8

A Primer on Startup Financing

This chapter focuses on the basics of startup financing—the different mechanisms for raising money, the how and why of funding rounds, and the purpose of financing agreements. It’s designed to give first-time founders an introduction to the language of financing, so you can move on to the much more difficult skill of building relationships. If phrases like “pre-money valuation” and “convertible note” scare the hell out of you, you are in the right place. Don’t get too caught up in trying to understand the ins and outs of startup financing, though. Most of the investors we know are much more interested in finding entrepreneurs they believe in and want to work with than they are in negotiating the best possible deal.

Key Elements:

• The four ways to raise money

• How funding rounds work

• Understanding equity financing agreements

The Four Ways to Raise Money

At the most basic level, all ventures raise cash through one or more of these four mechanisms.

Create It through Profits

Creating cash through profits is what businesses are designed to do. Businesses are “value creating” machines, and cash is simply an agreed-upon amount of stored value. One option for getting the cash you need would be to use the venture itself, or another venture, to create cash through selling a product or service. In other words, you sell some products for more than it cost you to make them, then take the profit and use it to make and sell more products. You could also sell a service like consulting and use the profits from that service to build your business. People call this “bootstrapping.” It is by far the cheapest form of getting cash. It can also be very slow. Many businesses finance their growth through this method.

Where does it come from?

Borrow It through Debt

Borrowing cash is another word for debt. With debt, you pay someone a monthly “rental fee” called interest in exchange for access to their cash. However, institutions that lend cash like to have assurances that you are going to pay that cash back. They often require some sort of collateral, like a factory or a big piece of machinery, so that if you can’t pay back the cash, they can take your factory instead and sell it to get the cash.

Borrowing cash through debt is more expensive than creating it, because you have to pay the interest (rental fee) each month, and it’s also risky to you, because if you can’t afford to pay back the money or the interest on time, the person who lent you money can bring you into bankruptcy.

Where does it come from?

Buy It through Selling Equity

Another way of raising money is to buy the cash by selling the most valuable thing you have: ownership of your venture and the future profits it might create. You hope your venture is going to be worth a lot of money, and anyone who owns a piece will have a claim to all that money. By selling equity to investors, you offer them a stake in the business—a percentage of ownership that you all agree on. Selling equity is typically thought of as the most expensive option for funding a venture, because if the venture does well, you end up giving away a bunch of money you could have had yourself. However, that’s only if the venture would have been just as successful without selling that equity. If you have to move fast or if you have investors that bring more than just money, selling equity can be a key part of the business’s success.

Where does it come from?

Get People to Donate It

There’s one other way to raise money for your venture: ask people to just give it to you. Institutions have donated money to ventures in the form of grants for years. Today, ventures use donor-based crowdfunding platforms to raise small amounts of cash from many customers and fans in exchange for rewards, such as a discount on the first run of a product or high levels of service. For startups with strong, aspirational branding, consumer products, and/or extremely motivated customers, this can be a great source of cash.

Where does it come from?

How Funding Rounds Work^*

Say a couple of scrappy and innovative founders come up with a brilliant new idea. In order to work on this idea, those founders decide to raise a small amount of cash from their friends and family, say, $250,000. In startup-speak, we would say this startup is in the seed stage. This is their first funding round—the first time they take on debt or equity to grow the venture. They use this money to live on and build a prototype.

Then, six months to a year later, those same founders will hit a point where they will need to raise more money, probably to hire more people and build a minimum viable product (the crappiest version of the product a customer is still willing to pay for). This time, they need more cash than their rich uncle can afford, maybe somewhere around $2.5 million. So, they decide to look to the local rich people in their area who invest in startups. These people, called angels, are often successful entrepreneurs themselves and either invest alone or band together with others in the area to form angel groups that help carry the load of finding and filtering startups that are good investments. With this new group of investors, our founders have entered the Series A round of funding.

