United States: Your Net Foothold - Financing Your Start-Up

The dot.com bug has bitten you. You quit your job to start an Internet company that will revolutionize the way businesses interact with each other. One problem — your new company (BIZ.com) needs capital, and lots of it, to develop its infrastructure and execute its strategy. Where will you get this capital and what will you have to give up for it? This three-article series will briefly examine some of the key issues involved in financing your new startup -- financing sources, choice of security and compliance with federal and state securities laws.

Because each financing transaction is unique, it is difficult to generalize the aspects of a transaction. However, the sources of capital for BIZ.com generally will include: founders, friends and family, angel investors and venture capital funds. A recent phenomenon, the incubator (or accelerator) is also an alternative in certain situations.

BIZ.com will initially raise its startup capital, or certainly some of it, from its founders. These funds may be used to develop the business plan, develop a web page, incorporate the business, lease office space and hire initial employees. These key employees may also contribute capital to BIZ.com in exchange for common stock at a price equal to or slightly higher than the price the founders paid.

Depending upon how far BIZ.com progresses on these initial funds, or seed capital, the company may then seek capital from friends and family of the founders and key employees. This friends and family round of financing accomplishes two goals: it provides additional capital for BIZ.com and it gives the friends and family of the founders and key employees an opportunity to participate in BIZ.com’s anticipated success.

Again, depending upon how far the friends and family capital take BIZ.com, the company may then approach more sophisticated investors for the next round of capital. Angel investors and/or venture capital funds are most likely BIZ.com’s next source of capital. Angel investors are typically wealthy individuals who have made either an active or passive business of investing in startup ventures. In recent years, angel investors have played an increasingly important role in financing startup enterprises. As a general rule, angels fill the financing gap between the seed capital or friends and family round and the first venture capital round of financing. Because the minimum venture capital investment today is in the $2 to $3 million range, angel investors play a vital role in providing start-up financing that may not be available otherwise.

A recent trend in angel investing is the formation of networks of angel investors, or mini-venture capital funds. In these networks, several angels will pool their money, typically in the form of a limited partnership or a limited liability company, and actively seek out investments. In this structure, the angel network may have a more formal investment approach and greater resources to invest, resulting in diversification of its risk into a larger portfolio of startups.

Finally, venture capital firms are a source of capital for BIZ.com, venture capital firms may invest after all of the prior rounds of financing have been completed, or in conjunction with earlier investors, if the business is especially attractive. In seeking angel or venture capital financing BIZ.com should try to match the business needs of the company with the business experience and contacts of the angel or venture capital investor. While a $3 million investment from a venture capital firm with no particular industry expertise may be valuable, a $3 million investment from a venture capital firm with particular experience and contacts in the business-to-business Internet space will be much more valuable to BIZ.com.

We have recently seen a trend in the venture capital arena of "strategic" venture capital financings. That is, investments by non-traditional venture capital firms who may be competitors of BIZ.com. These strategic investors may be operating companies that have committed large sums of money to invest in companies who are their direct or indirect competitors or who offer products or services which are complimentary to their own. While these strategic corporate investors can be valued-added investors, in that they bring valuable resources in addition to their capital to the deal, accepting them as investors (and likely board members) gives rise to complex issues which must be addressed, such as conflicts of interest, exclusivity, confidentiality and fiduciary duty issues.

If BIZ.com wants a bit more security and a safer place to grow, an incubator may be an alternative it considers. In the typical incubator arrangement, the incubator will provide office space, administrative support, human resource, legal, accounting and other services and pay the entrepreneur a salary in exchange for an equity interest in the range of 20% to 60% of the business. Most incubators have capital to invest in BIZ.com in addition to providing the office space, administrative and professional services. However, in exchange for the relative security of an incubator, BIZ.com’s founders should expect to give up a larger piece of the company.