Raising capital can be one of the most critical aspects of building a successful business — and often one of the most difficult. A successful funding round can make or break a company. Entrepreneurs will likely need to seek investment dollars at various points in the life cycle of their business, and from a variety of sources, in order to raise the necessary capital to sustain and grow their business.
The fundraising process
A thorough understanding of the process of raising capital is essential to achieving the best possible funding outcome for the entrepreneur's business.
Determining the Capital Need
An entrepreneur must first determine how much capital is required to fund the business's ongoing operations and growth objectives. Before meeting with investors, the entrepreneur should possess a detailed understanding of the capital requirements of the company (for example, hiring new employees, expanding office space, purchasing or developing new technology) and how this capital will help the company achieve its overall strategic goals and long-term business plan.
Raising the right amount of capital is a careful balance. If too little capital is raised in a fundraising round, the entrepreneur may need to raise additional funds sooner than they expected, diverting attention and resources away from running the day-to-day business. Conversely, if the company tries to raise too much capital up front, it may have difficulty achieving its fundraising target, which may be perceived as a sign of weakness by investors and the broader market. The company should also consider how existing shareholders will be impacted by an injection of new capital and whether they are getting fair value for their equity.
Choosing a Funding Type
The entrepreneur must also decide what type of funding to seek for his or her business. If the company is engaged in a formal fundraising round with venture capitalists, the venture capital firms will likely seek equity ownership in the company and some degree of control over business decisions (for example, a seat on the company's board of directors). If the entrepreneur chooses to raise capital from non-institutional investors, the investment may be structured as convertible debt, which is a hybrid of debt and equity. This can make fundraising simpler, since many of the terms of the investment do not have to be decided until the next formal fundraising round.
Pre- and Post-Money Valuation
Valuation is one of the most important negotiating points when raising capital. Prior to beginning the fundraising process, the entrepreneur should determine an estimated valuation for his or her company based on a detailed and defensible set of assumptions.
Private equity and venture capital fundraising typically involve negotiating a "pre-money" and "post-money" valuation of the business in order to determine what percentage of the company investors will receive in exchange for the capital they are willing to provide. Pre-money valuation is the value of the company before the new capital investment is included. Post-money valuation is the pre-money valuation of the company plus the value of the new capital invested.
Meeting With Investors
Once the entrepreneur understands what the goals of the fundraising round will be, he or she must begin the process of pitching to multiple potential investors. Most experts recommend that this process be as condensed as possible, since the time required to prepare for and hold meetings can take away from the entrepreneur's ability to run the day-to-day operations of the business. Since most institutional sources of money are constantly being pitched investment ideas, the entrepreneur should leverage his or her personal and professional networks to line up warm introductions to potential investors.
If an entrepreneur is successful, he or she will receive an offer from an investor. Typically, the investor will present the entrepreneur with a term sheet, which is a short document that covers the basic parameters of the deal including the amount to be invested, the pre-money valuation, the amount of equity the investor will receive and other big picture deal terms. The details will be ironed out by the attorneys after the term sheet is agreed upon. At this stage, the entrepreneur has the opportunity to negotiate and to compare competing offers. Once the term sheet is signed, negotiation over major deal terms becomes substantially more difficult, and pulling out of a signed term sheet could damage the reputation of both the entrepreneur and the company.
Subsequent Funding Rounds
Many successful businesses will have multiple rounds of investment from investors. Ideally, these rounds should all be at a pre-money valuation that is higher than the post-money valuation of the previous round (known as an "up round"). "Down rounds" not only dilute the value of existing shareholders, but can also signal to the market and other investors that the company has not experienced the level of success that previous investors had expected. In the venture capital funding process, there is typically an initial "seed round," followed by lettered rounds (Round A, Round B, etc.) as needed. A company will generally aim to raise enough capital to fund 12 to 18 months of operations and therefore will need to raise a new round at that frequency.
Entrepreneurs should also be aware that each subsequent funding round will become more difficult, since investors in later rounds will want to see growth and momentum in order to justify the earlier investor's confidence. While investors will give younger companies more leeway to figure out their business model, companies that have already been given this chance will need to show concrete results and achievements if they want to raise additional capital on attractive terms.
A Chance to Cash Out?
Some entrepreneurs may have the opportunity to cash out some of their equity when raising capital. The entrepreneur may want to diversify his or her personal wealth, or perhaps cash in on some of the success of his or her business. Many investors, however, may insist that the entrepreneur keep all or most of his or her equity rather than cashing out, since cashing out signals that the entrepreneur does not have full confidence in the future success of the company. The later the stage of the company, the less pressure there will be on the entrepreneur to retain equity. If the company is successful and mature enough to be the target of a private equity investor, it may even be expected that the entrepreneur cashes out a substantial portion of his or her equity. In addition, as companies delay initial public offerings and other exits, a growing secondary market has developed for shareholders to sell their stock privately to accredited investors. However, the entrepreneur and key shareholders may be reticent to sell any stock in these markets given the negative signal that the sale may send to other shareholders and investors.
