What to Consider Before Raising Capital
Bringing on New Partners in Exchange for Funding
A word of caution here is appropriate, because I’ve seen it happen a ton of times. Do not bring on a “partner” at this stage just because they have some money. Too often you have a great idea and you talk to people about it; and then, someone steps up and tells you they want to be your business partner and they will fund you in this very early stage. They don’t have any specific expertise in whatever area your idea falls, so they aren’t really going to be much help there, but they have some money, so…
Here’s what typically happens.
They put in, let’s say, $50K and for that you make them equal partners. It happens all the time. Now you have a partner whose sole role is going to be to drive you crazy and not be helpful.
After a couple of months of you noodling around on your computer and maybe getting something running, they are going to start asking, “When can we ship?” and ‘How much longer will this take?” This is the equivalent to your kids in the back seat constantly asking, “Are we there yet?” There are, of course, cases where this kind of partner works out well, but I believe they are few and far between and the risk is most often not worth the reward. Resist the temptation to take easy money and end up with a partner who isn’t helpful. If money is offered, structure it as an investment for a little bit of equity.
The Friends and Family Investment Round
The other less risky but still dicey strategy is what is often referred to as the “friends and family” investment round. Unless your friends and family source is very wealthy and won’t miss the money, this strategy is a great way to ruin future Thanksgiving dinners or close friendships for the same reasons I cited above. If you just want to bring them in as investors to share in your future success, the right time to do this is when you are raising your first real round of financing. Most professional investors will allow you to have a couple of small tag-along participants. Just don’t get crazy with it; a lot of paperwork and complication can be created down the road with a lot of these small investors.
If your friends and family are really wealthy, maybe take the money, but spend a lot of time setting their expectations. Your mileage may vary. Money at this stage is extremely expensive, use as little as you can get away with.
Building Your Startup Team
Let’s talk about building your appropriate startup team.
At this point, we’re assuming you’ve either hired your first employee or taken the initiative to build out a functional prototype on your own. And you’re either in the stage of growth where you’re actively working to raise capital or you’re considering what steps you should take to properly position yourself to do so. For most startups, this is an appropriate time to start thinking about building your startup team.
It’s going to be pretty hard to get the right team at this stage without thinking of them as partners, not employees. Keep in mind, all members of your startup team at this stage of growth are going to be working just as hard as you and are really taking the same risks that you are. Having a great idea is one thing, actually implementing it is harder. This is a good time to introduce the concept of stock compensation, so let’s digress for a moment.
A Quick Word on Compensating Employees with Stock Options
Full disclosure, I admittedly screwed this up in my first VC-backed company and it ended up costing me several million dollars, so pay attention.
Compensating partners or employees with stock options is extremely common in the tech industry, to the point of being expected. The people you bring in are taking career and financial risks in joining you, they deserve to be ultimately compensated for taking these risks. Given that the whole idea of a tech startup is to grow it and make it valuable, part ownership in this growth is not an unreasonable expectation and can help mitigate your likely lack of cash at this point. True partners may work for less than market rates for the opportunity to be involved at this very early stage.
Stock option incentives tie each individual’s success directly to the success of the company. This keeps them motivated and focused on building an acquirable business without the need to pay them current market value for their work at a time in which you are probably short on cash.
Things to Know About Startup Equity (“Ownership”)
Now that you’ve decided it’s time to start building your startup team, you are probably thinking about how many team members you can afford and how you are going to compensate them, especially if you haven’t acquired funding at this stage. This is a good time to start thinking about ownership, or equity compensation.
You may be able to leverage startup equity to build a successful startup team you otherwise might not be able to afford without funding. If your new startup is just you and your idea, you currently own 100% of it. If there are three of you that have the idea together and all participated in the brainstorming of that idea to this point (let’s call them “Founding Partners”), you probably each own a third of it.
There are no hard and fast rules about this stuff; you have to work it out with your founding partners, but work it out now before you get too far along and get it in writing to protect everyone involved.
The decisions you make at this critical junction can affect everything you do later. Think Facebook and the Winklevoss twins. Before a single line of code is written – before a single word of a business plan is written – decide on the ownership split between your founding partners. And, most importantly, write it down.
If you are really serious, form a corporation and document the ownership. You can hire a lawyer, it doesn’t cost much, or use a service like LegalZoom, which is cheaper. If you do this, your chances of surviving your startup journey are dramatically increased.
OK, so now it’s you and potentially a couple of founding partners. Ownership of the company adds up to a convenient 100%. (If it doesn’t, this is a good time to go back and check your math.) Time to start building your startup team. And for most startups in the tech industry, that means it’s time to hire some developers and a leadership team.
Now is the Time to Hire Developers
When it comes time to hire developers, a few questions will undoubtedly surface. How much stock do they get? Equal shares?
As with all things, it depends.
Probably not equal shares; I am presuming that they don’t qualify as founding partners, or we wouldn’t be asking this question.
Perhaps you are several months into the prototype, or you have written the complete business plan and/or initial specs for the product, and maybe even received some encouraging words from a couple of investors. And you need excellent software mechanics to implement things.
In other words, the idea is pretty fleshed out already.
The company I mentioned back in Part 2 of this series — where I needed three seasoned developers — actually fell halfway between these. I had the great idea, I had the beginnings of a business plan, and I needed serious help taking it all to the next level.
What to Pay Your New Startup Team
The three developers I hired were very well known to me from my previous startup, and we knew we worked well together and shared in our passion for the idea. I didn’t really know what I should be offering them, so I decided that if the business was a success, I wanted each of them to make at least $1 million (in 1980’s dollars). This was pretty arbitrary on my part, but it shows a way to think about stock compensation.
