by Ethan Stone, Stone Business Law
Do You Need Venture Capital?
You’re starting up a business. Everyone around you is talking about VCs and angels. All the blogs, website, books and articles you read focus on rounds of venture capital as key milestones on the road to success. It seems to be the way things are done, but is it inevitable? Are there alternatives?
These are important questions for two reasons. First, not every good startup business is going to get funded by angel or VC investment (for simplicity’s sake, I’ll refer to this generally as “venture capital”). There’s a limited amount of venture capital around, a lot of it goes to companies started by people the VCs and angels already know, and a lot of very profitable businesses don’t fit the profile that’s appropriate for venture capital. So you may be starting a great business that simply can’t get venture capital.
Second, venture capital has its drawbacks. You have to give up equity in your business, often a lot of equity. Moreover, venture capital is usually protected by “liquidation preferences” that set up a hurdle you have to clear before your equity will have any value. So if your business succeeds, you’ll benefit less if you took venture capital. Venture capital also means outside investors. Good VCs can be very helpful, but they can also take up a lot of your time. The process of attracting and taking venture capital is also time consuming and expensive. You may have to drag around for months, making pitches to everyone in sight. When you finally get someone interested, it can take months and significant legal bills to negotiate and close on the investment.
So it’s worth thinking about the alternatives. By the way, taking venture capital isn’t necessarily an either/or decision. Even if venture capital isn’t attractive (or possible) right now, it might be a good idea later on. The further along you get in developing your business without raising venture capital, the better the terms you’ll get if you eventually decide to take it.
The alternatives to venture capital depend a lot on the nature of the startup business. I’ll concentrate on two common scenarios: businesses that are likely to generate positive cash flow without a lot of initial capital and businesses that require a moderate amount (say $100,00-$5,000,000). I won’t address businesses that require very large capital investments to get off the ground, for example to build a state-of-the-art factory, since they raise different problems and possibilities.
Low Initial Capital Investment to Positive Cash Flow.
There are businesses that don’t need a lot of capital to generate positive cash flow. A consultant working from home or a modest office is a good example. The consultant has to shell out a few thousand dollars for computer equipment, furniture, insurance, software, telecommunication and online services, basic marketing and rent/mortgage. After that, if she has clients, she just starts working and billing.
These businesses are often inappropriate for venture capital because venture investors are looking for businesses that can scale up to a huge payday in the near term.
If your business fits this mold, you don’t need much startup capital and you don’t need it for long. So the best source of funding is usually your own savings. If your savings aren’t enough by you’re fairly sure revenues will come quickly, credit cards or home equity lines can also be good options. In theory, you might look for a business loan from a bank. In practice, banks don’t like to lend to startups. If they do, they’ll normally insist that you personally sign for the loan.
Loans from Friends and Family
If your personal resources and credit aren’t enough, consider seeking a short-term loan from a friend or relative. Taking equity from these people isn’t a great idea (more about that below), but borrowing from friends or family can save a lot of hassle and expense if you just need a short-term loan and you’re confident of your ability to generate cash flow to pay it back quickly.
If you go this route, make sure you document the loan. You don’t need piles of fancy paperwork, but you should have a simple promissory note. You don’t want to destroy your relationship with a friend or relative because your memories differ as to how much was loaned, when it was due, what interest you were supposed to pay, how it compounds etc. In particular, be clear about whether you’re personally borrowing the money or whether a business entity (e.g. an LLC) is the borrower. If you’re not personally on the hook for the loan, take the time to make sure the lender understands that, no matter how clear you think it is in the documentation. Again, it’s not worth destroying friendships and family relationships over misunderstandings. Be cautious about giving too low a rate of interest on the note. If you go below the IRS’ current posted rates, the loan will be considered part-gift for purposes of federal gift tax. The lender is unlikely to owe tax on the gift, but it will complicate everyone’s life.
A lawyer can help you do this right, but you can also do it yourself if you’re careful. However, if the loan has any non-standard provisions, such as rights to buy equity or take a share of profits, you need a lawyer, at very least to check compliance with securities laws.
Is This Your Business? Think Before You Say No.