Types of investors
Different types of investors target companies at different stages of their growth cycle. Here is a brief overview of the types of investors a company may consider raising capital from:
Friends, Fools and Family
An entrepreneur's personal network is often the first source of funding for getting a company off the ground. These investors know the entrepreneur personally and are willing to invest in an idea that has long odds of success based on this personal knowledge. Raising money from these non-institutional investors may require more legal work and regulatory monitoring. Because investment in a startup is inherently risky, the SEC has rules that limit how many non-accredited investors can participate in the investment. As a result, it is always a good idea for the company to hire an attorney experienced in raising capital.
These investments can be very lucrative. Jeff Bezos' parents invested $245,573 into Amazon in 1995. If they kept all of their stock it would be worth over $30 billion today.
Many companies will also raise money from an angel investor, who may be the first investor that the entrepreneur does not personally know. Angel investors are typically wealthy individuals (or even groups) who invest in very early-stage startups, oftentimes in an industry that the angel investor is familiar with. They are known as "angels" because they may invest at a time when the company has otherwise nearly run out of capital to continue operating.
Angel investors not only have substantial capital available to seed the business, they often have their own network of professionals and advisors that the entrepreneur can rely on to grow the business.
Some startup companies may opt to join a program known as an accelerator. These programs offer the company capital in exchange for equity, and the opportunity to participate in a several-month-long program aimed at accelerating the growth of the company alongside other startup companies. Accelerators typically offer the advice of their staff (who are successful entrepreneurs themselves), office space and access to networks of successful startups and advisors. Competition to earn a spot at a startup accelerator can be stiff, and successful participation in a well-regarded startup accelerator can give a company a degree of legitimacy. Well-known accelerators include Y-Combinator, Techstars and 500 Startups.
Venture capitalists are perhaps the most well-known and revered institutional investors in private businesses. Venture capital funds are typically organized as limited partnerships, with outside institutional investors (pension funds, endowments, insurance companies, ultra-high net worth investors) investing as the limited partners and the venture capital firm acting as the general partner. The venture capital fund will then invest in multiple startup companies. Venture capital firms typically earn 20% of a fund's profit in addition to a 2% management fee off the top.
Venture capital is an important player in the institutional investor space, since venture capitalists typically have a mandate to take on more risk than most other institutional investors. As a result, they fill a void for raising capital that would exist between traditional institutional investors (who cannot take on the risk of investing in an unproven company) and individual investors (who don't have sufficient capital or expertise to grow an early-stage company). Venture capital not only can provide startup companies with substantial capital, they also offer a very sophisticated network of resources and expertise from their portfolio companies. Venture capitalists typically participate in formal fundraising rounds, although recently they have begun participating in smaller seed rounds (which are now also larger than they historically have been).
While venture capital is a subset of private equity, traditional private equity firms are a relatively new class of investors in startup companies. They have historically invested in more established companies, but with big-name startups deciding to delay initial public offerings, there have been more late-stage startups raising substantial sums of money from traditional private equity firms. As a result, private equity is now how many high net worth investors gain access to late-stage startups.
Private equity firms are structured similarly to venture capital firms, where a general partner (the private equity firm) raises capital from institutional investors and ultra-high net worth individuals who are the limited partners in the fund. Since the mandate of a traditional private equity firm is to take less risk than a venture capital firm, the funds will typically invest in mature startups that have substantial revenue and the prospect for an initial public offering in the future.
Seek expert advice
An entrepreneur may only raise capital a few times in his or her lifetime, whereas investors meet with entrepreneurs every day. An entrepreneur can bridge this knowledge and experience gap by seeking advice from mentors, attorneys and other advisors who have expertise counseling companies raising capital. Keep in mind, most entrepreneurs will only have one shot with each potential investor they meet. It is critical to walk into the room with a detailed understanding of the process, the company's capital needs and the entrepreneur's negotiating options and alternatives.
Key Terms for Raising Capital
A lead investor is the first person to commit capital to a fundraising round. Having a lead investor offers validation to other investors, encouraging them to participate in the round.
An angel investor is a wealthy individual (or group of individuals) who provides startup capital to businesses in exchange for equity. Angel investors typically invest their own money in the venture and often invest in areas where they have expertise and connections.
A venture capitalist is an investor who raises capital from other investors and uses that fund to invest in early-stage startup companies seeking capital.
An accelerator is a program for startup companies that offers seed capital, connections, mentorship and education to startup companies in exchange for equity. They are typically fixed-term programs (e.g., four months).
A business seeking capital will determine its pre-money and post-money valuations. Those valuations dictate the amount of equity that investors will receive, in addition to the value of any existing shareholder's equity.
A down round occurs when an investor purchases equity in a private company at a valuation lower than the previous round's valuation. Since raising capital often dilutes the value of the existing shareholders, raising capital at a lower valuation will further dilute existing shareholders. In addition, a down round is a very strong negative indicator to the market, making further fundraising more difficult.
Convertible debt is a hybrid debt and equity instrument that allows for companies to raise capital between formal fundraising rounds without having to establish a pre-money valuation of the company. An investor loans money to the company with the ability to convert the loan to an equity investment on the same or better terms than the next formal fundraising round. Convertible debt is often a useful vehicle for raising capital quickly and without substantial upfront negotiation.