What are the alternatives to VC and angel funding?

QUESTION:

I’m getting my startup off the ground, and I’d like to know what are the alternatives to VC and angel funding?

ANSWER:

Ethan Stone

Ethan Stone

by Ethan Stone, Stone Business Law

First, a quick caveat: I’m not your lawyer and this answer doesn’t establish an lawyer-client relationship. I’m giving a generic answer to a generic question to educate the users of this site.

The answer to this question depends a lot on the nature of the startup. Since I don’t know what you’ve got planned, I’ll try to cover the most likely 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 (e.g. requiring installation of significant physical infrastructure) since they raise different problems and possibilities. Also, bear in mind that VC funding isn’t an either/or matter. If you can fund your early development some other way, you can bring in VC funding at a later stage to help you ramp up. I’ll assume this is a possibility in my answer below.

1. 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. You shell out a few thousand dollars for some computer equipment, furniture, insurance, software, online services, and rent/mortgage. Then you start billing.

Since you won’t need much capital and you won’t need it for long, this kind of business is best capitalized out of savings or (if you have none and you’re pretty sure revenue will be forthcoming), credit cards or home equity lines. You should think very hard about how close your business is to this model. A lot of web or software-based businesses really don’t need a ton of capital to get going (bringing in revenue can be more of a challenge).

Also, consider getting a 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 you a lot of hassle and expense if you need a short-term loan and you’re pretty confident of your ability to generate cash flow to pay it back. 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 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, make sure the lender understands that. Again, it’s not worth destroying friendships and family relationships over misunderstandings. A lawyer can help you do this right, but you can also do it yourself if you’re careful. If the loan has any non-standard provisions (e.g. rights to buy equity, profit shares etc.), you need a lawyer, at very least to check compliance with securities laws.

Incidentally, these businesses are often (not always) inappropriate for angel or VC investing, not only because you don’t need their money, but also because a business that generate good profits right away often isn’t likely to scale up to a huge payday down the line.

2. 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, it may still be feasible to fund this kind of business out of personal savings (loans are usually a bad idea if you don’t have a clear and fairly quick path to cash flow). 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.

Often, however, personal savings won’t get you very far. You need equity capital.

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 and because they’ll also be able to contribute to your success through advice, introductions and validation.

Another quick but very important warning: Anytime you raise 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 you need to make sure you get it right. The consequences of getting this wrong 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.

If you can’t get traditional equity from professionals or technical experts, it’s worth thinking about strategic partnerships. In this regard, 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.

Be very careful about how you do this. 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.

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.

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. And they might be.

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.

Their money is just as green as the professional investors’, of course. But you’ll likely pay a high price for it in trouble. They are unlikely to add anything other than money to your success. They will require constant hand-holding and 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. They will also scare off VCs. Most importantly, you run the risk of can 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.

I hope this helps. Good luck!

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