Since we’re making things up, let’s say everything goes exactly as planned. Now, the startup has grown into a profitable or soon-to-be-profitable company. The founders decide they need even more money to take the company to scale, say, $10 million. With this amount of money, they can’t play around. They decide to go after institutional funding called venture capital (VC). VC firms are startups themselves; a founder raises money from high-net-worth investors like family investment offices, pension funds, and insurance companies and uses that money to invest in startups that will earn the investors a high return. With this funding, the venture has entered the growth stage and raised a Series B.

This process continues, with more and more money being raised from bigger and bigger sources, all the way until the company makes an initial public offering and goes public or is acquired by a bigger corporation.

Let’s sum up our mythical company’s journey:

Series seed round. Friends and family ($250,000)

Series A round. Angel investors ($2.5 million)

Series B round. Venture capital ($10 million)

That is the story of how funding rounds work. Raise a little money from one group of investors, make progress, and then raise more money from more investors. Paul Graham, founder of the accelerator Y Combinator, compares funding rounds to shifting into the right gear. Like a bicycle or car, a venture-backed company moves through several gears, or rounds, of funding as it grows. Each of these rounds gives the venture a boost of cash that allows it to move at an increasingly fast speed. The right kind and amount of funding will move your venture at exactly the right speed, moving the venture fast enough to take advantage of the opportunity before it but not so fast that you lose control and can’t make changes as you grow.

Understanding Equity Financing Agreements

Any time a founder sells a stake in his company in exchange for cash, he enters into a legal agreement with whoever gave him that cash. According to Brad Feld and Jason Mendelson in their book Venture Deals, that legal agreement is designed to decide two primary things:

Investors use a lot of different mechanisms in an agreement to make sure they get the kind of economics and control they want. All the different mechanisms and terms can quickly get confusing. As a founder, your challenge is to decipher the language of investing into what it means for you, your venture, and your stake in it—if the business does very well, if the business does very badly, and everything else in between. We include descriptions of the most important terms here.

Price

Price is the amount investors are paying for an equity stake and what percentage of the venture they get. A correlated term is valuation—the total value of the venture based on the price the investors paid for their shares. Investors look at the issue of price in two different ways.

This pre-money, post-money thing can get tricky. Pay close attention to which you are talking about during negotiations. You may see other terms related to price on a term sheet; they all come down to the same two things: the amount of cash that is being invested and how much of the company that cash gets the investor. Here are some other ways to present price:

Liquidation Preference

Liquidation preference is a way for investors to protect their investment if the venture doesn’t do well. They do this by asking for a multiple of their original investment, two times or three times, for instance, when the business is acquired or liquidated. This way, if there isn’t enough cash to go around, investors get their money back (and then some) first.

In addition, investors may ask to “participate” as well, meaning that after they’ve received the multiple of their investment back, they still get their percentage of whatever money is left.

Vesting

Vesting is dividing up the total amount of equity a founder or employee gets over time, so that people who leave the venture early don’t get rewarded as much as someone who sticks with it. A typical vesting agreement, or schedule, says that founders or employees will earn their shares over a four-year period, gaining ¹/₄₈ of their shares every month. Usually, there is also a stipulation that they must be with the venture for a full year before they get anything. This one-year rule is referred to as a “one-year cliff.”

Not-Quite-Equity Agreements

There is one other thing we should mention about early-stage financing agreements. Often, very-early-stage companies will raise money but want to avoid a valuation—having a price set on how much the venture is worth. They do this because it is too early to decide in any rational way how much the company is worth. In these scenarios, the founders may want to raise money through a convertible note—an equity agreement that starts out as debt and then automatically converts into equity the next time the venture raises money. In exchange, the investor can negotiate a discount on the future shares his money will buy. At the end of the day, the basic goals of the agreement don’t change—you are still making decisions about who gets what when and who decides what when—but the terms for convertible notes are different.

*Paul Graham has done an excellent narration of the way startups move through funding rounds; our scenario is inspired by his. See http://www.paulgraham.com/startupfunding.html.