I am pivoting my blog towards writing more on startups and investing.
This blog post examines what happens at each step along the path of a startup as it grows from a speck of an idea into a living, breathing organism with the potential to build meaningful wealth and change the world.
Stage 1: The entrepreneur puts in their own money as first cash in the business
Investors no longer fund ideas. In an era of increasing technology and decreasing costs, the expectation is that the entrepreneur will be bringing an operating company with at least some traction.
The second reason is that investors want to know that the entrepreneur believes in his own startup. And the best proof of this is to show that he has put his own money in. Any cash invested by the entrepreneur will remain in the company as founders’ equity, and will come back to him only at the time of a successful exit in which the other investors make money.
Investors want entrepreneurs to have what is known as skin in the game; that is, an amount of their own capital serious enough for them to pay close attention to, but not so much that they will be distracted by having to worry about where their next meal is coming from.
It is likely that the first money into a company, up to $25,000 or $50,000, will come from the entrepreneur directly.
Stage 2: The first outside capital is often raised by friends and family
Although this stage is not required, most startups do raise money from friends and family in the form of equity or loans, to help get the company to a stage at which it is legitimately investable by third parties. The amount raised here can vary significantly based on family resources, but we typically see investments at this stage of $25,000 to $150,000. Well-heeled entrepreneurs often start off with $1 million or more.
The important thing is that the money should probably go into the company directly as a convertible note that will convert into the same security as the next professional round, but with a discounted conversion price. However, depending on the personal relationships involved (and on whether or not the family member is an Accredited Investor), the money might actually go in as a personal loan to the entrepreneur. The loaned money would then be invested by the founder as equity in the company, but must be repaid even if the company fails.
Stage 3: The entrepreneur begins fund raising
In the same way that an angel, is looking under every rock for a great entrepreneur, so is the founder of a startup looking in every nook and cranny for a great investor. The entrepreneur, if he is smart, will start by letting everyone know that he has a great startup looking for early investors. So keep your eyes and ears open for leads to interesting investment opportunities, even from the most unexpected sources.
At the same time, the entrepreneur must research which specific investors would be productive to approach. Some angels only invest in their home city, others only invest $5,000 at a time, others only invest in biotech opportunities. Blindly sending a business plan or PowerPoint deck to every angel and VC in the world will have zero effect, and simply clogs the system “while annoying everyone — the smart entrepreneur knows this and behaves accordingly.”
Stage 4: The entrepreneur should consider applying to one of the new breed of accelerators.
Accelerators typically provide several months of intensive mentoring — together with small but meaningful stipends for company founders — at the end of which they host a Demo Day to introduce their graduating companies to a number of local angel investors. While Y Combinator (based in Silicon Valley) and TechStars (with several locations and affiliates around the world) are two of the best known, there are dozens of others: local, national, and international, many specializing in specific areas (including fashion, food, finance, gaming, and more).
Accelerators are an interesting sidestep when it comes to the usual trajectory of fundraising, valuations, and amounts raised. Rather than negotiate with each company and set valuations based on the company’s traction to date, accelerators tend to be extremely selective in the participants they accept into their programs, and thus come from a position of strength. While there is some variation, most accelerators provide investments of $25,000 to $50,000 to cover the team’s expenses during the three months of the program in exchange for 5 to 6 percent of the company’s equity (which works out to roughly a $500K valuation: low for a typical high-growth startup, but made up for — at least in theory — by the mentoring, contacts, and support from the accelerator).
Stage 5: Enter the angels, either independentally or in groups
As a very rough range, from $150,000 to $1.5 million in invested capital, the entrepreneur enters angel territory, either by lucking into one rich and generous angel, or (more likely) by pulling together either a group of individuals (at $10,000 to $100,000 each), or one or more organized angel groups, or one or more micro-VCs (colloquially known as “super angels”). Depending on the circumstances, these more-or-less professional, arms-length investors will fund their money either in the form of a convertible note (with a cap on valuation), or in a Series Seed or Series A convertible preferred stock round, using similar documentation to that used by venture capitalists.
