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How to Raise a Founding Round
2019-02-25: by Dustin Betz
A guide to raising your very first funding for your company
1. What Investors Are Looking For
Investors are looking to get much more money back again than the money they give you. To increase their chance of getting any money back, they like to reduce risk in their investments:
- risk of your business failing: investors look for companies with a full-time team, first product, and initial sales and traction to reduce this risk. If your business has these things, you are ready to fundraise from professional, experienced angels, as outlined in a different guide, https://fi.co/guides/1091.
- risk of dealing with strangers: investors prefer to invest in people they already know and have done business with. If they don’t know you and aren’t ‘fools’, they will spend tens of thousands of dollars on ‘due diligence’ to confirm you aren’t lying. This adds so much cost that it only makes sense to do when you are raising larger, professional amounts. The only people who can avoid this cost are people who already know and trust you.
2. Using Your Own Savings
While your own savings are the best way to fund a company launch, don’t use up all of your savings too soon. Companies fail when their Founders give up. Do give up if it is a bad company. Often good companies die because the Founders run out of personal savings, and can’t afford to live as a Founder anymore.
Even if you can fully launch the business today on your own savings, keep in mind that you are running a marathon, not a sprint. The company will have funding crises in its future. You will want some savings left to help the company then. You also need personal savings to support you for two years or more of no or a drastically reduced salary. NOTE: using the same logic, it is better to take a minimum wage-level salary as soon as the company can pay it, rather than working for free.
Consider the future when deciding how much of your savings to use, and consider raising a Founding Round from others in addition to investing yourself, to give your company more chance of success.
3. Who To Get Money From
Almost every company raises their first funding from people that they already know.
If you have made money for investors before, it can be easy to convince them that you can do it again. This is how high profile entrepreneurs raise millions of dollars on just an idea: they know the investor well.
If you do not already have strong investor relationships you will have to fall back on the people you know, commonly known as ‘friends and family’ or ‘friends, family, and fools’. This list typically includes three groups:
- People you know well: including parents, other family members, former employers and co-workers, friends or teachers from school, close friends, and others.
- Their contacts: people you know well can refer their contacts to you. The investor will trust you because they trust the referrer, who is willing to vouch strongly for you. This is most effective when the referrer is investing their own money as well.
- People you don’t know well who have a reason to quickly trust you: one group are people who know your industry exceptionally well and hence can ‘know’ your idea is ‘guaranteed to work’. Another group is Founder Institute Mentors, who may trust you quickly because of their familiarity with the Founder Institute and their relationship with your Directors.
4. Dealing with Unsophisticated Investors
Friends and family often do not invest in private companies and do not know the risks. Before taking their money, make these risks clear to them, and only take the money they can afford to lose. You don’t want the failure of your business to also mean financial hardship for your parents or a loss of relationships with friends and family. Things to consider saying include:
- ‘80% of early-stage startups fail, and though I’m sure we’re different, we can fail too’
- ‘think of the money invested like a lottery ticket: the odds are you will probably get nothing back and may get a lot’
- ‘can you afford to lose all of this, or should you give me less?’
If the business does fail, it is important to be able to point back to these warnings you gave, to keep your relationship. Do this well, and even if you fail, you can often raise funds for your next business from the same people.
Some Founders don’t want to risk losing the money of friends and family. Remember to consider the alternate risk: what if the business does succeed? Will your friends and family be upset that you didn’t give them a chance to invest when they had money to spare? How will you feel about having made strangers rich, without having given a chance to the people who know you the best to grow their wealth? It can be good for your future relationships to have given friends and family a chance … while having made certain to only take the money they could afford to lose.
5. Legal Structures to Use
If you raise money before you are incorporated, you will often have to take the money either as a personal loan or on a ‘trust me, I will give you paperwork after we are incorporated’ basis. This works only where you have a very strong relationship with the investor.
If you are incorporated, there are two ways to structure the transaction, depending on how you are thinking about this Founding Round:
- as a favor the Funder is doing you: in this case, you normally take the money as a personal loan between you and the investor and then loan the money to the business under your name. You promise to pay the Funder back with interest if you do well and may feel obligated to pay them back anyway even if the business fails.
- as a professional investment by the Funder: in this case, it is important that the paperwork is signed between them and the corporation. If not, whatever you promise now, you risk later investors saying ‘there is no paperwork, it didn’t happen professionally’. In this case, don’t feel obliged to pay the Funder back on failure. They are an investor, who is taking a risk, and will benefit if the corporation does. Good structures to use in this case include SAFE notes or common shares.
- SAFE notes: a SAFE note is a convertible debenture common in early-stage funding. It was developed in the US, and variants are now common in other countries. It is debt, which means it is paid back with interest if the company is doing badly. The debt holder can also choose to ‘convert’ the debt into equity or shares of the company if the company is doing well. Unlike other debt it is ‘safe’ because the debt holder can’t ask for their money back: they only receive it if and when you decide to close down the company.
NOTE: it is risky to use non-SAFE loan agreements to fund your company. If you leave debt holders the right to ask for their money back they may do so at a time when the company is doing well but has no cash to repay them with. In this case, the debt holders may end up owning all the company, and shareholders will own nothing.
- common shares: you can sell common shares to your first investors. You should only do this after you have sold and issued all your Founder shares, otherwise, Founders can have a tax liability for buying their shares at less than the true market value. Common shares are a simple structure, that allow investors to profit or fail when you do. If you do this, make sure you have a good Unanimous Shareholder Agreement in place which includes structures like a ‘drag-along’ clause, which makes sure that one small investor can’t later block a sale of the company. Don’t issue more than 15%, and preferably 10% of the shares in your company in a Founding Round.
- SAFE notes: a SAFE note is a convertible debenture common in early-stage funding. It was developed in the US, and variants are now common in other countries. It is debt, which means it is paid back with interest if the company is doing badly. The debt holder can also choose to ‘convert’ the debt into equity or shares of the company if the company is doing well. Unlike other debt it is ‘safe’ because the debt holder can’t ask for their money back: they only receive it if and when you decide to close down the company.
6. Protecting Your First Funders
It is common for venture capitalists and other professional investors to assume that your first Funders did it unprofessionally, as a favor. They will often tell you that as a condition of a later round of funding ‘we need to clean up the cap table’, and ‘give them their money back plus interest, that is what everyone does’. If these first Funders have invested via a personal loan that you have quasi-guaranteed, this may be appropriate.
If the first Funders have invested directly in the company, on professional terms, with high risk in return for a potentially high reward, this is not appropriate. It will fall on your shoulders as Founder to protect your first Funders in the negotiations and ensure that they get the proper rewards to match the risk they took. You may say ‘I protect and stand by my investors, as I will with you’. You should also point to a high-quality Shareholder’s Agreement to say ‘the cap table is fine with small shareholders since they can’t block us’.
If the negotiation is difficult, consider what it will be like to be partnered with this investor. If the investor wants to push out past investors, how will they feel about pushing you out in a few years? If your desire to protect your early investors is a sticking point, perhaps this is money you don’t wish to take.
Alternatively, if you feel you won’t be willing to stand up for your first Funders later, then be honest with them today that there is an additional risk they are facing: that the company may succeed, yet they won’t share in the upside, because a later round investor may force them out. NOTE: many angel investors have stopped all of their angel investing because the Founders they backed didn’t protect them. If you want angels to exist for others in the future, you need to protect them.
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