In creating a financing plan, the entrepreneur must consider three basic questions:
- How much money is needed and when?
- Who is a likely source of capital?
- What terms are likely to be attached to the financing (including valuation)?
1. How much money to raise
Generally money is raised in stages in a new venture. That is, the entrepreneur does not calculate how much money is required to achieve cash flow positive operations and then raise that total amount in one investment (or round). The reason is that in general investors would not put that much capital into a venture all at once. They like to see progress toward a positive outcome in steps. The see early rounds as allowing them to test whether the venture is likely to succeed. Then they (or other investors) are willing to invest more if they have seen positive interim results and progress toward a successful outcome.
The reasoning from an entrepreneur’s perspective is similar, and leads to a plan where investments are staged, notwithstanding the fact that raising capital is a very time consuming and arduous process. Uncertainty about a positive outcome leads directly to a lower valuation of the venture and therefore a higher cost of capital. One objective of the entrepreneur is to raise money on the best possible terms for the current shareholders (beginning with the founders). Events and achievements that lower the probability or risk of a negative outcome (or in other words reduce the uncertainty of a positive outcome) lead to a corresponding increase in the valuation of the venture (and a lowering of the cost of capital).
This line of reasoning leads to breaking the total amount of capital required into a series of “rounds.” The objective of the company is to create a roadmap of achievements where the greatest amount of uncertainty is resolved for the least amount of money. A financing plan following this approach will preserve the maximum amount of equity for the founders (and also the earlier investors). The company will use the proceeds of each round to achieve these milestones and then raise additional capital now at a lower cost to achieve the next milestone on the roadmap.
These steps are spelled out in more detail at Milestone planning and risk in a New Venture.
2. Sources of capital
There are two main methods entrepreneurs use to finance their businesses: Debt and Equity.
Debt financing is the riskiest method of financing, but also relatively inexpensive. It is risky in that you are actually risking assets that you currently own, and therefore the downside risk is that you lose the asset (like your home) that is securing the debt. It is relatively inexpensive because after you pay back the debt, you can keep the upside gains because you retain more of the equity (ownership) of the company.
Equity financing is less risky than debt financing, but rather expensive. It is less risky than debt financing because the downside risk is that you lose someone else’s money (along with some of your own pride), rather than your own assets. It is more expensive because you give up more of the upside, in the form of both equity and participation.
There are two main forms of equity financing, Venture Capital and Angels.
Angels are generally wealthy individuals that have the ability to risk their capital in a startup. They come in many different forms, sometimes as individuals, sometimes as part of a loosely affiliated “network”, and sometimes more formally as a part of an Angel “fund”.
Venture Capital is known as “institutional money” and is usually a partnership (known as the “general partners”) that invests money on behalf of larger institutions (known as “limited partners”).
As a practical matter, entrepreneurs should try to find investors
- Whose interests are aligned (as much as is possible)
- Whose knowledge, experience & contacts can help
- Who are competent to evaluate the opportunity
“Bootstrapping” refers to the process of advancing the new venture without the use of outside funds. The entrepreneur uses his/her own funds and any other means that his/her ingenuity can devise to make progress in the venture. The more progress that can be made without the use of outside funds, the higher the value of the company when funds are actually raised from investors. Then the entrepreneur will retain a higher percentage of the equity of the venture as well as possibly more control. Bootstrapping also implies severe financial discipline, which is also generally good in a new venture.
The main risk that comes with a bootstrapping approach, if it is feasible at all, is potentially slower growth and lost opportunities.
3. Usual terms
When negotiating Venture Capital contracts, there are two main forms of contracts: Round Financing and Milestone Financing. The difference between the two is the completeness of the contracts. In Round Financing, the price is not set for future rounds of financing. The opposite is true in Milestone Financing, in that prices are set in advance.
Generally speaking, the lower the entrepreneur’s bargaining power will be at the next financing event, the more likely they will use the more complete Milestone Financing. This helps reduce the chances that the VC firm can “hold-up” the entrepreneur. (Bienz and Hirsch, “The Dynamics of Venture Capital Contracts”, http://ssrn.com/abstract=929491)
The main terms of a venture financing are the following.
- Valuation: This is generally set by the investor based on comparables and market conditions, although there is often room for a little negotiation on this point.
- In a milestone financing, the release of cash to the company is not all at closing but is staged based on the achievement of particular milestones. Although there is often some give and take, the ultimate decision on the release of funds is in the hands of the investors.
- Downside protection: The investors generally require that all new rounds are “senior” to previous rounds. The are also convertible in the sense that they will act as debt in the event of negative outcomes and preferred equity in the case of positive outcomes.
- Control: Investors generally are given board seats (or at least observer rights) and well as various approval rights.