A tech startup is usually very different from a new consultancy. Still, it’s worth thinking about how close your business is, from the perspective of capital requirements. Web or software-based businesses often need very little capital to develop the product. Marketing and bringing in revenues can be more challenging, but you may be able to do it on the cheap if you’re creative. Even if you think you’ll eventually need venture capital, think about how far you can get on your own resources. You’re better off seeking venture capital with a finished product and some customers than with a beautiful idea and nothing else.
Moderate Capital Investment to Positive Cash Flow or Clear Proof of Concept.
A good example of this kind of business is a new and complex software application. You don’t need to invest $50 million in manufacturing facilities and raw materials to get going. But you might have to spend $200,000-$5,000,000 (depending on the business) to start making real money or, at least, get to the point where you’ve got enough market acceptance and sales momentum to convince the next round of investors that you’ve taken off. You may need to hire a lot of people to do architecture, coding and quality control. You may need to spend real money on marketing, distribution and support.
This kind of business is often appropriate for angel or early-stage VC investment. But that investment can be very hard to come by. You also might have better alternatives.
Depending on the personal resources of the founders and the capital requirements of the business, it may still be feasible to fund this kind of business out of personal savings. Since this kind of business usually doesn’t present a clear and quick path to positive cash flow, credit cards, home equity loans and loans from friends and relatives are usually a bad idea. If your business is the exception, however, you might consider borrowing money, as discussed above. Just remember that loans have to be paid back. As soon as you take on a fixed obligation to pay back capital, you’ve effectively set a deadline to succeed or fail. Your lender may be willing to negotiate when the loan comes due, but might not. The decision will not be in your hands.
Even if you don’t have enough to carry you all the way through commercialization, it’s worth thinking about whether you can fund yourself through a key milestone that will validate the business and attract angel or VC interest. As you talk to potential investors, seek advice on this idea, particularly from people who turn you down. Ask them how much of your business plan you’d have to achieve for them to get interested and think about how much money it would really take to get there.
Depending on the nature of your business, it may be worth looking into strategic partnerships. The ideal business for this kind of financing is one that is developing a technology that has two distinct applications, only one of which you’re interested in pursuing. The idea is to seek financing from someone who might be interested in the other application. Think about what you already have and what you’re planning to develop and where it might be valuable, outside of the business you’re planning. If you’re developing technology that would be useful to a large, incumbent company, you may be able to work out a licensing/technology development contract that makes sense for both sides.
A couple of real-life examples might help illustrate the opportunities. A client of mine was developing a system of algorithms and software to analyze complex systems for hidden statistical regularities. The technology had potential applications in many different fields, so a strategic partnership was a good idea. The client found a manufacturer that could save a lot of money by reducing its reject rate. That manufacturer paid for commercialization of the technology, in exchange for an exclusive license in its field of manufacturing.
Another client is developing analytics software. It has secured consulting agreements to develop analytics packages for specific clients. The client will get a license to use the resulting package, but the license isn’t exclusive, so the client will be free to license the software to other customers and develop it further. The consulting fees aren’t making anyone rich, but they’re floating the founders through development.
While strategic partnerships can be a great source of funding, they require a lot of care. You need to think about the risk that your potential partner will just take the idea and run. A good lawyer can help you diminish this risk, but will also advise you about the practicalities. Ultimately, you want your IP, not a lawsuit. You also need to be careful not to turn over the core of your business to a “partner.” In the ideal situation, the partner is interested in an application of your technology that you regard as incidental and vice versa.
Be aware that this kind of deal takes time and (sorry) legal fees. If you try to do a strategic partnership quickly and without adequate representation, you’ll probably regret it. I’ve had a number of clients that did “simple” licensing or joint development deals without a lawyer and ended up in slow-moving train wrecks, headed toward IP litigation with the partner, and/or with such serious IP problems that they found it very hard to raise further capital. I charged a lot more to try to clean up those problems than I would have charged to help the clients avoid them, with much less satisfying results.
By the way, a good strategic partnership is sometimes much better than a VC investment. If a big name company signs up with you, it not only pays for commercialization but also validates your technology. That can help get the top VCs competing to fund you down the line, but it can also get you directly to the customer credibility you need to take off on your own.