During this period and each of the subsequent fundraising episodes in a company’s life, the most important goal for the entrepreneur is to identify a lead investor or champion. For many reasons — most notably limited experience/skill in the case of a novice angel, and limited bandwidth/capital in the case of an experienced angel — this is often a challenge. The deal lead will be critical in rounding up other investors, drafting a term sheet, and getting the deal done. He or she will be the entrepreneur’s primary champion and often mentor. The lead investor can vouch for the entrepreneur other investors in their circle or who follow them on online.
Angel groups are an interesting and useful way for new angels to get their wings wet. There are hundreds of these groups across the United States and around the world, and the majority of them accept applications from entrepreneurs over the transom through Gust (although, of course, a personal connection is always valuable). An invitation to come in for a preliminary screening by an angel group provides the entrepreneur with an opportunity to present her business to experienced investors, yielding pitching experience and solid feedback on the business plan.
Stage 6: Venture capital and series A crunch
After angels have been tapped for whatever funds they can supply (generally no more than $1 to $2 million), the company has to deliver on its rosy projections. Just as the majority of companies that raise money from friends and family never make it to the angel stage, the vast majority of companies — 90 to 95 percent or more — that are funded by angels never see venture financing. It is this tough winnowing process that periodically has entrepreneurs bemoaning the apparent crunch in funding once they begin to need large amounts of cash.
For the successful/lucky ones that do make it, they will raise amounts from roughly $1.5 million (perhaps from one or two seed-stage funds joining together) up to $5 million to $10 million (likely from one or two traditional venture funds). In either case, these professional investors will almost certainly be investing in the form of convertible preferred stock using something like the National Venture Capital Association’s Model Series A documents. They will likely make their first investment about half of what they’re prepared to put in, with the rest coming in one or more follow-on rounds if the entrepreneur successfully executes the business plan.
Stage 7: Growth capital and letters beyond B
Finally, north of $10 million to $20 million in total capital raised, the entrepreneur will be getting money from a later-stage VC growth fund, whose paperwork will be similar to the earlier venture capitalists. They will put in much larger amounts of cash in successive rounds of convertible preferred stock investments (known as Series B, Series C, Series D, and so on) but the business valuation will be much higher, so they may end up with a smaller stake than the earlier investors (who likely would have continued to invest in each round in order to maintain their percentage ownership).
At this point, the role of the early angel investor will change dramatically. In the early days of the company’s life, angels are perceived as heavenly beings bringing cash, validation, advice, connections, and other good things. They may have a seat on the board of directors, and may get used to speaking with the entrepreneurial CEO every few months, or even weeks. This close relationship begins to weaken when the venture fund comes along, at which
point the angel will probably step down from the board. By the time the later-stage fund enters the picture, to the entrepreneur the angel is typically only a fond memory of days gone by. But like children leaving the nest after college, this is generally a good and natural thing, freeing the angel to get involved with the next generation of startups, and letting the company play in the big leagues. Provided the initial investors haven’t been overly diluted by this point, this is normal and not something that should be resisted.
Stage 8: The public or private exit
Once the later stage funds have provided the company with the cash it needs to generate value, the focus shifts to the long-term future of the venture, and, more important, how to provide liquidity for the company’s founders and investors. The choices here are typically an acquisition by a larger company, or entering the public markets through an initial public offering (IPO). The former path is much more common than the latter, but in both cases the company’s investors are able to see the fruits of their prescience and bold actions. While the bulk of acquisitions happen in the $30 million to $50 million range after a Series A or Series B round, if the original investments were priced correctly, those exits can often return 10 to 20 times to the company’s early investors. And, in the unlikely case of an IPO (which would typically happen only after several later stage investment rounds), the returns can be 100x or more.
Although the foregoing steps comprise the canonical progression of startup financing, keep in mind that the number of companies that go all the way through it is very, very small. A majority of companies started in the United States begin and end with the first stage: the founders’ own money. The number of companies able to get outside funding then begins to drop by orders of magnitude: the percentages (again, very rough) are that 25 percent of startups will get friends-and-family money; 2.5 percent will get angel money; 0.25 percent will get early-stage VC money; and probably 0.025 percent will make it to later-stage VC funds, with only one or two dozen startups (out of the 600,000 that started) making it to an IPO.