This is the first post of my newly launched personal blog, where I will discuss startups, venture-capital & entrepreneurship. I’ve wanted to start a blog for some time now and I’m excited that it’s finally launched. I am unsure how frequently I will be able to write, but I hope to write at least a few in-depth, meatier posts every month for an indefinite period of time. I’m very happy with the way the design turned out (shout out to Web2Feel – who created beautiful premium Wordpress themes for free).
I figured a good place to start my first post is to describe financing options for new businesses and make some definitions to give a context to later posts. Please note these are my definitions from personal experience, not official/textbook ones. They are also very, very general descriptions of an exceptionally complex industry – so this entire post should be taken as a quick crash-course to those just starting to learn about the industry, not as a a comprehensive review.
1. What are the ways to finance a startup company?
The classic ways to finance a startup are:
Bootstrapping: Paying expenses by earning revenue. The classic method but implies the company is profitable and already has a product to sell. Many technology companies cannot take advantage of this method since they need to develop or productize their technology. If a company only bootstraps, it retains all of the ownership for the founders, yet it can sometimes be a much smaller growth curve than if financing is applied correctly.
Friends & Family (+ Fools): Classic 3F’s. In essence, you hit up your rich uncle (or others) for money to start your business. Depending on your friends/family the structure can come in many forms – equity, straight debt, convertible debt, etc. In theory, 3F’s are supposed to provide funding support from $1k – ~$250k. In actuality, I know very few entrepreneurs who have found capital from family at the upper limits of that range – usually it’s in the sub-$50k range.
Angel Funding: See below.
Seed: Typically, “Seed” investing has a very loose definition and is roughly in the same space and size as angel & early VC. In fact the term can be overlapped with virtually any of the above types of financing. In my mind, it typically falls in the $400k – $800k range and can be supplied from an early VC prior to a full investment, a group of angels, a grant, or any other mechanism that is designed to jump-start a business. As an entrepreneur, I wouldn’t get too caught up in the nomenclature. Many times over in the sub-$1M range I’ve seen identical things labeled “seed,” “angel,” and “VC.” The point is that it exists and a startup-newbie should at least be aware of the term.
Venture Capital: See below.
2. What are angel investors?
Angels are typically non-professional startup company investors (note: In my experience the majority of angels are non-professional investors, however there are a number of very active angels that invest professionally including VCs who also do angel investing). In my experience they are typically retired CEO’s, executives, lawyers, doctors, etc. and generally invest and meet in groups (hence the term Angel Groups). Many I know view angel investing as a hobby and most groups are usually a wealth of connections and knowledge. Angels invest their own money into companies – often times in the $10,000 – $50,000 range each per investment. Also, most angels I know genuinely enjoy meeting young entrepreneurs and helping them – providing mentor-ship, advice, and of course investment dollars.
Uber Angels: an “uber-angel” can refer to both an angel’s level of involvement/activity, and the size of investment. In referring to activity, there are many notable uber angels who approach angel investing as a full time profession. They are known for, and make their livelihood, on professional investing in very, very early stage companies. Well known examples would be Chris Sacca and Ron Conway. I would also suggest Gene Hammond as one example of a Boston uber angel. In referring to size of investment, an uber angel is referred to as an exceptionally high net worth angel who can and will put $1M or more into a single company without it having a sizable impact on their net worth.
3. How does angel investing work?
As mentioned, angels typically work in groups. The collective approach often helps prompt valuable discussion about potential investments, and others in the group can act as sounding boards. It also allows angels to hopefully collectively provide enough funding to a company (i.e. if the company needs $200k, the group could theoretically supply that with 5-10 simultaneous investments from different angels). Like everything, there are exceptions to the rule. For example, Hub Angels which operates in the Boston area, acts as a fund. However, the majority of groups operate by having individuals make investments.
The investment process generally works like this:
First, the entrepreneur seeking funding will apply to the group in one of two ways. The first way is by an online submission process found on the groups’ website like Angelsoft, a submission form, or by email. The second way is to have an introduction from a member, who will generally “sponsor” the company presenting. In essence, it’s a vetting process. The idea is that if a member is comfortable enough to put their name alongside a company, it will be fairly interesting/valuable.
Of all of the companies, the group’s organizer will then choose a number of them (usually 3-4) to present at the next meeting. During the meeting, the angels will gather and the companies will come in to pitch one by one. Once they have pitched for 10-20 minutes and answered questions, the company will be asked to leave so that the angels can have a chance to discuss it. In that discussion, the angels will debate the merits (both positive and negative) of the company. After the discussion ends, the organizer will ask who wants to follow up and pursue the investment. If there is enough interest (generally 3-5 angels), than the group will go into diligence (or research) of the company.
The diligence process ranges widely from group to group. Sometimes it can be exceptionally quick, i.e. within a week or two, or it can be as long as multiple months. Angels are generally faster at making investments than VCs, usually because their diligence requirements are lower as well as an increased appetite for risk (again, the key word is usually). After diligence is complete, the group and the company will draw up a term sheet and the individuals will make the investment.
