Brian Hall - July 21, 2017 - Business Law, Outside General Counsel Law
Before digging deeper, let’s start with a question: what do a self-made millionaire and a venture-backed millionaire have in common? Yes, that’s right, so with that in mind, now we can discuss the fact that you have a great new business idea and are ready to make your idea a reality. You will undoubtedly be asking yourself where the funds to make that idea a reality are going to come from? Granted, resources (time, money, etc.) are needed, with cold, hard cash being king. Thus, whether to bootstrap or finance is one of the most important and earliest questions a founder needs to ask when pursuing a new business venture. Initially, there are two paths, bootstrap (self-finance) or finance (raising capital through outside sources). The path you take depends on a multitude of factors, including the capital you have on hand, your access to outside capital (friends/family, angels, VCs) and the runway needed prior to MRR (monthly recurring revenue).
Almost every new business venture starts in the bootstrapping stage. Bootstrapping a business means you’re self-funded. You’re likely using savings, income from your current job, and/or personal credit cards in order to support your business. The longer you can build your business while bootstrapping, you will undoubtedly benefit from the financial and creative control of your business, without any investors demanding you move in a certain direction. You’ll improve your negotiation position with potential on investors, which typically means you’ll end up giving up less of your equity. Of course, there is also a downside to bootstrapping. Your business budget is limited to your personal finances and there is often not enough money to draw any form of salary for the founders and just enough to cover overhead expenses.
Eventually, it is unlikely that you’ll be able to bootstrap until profitability. That said, it has been done! If bootstrapping is no longer viable, it’s time to look for external funding sources. For a startup with limited operating history, this will usually be accomplished through a private offering to accredited investors (as such term is defined under the Securities Act of 1933) as opposed to traditional bank financing. In order to move forward with a private offering, you’ll need to identify the funding sources and funding methods. Funding sources typically include friends and family, crowdfunding, angel investors, and venture capital firms. Funding methods include convertible debt, convertible equity, common equity and preferred equity.
The funding source and method will vary depending on the funding stage of the startup. A startup’s funding rounds can be broken up into the following stages: (1) Seed Round; (2) Angel Round; and (3) Venture Round. When a startup is in the Seed Round, it is typically looking to raise less than $250,000, likely issuing some form of convertible debt or convertible equity (i.e. SAFE) or in some situations common equity. Often the investors in this raise are friends and family. In the Angel Round, the company is typically looking to raise less than $1M from angel investors, who are accredited investors looking for early stage companies with high upside. These angels sometimes invest through various angel networks that often have pitch nights where startups can come in a pitch an entire room full of angels. In this round, startups will over both convertible debt and equity, preferred equity, common equity and sometimes even warrants.
Both in the Seed and Angel Rounds, the structure of the startup is less of a concern to investors. As long as the terms of their investment make sense and you are either an LLC or C-Corp, then the choice of entity decision doesn’t really exist. However, once a startup reaches the Venture Round, there is often a strong preference from VC Firms that their portfolio companies are structured as C-Corps and that the VCs are issued preferred stock for their investment. The first VC Round is called a Series A Round and the size of the raise can range from $1M to $10M. In many situations startups will have multiple VC Rounds, with each subsequent round identified as a different series (i.e. Series A-2, B, C, D and so on).
Ultimately, whether to bootstrap or finance depends on all of the factors identified in this article, if not more. An analysis of those factors with your corporate counsel will help set your startup for success now and in the future.
Founders’ Friday is a series published by attorney Brian A. Hall of Traverse Legal, PLC d/b/a Hall Law dedicated to legal considerations facing founders and start-ups. This week’s post contributed by corporate and securities attorney Stephen M. Aarons.