Come up with two numbers for this. One is what you think the company might be worth at the point you either sell it or go public. Err on the conservative side, and it’s probably best to assume an acquisition, going public, is probably not going to happen.
Come up with reasonable numbers, if you exceed them everyone is going to be happy. So, if you really think your great idea will be worth $100MM, they would, in this scenario, get 1%.
This is probably not a reasonable number or expectation. For my purposes, I came up with $30MM. If we could make this company worth $30MM in an acquisition and I wanted them to each make at least $1MM, they should each get about 3.5%.
Remembering that they would get diluted when we actually raise money, I think I took them each to 5% and they were very happy with this approach.
Employee Stock Options, Not Actual Stock
Make sure these are stock options, not actual stock. There are stories about first employees being given actual stock, then taking off 3 months later, stock in hand. Stock options require the employee stick around until they vest. This is a good time to get a bit of legal help to set up a stock option plan.
So where does this (in this case) 15% ownership come from? Well, from you.
You just went from owning 100% to owning 85%. If there were two founding partners with equal shares, they each went from owning 50% to owning 42.5%. No magic here. And again, as above, document this and get some legal docs in place.
You may need a stock option plan, a corporate structure and a lawyer. Pay the money for the lawyer and do this right as there are zillions of permutations to consider. If you are ultimately successful, this will save you from massive nightmares down the road, and any investor will require all this anyways. It’s easier to not make a mess than it is to try to clean up the mess later.
Now is the Time to Create an Equity Pool for Future Employees
Although more typically done when raising a real Series A round of financing, this might be a good time to create what’s called an “equity pool” for future employees.
Get startup legal advice, please (I can’t say this enough); but, basically you are setting aside a portion of the company in the form of stock options to be used for employees. This equity pool also comes out of the ownership of everyone involved at this point. Everyone with any ownership in the company dilutes equally when creating this pool.
Going back to my previous example, this would include the three developers I initially hired and offered 5% ownership, as well as to the founders. Remember, I gave them 5% instead of the 3.5% I hoped would eventually be worth $1MM for this very reason.
A typical amount, if there is such a thing, might be 15%-20% of the company equity. In other words, if you have 100 shares representing 100% of the company, 15 to 20 new shares (typically) will be created and go into this pool. Now there are 120 shares in the company, and everyone diluted a little.
This is an amount that should easily cover hiring your entire team and employees through several rounds of investment. Get legal and tax advice here, as this can have serious implications down the road depending on how it’s done. Be frugal when handing out options to new people coming in; base the amount of options on the amount of risk they are actually taking. For example, if you are compensating members of your startup team an actual fair market value for their work right now, you may not even need to offer them stock options. As the company progresses, the risk goes down and the option grants are reduced in size.
Avoid This Big ‘Screw Up’ – Learn from My Mistake
Earlier in this article (under “Building Your Startup Team”), I mentioned a big screw-up on my part when raising my first round of venture capital. It’s worth a quick discussion. And, fortunately, I can actually laugh about it now. Sort of.
I was pretty naïve regarding how any of this worked, but I had a very fundable idea and a functional prototype. I ended up with four venture firms wanting to participate in this first round. At this point, I owned 50%, with my business partner having the other half.
Not having any real idea how VC money or stock worked, I let the investors decide how much we each owned after the round. I believe the number for me was about 10% and my partner ended up with about 5%. Pre and post-money valuations never entered into the conversation, so this all seemed reasonable to me. I just didn’t know any better; I was an engineer, not a business guy.
Fast forward three years and a second round of financing later, my ownership was diluted down to about 6% . The company was acquired by our competitor for about $28MM. My share was 6% of that. If I had been able to read this article back then, or if I had bothered to get some legal advice, I would have still owned, by my calculations, 25% or more at the time of the acquisition, not 6%. You do the math. Startup educations can be very expensive.
Venture Capital Isn’t Your Only Option
The truth is that venture capital is not the only option available to companies just starting out. There are other sources of growth capital that may make more sense at different stages in a business life cycle.
The above graph maps out in broad terms when different types of funding might make the most sense in a business’s growth trajectory. While many startups rely on bootstrapping or funding from family and friends to get their ideas up and running pre-revenue, as you start to grow your concept, angel investors provide small, early sums of money and operating expertise and mentorship. Another alternative for early-stage tech startups is revenue-based financing. This is a type of funding in which a company agrees to share a percentage of future revenue with an investor in exchange for capital up front. The loan payments are tied to monthly revenue, going up for strong-revenue months and down for low-revenue months.
What is the Best Funding Option for Your Business?
Some startups may be making $10K in sales per month, but doubling month-over-month, while other companies are more established, with perhaps $600K per year in revenues, but growing very slowly. So obviously the financing scenarios and options can be unique for each business. What’s important for founders looking to finance those in-between years – after launch and before stable growth – is to make sure you are aware of all the funding options and figure out what is right for you.
Every situation is different, especially at the very beginning, but the main takeaway in this article is to give you some strategies for raising capital to build your startup team when it’s just you and an idea.
In the next article in this series, we discuss what is seed money and how to find angel investors.
Enjoyed this post? Subscribe to our newsletter to get our latest stories delivered to your inbox.
Raising Capital to Build Your Startup Team?
The loan payments are tied to monthly revenue, going up for strong-revenue months and down for low-revenue months. Visit here to see how it works, and if you like what you see, apply for funding today to connect with our investment team!