4. Where can I find angels?
There are many amazing angel groups found around strong startup ecosystems. I know I’ve always been impressed with Boston’s angel community. I will write a later blog post listing angel groups in detail at a later time, however a few minutes Google searching will be exceptionally valuable. If your goal is to try and get invited to pitch to a group, like any endeavor, you should spend a significant amount of time researching the group – the members, investment philosophy, past investments, etc. - to become familiar with them.
5. What is a venture capitalist?
A venture capitalist is a professional investor in private companies. Generally, the term applies to early-stage investors – who can and will regularly invest in pre-revenue companies. That being said, venture capital spans a wide breadth of investment classes, from early stage (roughly speaking $1M – $10M) to growth ($10M+). The larger the rounds become, the more likely they are going to fall into the larger private equity classes – for example mezzanine rounds ($50 – $100M +) would generally fall to different capital firms.
Investment rounds in a company are usually designated by letters – and often correlate loosely to the size of the investment (but not always). So an “A” round, or the first round of financing for a startup might be in the $1-5M range, a B-round in the $5-10M, a C $10-$20M, and D is above that. The sizes range drastically (you might have a “D” that is $1M for example, or an “A” that is in the $10M range), but the main thing to take away is that the letters designate the order of the rounds.
Venture capitalists are well-known for having exceptionally busy schedules, meeting many companies, and having extremely large networks of business contacts.
6. How does venture capital investing work?
Venture capitalists invest mostly other people’s money. They will receive investment themselves from LP’s (or Limited Partners), and the collective investment will be pooled into one or more funds. A “standard” arrangement is that the LPs provide 99% of the capital requirement while the GP (general partnership, or the partners of a firm) provide 1%. The partners of the fund will then invest in companies from the fund itself, with the goal of giving back a significant return to their investors (many firms shoot for an annual return of 10 – 25%). A typical fund’s lifetime is in the 5 to 10 year time-frame and generally has three phases: seed, growth, and maturity, where the fund eventually sells the large companies to provide the return.
I won’t get into the deep details of the metrics of a typical VC firm, but most venture capitalists have strong incentives to provide large returns. A good fund performance 1) usually ties with their compensation, 2) affects their ability to raise more money from investors for future funds, and 3) has a network effect and will increase potential deal leads.
In order to make those returns at scale, i.e. investing millions of dollars at once, many VC firms need their companies to grow substantially (3x – 10x), and so VCs are exceptionally selective about potential investments. The process is somewhat similar to an angel group, except of course that there is no standard group meeting. If a VC hears about a potential interesting company (often times at the associate level), they will set up a meeting or call to talk with the company’s management - referred to as “sourcing” in VC terminology. Generally if a VC is interested, they will invite the company back for multiple meetings, so that a number of the partners of a firm have a chance to meet with the company alongside the “lead” partner on a particular deal.
If a company sounds interesting enough, it will be brought up on the Monday Morning Partner Call/Meeting. I capitalize that because it is a big deal. It is where companies usually pass the gauntlet to move forward with diligence or a term-sheet, or where the partners collectively decide to pass on an investment. If the partnership agrees that the deal is worth investing in, they will progress with more diligence/research and eventually decide to issue a term-sheet. A term-sheet is a legal document expressing interest to invest a certain amount of money into a company at a certain valuation (price).
If the term-sheet is agreed to and signed by the company and the firm, then the deal enters final diligence. Final diligence is when the VC firm will review in deep detail everything they can about the company. Basically it’s a process to verify that everything which was discussed previously is in fact, true. So if a company said they have a patent, the VC checks and verifies the quality of the patent to make sure it’s what the company represented. If there are no major kill-switches in the deal (i.e. if the VC finds there is actually no patent at all, or that they didn’t have the major contract they said they did), the deal will officially close, the firm receives the shares in the company, and the VC wires the money to the company.
7. How can I find venture capitalists?
VCs usually admit they rarely have time to check the submissions they receive from their firm’s website. A much more effective way is to become introduced to a VC with a potential deal. If a deal comes from a warm intro, it has a much, much greater chance of being reviewed and considered.
What if you don’t know any VCs? That’s the age-old problem of entrepreneurs. The best way is to use LinkedIn or another mechanism to see who they know and try to network your way towards them.
Of course, I am a VC, and would be very happy to talk to entrepreneurs and take a look at a pitch deck if you are seeking funding. Dace Ventures is an early-stage VC focusing on digital media, consumer marketing, and mobile – and we love speaking to interesting entrepreneurs.
If you have a startup that falls generally in the internet space, please feel free to reach out to me by email at: oshaughnessy (at) daceventures (dot) com with an executive summary and/or a pitch deck (no full business plans please – I won’t have time to read them), and I’ll happily take a look.
Whew! Well I hope that helped give some clarity to anyone who had questions about early-stage investing. It’s admittedly NOT a comprehensive description, nor goes into the many, many complexities of the early-stage investing culture, but it’s a good place to start.
Thanks and I look forward to writing more! I’d love to hear feedback – both on the post and the blog in general.
