importance of Angels
Although the business media tend to focus on the activities of the institutional venture-capital firms, the amount of money invested annually by angels or private investors in growing businesses is much greater. Angel investors have become a critical source of seed capital at a time when venture capital funds are leaning towards latter-stage investments.
However, the number of ventures under management remains small because it takes as much time to research and manage a small investment as a large one. Thus, the minimum first-round investment by a venture-capital firm is now about $4 million, eliminating many entrepreneurs and early-stage companies who are looking for investments of as little as $50,000. The enormous success of the venture capital-industry has opened a window of opportunity for angels or private investors looking for start-ups in which to invest.
Angel investing has grown significantly in recent years as baby-boomers near retirement with significant wealth. Angels also include cashed-out entrepreneurs who may have feathered their nests by selling their business or taking it public. Some angels provide capital to entrepreneurs as a type of “quasi-philanthropy,” a way to give something back to their communities in the spirit of fostering local economic growth. Others are savvy private investors who also helping an entrepreneur launch a new business along the way.
It is critical for an entrepreneur seeking angel investment to understand the angel’s need and motivations and then take steps to meet these needs. Maybe you are the son or daughter these angels never had; maybe you remind them of themselves when they were younger; or perhaps they just want someone to coach. Maybe they’ve retired and need to get out of the house and feel useful; maybe they have expertise and relationships that they want to share, or they’re just bullish on your industry and looking for a way to participate. It’s your job to discover the reason and structure your relationship accordingly.
Finding an Angel
While you can find individual angels through referral from an accountant or attorney, angels increasingly participate in a variety of networks.
NONPROFIT ANGEL NETWORKS. There are more than 50 loose-knit organizations nationwide through which investors learn about opportunities, attend programs about investing, and develop a sense of community. These networks are usually run by nonprofit entities, have tax-exempt status, and are oriented toward economic development. The greatest benefits come from community building among investors and creating a more efficient marketplace for entrepreneurs to approach sources of capital.
PLEDGE FUNDS. A more recent phenomenon involves pools of funds in which investors (anywhere from a handful to dozens) pledge a specific amount of money to be invested in private-equity transactions that are selected and managed by the group. Sometimes the group has centralized paid staff; sometimes it is led and organized by a lead investor. These groups set legally rigorous standards, are focused, and are designed to profit from multiple transactions.
THE CLUB APPROACH. In this model, investors place a set amount into a “club” account that is used like a venture fund to make investments found and voted on by club members. This approach can be staffed or unstaffed. More money can be accumulated than an individual can afford, and a more diversified fund can be created. Group dynamics are involved because each member must review potential opportunities in order to decide “vote” for or against a deal.
CEO ANGELS. A small venture fund, usually a limited partnership, is created by investors drawn from a specific business community. They provide assistance as well as capital to chosen companies, which are usually from the same field. Members of the group may take on general partnership responsibilities, or professional managers can be employed. This model is similar to the traditional venture-capital model, except that investments are more focused and the limited partners are more active in helping to find opportunities and to provide hands-on assistance to the companies chosen.
ACTIVE ANGELS. In this model, angels are more active in the role that they propose to play in the growing company once funds are committed. Some angels in this model are really looking for full or almost full-time employment with the companies in which they invest.
ANGELS ONLINE. These websites that seek to match angels and entrepreneurs as well as provide information and resources for early-stage companies seeking to raise public or private capital. These “e-capitalists” all focus on different niches and services at different fee levels. Typically, the entrepreneurs are asked to fill out forms that outline the history of their business, the market for their product or service, the amount of capital they are seeking, and related background information. The online matchmaker will then screen submissions and post them, or in some cases it will match entrepreneurs with interested angel investors. Some sites offer online chat areas where angels and entrepreneurs can meet to discuss the business plans. Other sites post the business plans, and still others simply encourage the investor to contact the entrepreneur directly. The sites are open only to institutional investors and venture-capital funds.
Asking an Angel to Dance
From a practical perspective, it’s just as important for you to perform due diligence and pre-qualify your prospective funding sources as for the angel to scrutinize your business plans and evaluate management. In addition to the regional or national angel networks mentioned above, there are a number of online resources to direct entrepreneurs to private investors. You should also attend venture and trade fairs and forums. Networking through friends and associates—getting out there and talking to as many people as possible—is still the best way to find an angel. Remember, dancing is, in the end, a person-to-person activity.
You can also find potential angels through networking in business and venture groups, private investor clubs (which usually have organized monthly presentations by entrepreneurs to potential pre-qualified angels), venture-capital networks, incubators, industry trade associations, university and fraternity alumni meetings, social and country clubs, and virtually any other place where semi-retired and cashed-out entrepreneurs may hang out. Angels may invest alone or as a group through clubs and networks (“bands of angels”). Although many won’t consider a deal that requires more than $50,000, a growing number of very-high-net-worth individuals (“super-angels”) will invest $500,000 or more of their own money and help you identify other potential investors. These super-angels also bring respect and credibility to a new business because others respect their expertise and industry knowledge.
As I mentioned earlier, you’ve got to do your own due diligence on each angel you consider. Remember that the relationship is akin to a spouse or parent—so you have to be sure that you can get along personally with the individual. You’ll also need to define your non-financial expectations and have a meeting of the minds on these issues. A good angel offers you and your business a lot more than money. You need to reach an agreement regarding how much of the angel’s time will be available for advice, coaching, and mentoring as well as what doors the angel is expected to open on your behalf. Ideally, your angel should have a diverse and current Rolodex, deep industry experience, and significant company-building experience in addition to being a source of seed capital. Indeed, the angel-entrepreneur relationships that don’t work out over the years often fail because of misunderstandings about the non-financial aspects of the relationship.