Rocky Top MBA

CMM August 28th, 2008

The world of entrepreneurship is a wilderness. It’s harsh, it requires a survival instinct, and it punishes bad decision-making. Contrary to some expectations, it isn’t a city-park-greenway-with-swings kind of wilderness; we’re talking about deep-jungle-savages-with-spears kind of wilderness. It takes a total commitment to living on the edge, not a commitment to the sexy, TV-friendly version of entrepreneurship. It takes time, careful planning, and proper execution just to survive. But with a little luck, all the hard work pays off with a profitable and rewarding exit.

The journey through that wilderness isn’t without the occasional victory. One of the earliest inflection points of a start-up is securing that first round of outside investment. Right as the entrepreneur has almost topped out their credit cards, exhausted their savings, and been banned from family dinners due to borrowing from relatives… the oasis appears!

In the life of a start-up, there are few events more exciting than raising the initial round of funding. This initial round, often called the seed round or seed capital, is some of the most critical but most difficult to raise. This money goes for flushing out the business model, building the prototype, protecting the intellectual property, getting critical market validation, and beginning to generate early adopter revenue.

In addition, it marks an important point in the entrepreneurs maturity. They’ve probably gone a few months without an income… and outside investors mean an actual paycheck. It feels so good, they won’t even care that the salary is 1/3rd what they could earn in corporate America.

Unfortunately, there is a problem with securing seed money. The risk and lack of revenue associated with a seed investment is a turn off for most institutional investors, and most high net individuals are too busy investing in real estate (or maybe that’s just in East Tennessee?). As a result, many potential entrepreneurs lose hope, run out of savings, and eventually throw in the towel. While this lesson is critical for technology start-ups, it happens across the board, from lifestyle, to serial, to social entrepreneurs. Academics have identified a funding gap between traditional venture funds (which focus on growth and expansion opportunities) and seed investments.

In order to be successful at raising seed capital, and to avoid major complications in later stages of fund raising, entrepreneurs should develop a fund raising strategy. The idea that “all money is good money” is a bad idea that gets good entrepreneurs into horrible, dead-end situations. Remember, there is no such thing as a free lunch… so consider the conditions (both legal and implied) that come with every outside dollar you raise. Make sure every dollar raised creates the kind of value that grows the company beyond seed and into the growth stages.

Some points for consideration are as follows:

Seed Stage Funding Sources:

• FFF– The classic friends, family and fools. Unless an effort is backed by a research institute or corporation, most start-ups rely on founder’s capital and resources to get the concept nailed down, technology flushed out, and business plan pieced together. It can be very beneficial to be an early investor, since this money gets to experience the most value gain over time. Likewise, early investors typically get diluted (or see a decreasing stake in the company) with the entrance of larger institutional players. That’s usually okay, though. Institutional money can make the difference between owning 20% of a hot dog stand of 1% of a MacDonalds. Be careful with FFF and how the deal gets structured. Later in the companies maturing, it will be tricky to raise money if the earlier investors are at odds with potential future investors.
• Grants– Free money! Well, mostly free besides the time spent battling the annoying application process. Common resources for grants are federal grants like the Small business Innovation Research grant. Aside from providing capital, these awards are 3rd party validation for the concept.
• Boot Strapping–Boot strapping is the funding strategy for most non-serial, non-technology entrepreneurs. This is a great way to establish a lifestyle company (one with no desired exit, but with intent of operating under founder’s control to provide income for a certain lifestyle). As revenues grow, the company is able to increase its relationship with the bank, throttle up cash flow, and expand operations.
• Angel Investors–Angel Investors come in many shapes and forms, which makes it difficult to understand what someone means when they claim to be an “angel investor.” Also, there are lots of decoys out there… people claiming to have access to angel money but with no real ability to invest. Depending on what the angel brings to the table, the deal should be assembled accordingly. An angel with industry experience and a willingness to serve as an adviser or board member should have more seniority and stronger investment rights. An angel without the resources or acumen should be treated as a typical FFF investor. Some would even argue that angels without special resources or acumen aren’t really angels… they’re really just part of FFF fund raising.
• Institutional Seed Investors–Before its all said and done, almost every technology start-up needs some kind of institutional investment. Institutional investors are the true commercial venture and private equity funds. Venture and private equity money is supposed to be “smart money.” Be careful… there are many groups passing themselves off as venture funds without the resources (and most importantly capital) to support their claim. A real institutional investor will have provide the start-up with access to their network (both industry specific and fund raising), provide operational value as an adviser or board member, and be able to offer fresh and relative opinions.

Concerns:

I can’t believe I’m making this recommendation, but when it gets time to negotiate the terms of a seed round, I recommend the entrepreneur bring their own lawyer to the table. Certain lawyers specialize in business formation and investing, so they have the acumen necessary for writing the appropriate investment documents.

• Valuation– This needs to be a post all its own. Raising too much money or at the wrong valuation cause cause major problems in the long run. The most frequent mistake of naive and rookie entrepreneurs is trying to raise money at too high a valuation. Typically, $500k seed investment in a company that is pre-revenue, pre-prototype, and pre-IP (patent) is going to purchase 35% to 45% of a start-up. This isn’t written in stone, but its a good starting point for negotiations. The longer the company waits to raise seed money and the more value squeezed from founder’s capital, the better the valuation. For example, a company raising a frist round of seed money that already has a patent filed, a prototype built, and recurring revenue off a small number of beta customers is going to give up much less than a company with only a business plan and pitch.
• Anti-Dilution– Some companies are tempted to include an anti-dilution clause, which is a BAD idea in my opinion. Early ivnestors should have tag-along rights (or the option to invest pari-passau) with future rounds. The harsh reality is that most early investors, won’t have the cash reserves to follow-on with later institutional investments. As the multi-million dollar investments close, ownership percentage becomes diluted for both early investors that don’t participate and founder’s equity. This is natural and to be expected, so entrepreneurs should manage expectations with the FFF. Like I said earlier…. 10% of a hotdog stand or 1% of a MacDonalds.
• Investment Tool– There is much debate around what type of tool to use with seed investors. Typically, investments are made as either common stock, preferred participating convertible stock (yeah… a mouthful!), or as convertible debentures. Personally, I think REALLY early institutional seed money should be raised as convertible debentures, founder’s equity should be treated as common stock, and only after revenue generation and market acceptance should preferred equity tools be used.
• Voting Rights–If you’ve ever heard the old saying that “a donkey was a horse designed by committee,” you understand the danger of having too many people involved in the company’s decision-making process. Giving voting and board seats to early investors can create complications and frustrations long-term, not to mention deter insituional investors. Some seed investors are of great value and should be awarded board seats, but in my opinion these true angels are rare. Giving Uncle Bob and your college roommate preferred voting status and/or board seats in exchange for $20,000 is foolish. Its one thing if they are industry experts… but giving them seniority because of their relationship is naive at best.

Check back soon for future posts on:

• Setting a seed stage valuation
• What happens when entrepreneurs do bad seed deals
• How to be attractive for seed fund raising

• Angel Investment , Entrepreneurship , Seed Investment , Venture Capital