How DOES Funding Work Exactly?

One of the most common questions I have received from new entrepreneur’s launching new product was about funding – deal terms and structure, what a “financing “round” is, and what it all means for them at the end of the day. How does an Entrepreneur get started? How do they scale? “…but I have this great idea, won’t someone ELSE pay for it?” (Insert overwhelmed face) I didn’t know, I was a former Banker. Banks didn’t lend to anyone without perfect business credit, personal credit, revenue, cash in the bank, and they had to have been profitable for more than 2 years. We didn’t lend to the new guys with the napkin sketches and grandiose ideas. So who does?

 The earliest investment required for a company actually has several possible sources;

The “three F’s – Friends, Family, and Fools (or Foes, to be kind): Usually these investors put in small sums (<$100k) that can be used to build a prototype or explore a market potential. These investors are generally considered “unsophisticated”, and no that’s not a comment about your Dad or a “yo mama” joke. One of the best ways to help protect their investment is to use a convertible note (debt that converts into equity at a later date).

Grants from State or Federal Funds: Rather than provide an exhaustive list of potential grants, which is widely available on the internet, let me just say that programs like the Small Business Innovative Research (Link here to SBIR website) are called “America’s Seed Fund” for a good reason. They fund hundreds of millions of dollars for the exploration and development of great technologies and ideas. Most states also have start up funds. I go between Utah and Washington State, so ask me if you live in either.

Accelerator or Incubator Funds: For the last several years, accelerators like YC and Techstars have used total money raised collectively by their companies as an indicator of success. I would follow that (at least optically), they put pressure on the companies to raise at the highest valuation possible. Most accelerators take dilutive positions in companies making high valuations early and are more valuable. However, I personally know that accelerators push their companies to optimize vs maximize valuations because they recognize that early valuations that are too high can actually hurt a companies chances of success.

·      Seed Stage Investment: At this point most entrepreneurs are still figuring out the product – market fit, sales channels, and production issues. This is what most investors might call the “3 Guys in a Garage”(mode), “Two Broke Girls..(in an apartment)”, one I haven’t heard in awhile is “Three Men and a Baby…(in a basement)”. Okay, I like comedies and the 80’s. The first one, “3 Guys in a Gargage Mode” is a legit term. Google it.

In the last decade angel investors have formed hundreds of very active investing groups and become very sophisticated and well organized. At this stage most investors will use Terms Sheets that contain provisions that can be found at NVCA Model Deal Documents. The National Venture Capital Association (NVCA) is the voice of the Venture Financing Community in the U.S. These documents are the entrepreneur’s best guide to the industries “best practices” and you’ll want to use them to both reduce your legal expenses and to avoid potential problems. According to the NVCA, these documents are intended to reflect current practices and customs, and one of our goals in drafting these documents is to reflect “best practices” and avoid hidden legal traps, even if doing so means straying from current custom and practice. If you find all the legal language confusing try this “plain English Term Sheet that was developed by Passion Capital. Thank you, Passion Capital, you are the true meaning of, “PC”.

·      Series A: The clearest milestone for this stage is to have a good idea of customer pain and the solution or what we call product/market fit. Some revenue evidencing customer demand best verifies this. Investors will be more receptive to the Series A being raised to verify the demand and scale the business. This is usually the point an entrepreneur will be attractive to institutional investors like a traditional early stage venture capital firm. Entrepreneur’s need to know that, these days, Series A is often the most difficult round of financing. According to Pitchbook, in 2013, VC investors, startups and the media were getting more concerned about the so-called Series A Crunch—a phenomenon where a growing number of companies received angel and seed funding, leading to a dearth of capital for businesses ready for the crucial Series A round of funding. The data suggest that, with Seed financing increasing, startups often suffer a shortage of capital in the Series A and beyond. This has been a growing problem over the last several years, because more startups are competing for increasing rounds of Series A Financing.

·      Series B and on: Don’t take your ball and go home yet! At this point a company must have what VCs call “clear velocity” (the rest of us just call it sales), now its time to pour gas (or money) into the tank to fuel growth and scale. One important thing to keep in mind is that, in general, there are fewer companies funded at every subsequent round of financing. This happens because few companies really meet valuable milestones that demonstrate their value for larger rounds.

Remember too that you don’t have to go from a seed to an A to a B, etc. You can do an A1, A2, A3, etc. or a bridge round or a debt round. There are many ways to manage the optics of the financing. It is not a “one size fits all” deal and is somewhat customizable to your little entrepreneurial desires.

Another factor that will impact your financing is valuation. Consider the following two scenarios;

Founder 1: First round is $500k at a $2mm pre-money. You do well, hit your milestones, and raise the next round at a $10mm – a 4x value creation. Awesome, achievement unlocked. To justify a $10mm pre, the milestones are near, clear and achievable. Angels and institutional VCs are all in play in the second round.

Founder 2: First round is a $2mm at a $10mm pre-money. Now, the next round has to be at ~$50mm to get the same 4x value growth. A $50mm valuation does two things: 1) requires significant growth in users and/or revenue; 2) eliminates most angels and many smaller institutional investors. So now the requirements for success are higher, and the pool at which you can raise from is smaller. Crud.

I have not seen this work unless you are 100%, totally, completely and unequivocally on target with your projections. I would be excited to hear in the comments where I’m wrong, so please be sure to let me know.

By shifting the “big” round at that higher $50mm valuation to a later stage, the requirements for velocity and traction are spread out for the founder, reducing the focus on short-term rapid growth and making early milestones more achievable.

As you can see from the example infographic below, there are just not many cases where a Founder maintains “controlling interest” or even the largest single piece of equity, especially when multiple financing rounds are required. I always suggest Founders focus on “value creation” rather than valuation. I believe that by optimizing for the full relationship over time, and focusing on partners whose goals are aligned with the founder’s and whose investment will enable the startup to realize — not hinder — its potential.

Idea to IPO, how Funding Works

There will never be enough venture capital in the world to satisfy all of our entrepreneurial dreams. To be one of the lucky few who actually gets financed, every Founder needs to become familiar with the issues around deal terms, structure and valuation to be successful – or find somebody who is to make sure you know how to navigate this process. Please don’t quit dreaming and putting goals in place for yourself. My team and I are happy to help provide guidance. You’re not alone, reach out.

Author: Sandeep Shinde