Prizes and Grants
Generally speaking, you won’t find anyone willing to give you capital without demanding equity or repayment, but there are exceptions. It’s worth looking at outfits such as the X Prize Foundation (here’s a recent article listing more) to see if someone is offering a prize for something close to what you’re planning to do. Likewise, government agencies, such as the National Institute of Technology and the National Institutes of Health, as well as non-profit foundations occasionally have grant programs that might help fund for-profit technology development. If you’re lucky enough to find money offered through a prize or grant, be careful about the details. Government grants, in particular, almost always require you to give up significant IP rights to the government. As you might expect, they also involve a lot of red tape.
Outside Equity Investment
Often, however, personal resources won’t get you very far. You need equity capital. If you are going to raise equity private equity (including capital contributions from the founders’ personal savings), you need to make sure that you comply with state and federal securities laws. Those laws apply to your marketing activities as well as actual sales of securities, so you need to have a compliance plan in place before you start talking to anyone about investing. Unfortunately, securities compliance is not something you can safely do for yourself. It’s usually not very hard to comply, but there are lots of ways to get it wrong and the consequences can be dire. You need a lawyer.
Also, be careful about how many investors participate. Having lots of small stockholders will be a headache for you and will make you less attractive to VCs down the road. A good lawyer can mitigate this problem by containing some of the stockholders’ more troublesome rights in advance, but there are limits. Lots of small stockholders almost always means lots of trouble.
At this point, your best bet is to raise your equity either from professional investors (angels/VCs) or from executives or established companies in your industry. You should prefer these people because there’s a better chance they’ll understand the business and the risk of the investment. Just as important, these investors bring more than money to the table. They’ll also be able to contribute to your success through advice, introductions and validation.
So what if none of those sources of funding are available? You’re now leaving the good options. Before you do that, think very hard. In particular, try to talk to some of the professional investors who turned you down about their concerns and ways you might be able to shift your plans to address them. You should also give serious thought to whether you’re pursuing the right idea. That said, you’re an entrepreneur and this is your baby. So you’re probably certain it’s a good idea and that the doubters are fools. You may be right.
So what’s next? Equity from non-professional investors: Friends, relatives and rich but unsophisticated people (dentists, doctors, lawyers etc.). If you need the money and these people are the best you can do, you have to make the best of it.
Unsophisticated investors’ money is just as green as the professional investors’, of course. But you’ll likely pay a high price for it in trouble. These investors are unlikely to add anything other than money to your success. They will require constant hand-holding. They probably won’t be very understanding (let alone willing to ante up more cash) if you run into problems during development. They are likely to have unrealistic expectations. They will be inclined to make irrational decisions out of emotion (realistically, this probably describes their decision to invest), including using their stockholder rights in self-destructive ways. I’ve seen good companies trashed by stupid, short-sighted investors. Unsophisticated investors can also scare off VCs (they are aware of all the problems mentioned above). Most importantly, you run the risk of permanently losing the affection of friends and relatives, even if the business succeeds. Be careful. Some things are more valuable than a shot at business success.
As noted above, you need to make sure that you comply with the securities laws and, if possible, keep down the head count and tightly contain their rights. It’s also worth pulling your punches a bit with regard to pricing. Unsophisticated investors generally have no idea what your company is worth, so they’re likely to agree on any valuation. In fact, the higher the valuation, the more excited they’ll be. Setting an unrealistically high valuation at an early stage would seem to help you: You get more money and give up less equity. It can be a big problem down the line, however. If you sell the company or take VC investment at a lower valuation, your initial investors will be upset. They’ll either feel that you ripped them off (an understandable conclusion) or that you have failed to deliver. Even if they recognize that they overpaid, that won’t put them in a good mood. VCs will anticipate these reactions and tend to shy away from your company, rather than wade into a nest of vipers.
Be Thoughtful, Creative and Flexible
The upshot of this discussion is that equity investment, including venture capital, is a tool to fund your business, not an end in itself. Like any tool, it can be very good for some tasks and inappropriate for others. So don’t assume that venture capital is a necessary stage in starting your business. You should be just as creative, flexible and tenacious in your approach to funding as you are in every other aspect of starting up. Don’t reinvent the wheel if you don’t have to, but don’t overlook a great opportunity, merely because it isn’t part of the standard playbook.