Startup Fundraising and the Road to Liquidity

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Startup Fundraising and the Road to Liquidity

Startup CEOs spend a surprising amount of time trying to raise money. Over the course of five to ten years they will likely raise many rounds of financing from many different sources, including angel investors. Each round of financing impacts the value and rights associated with the previous rounds of investors, and as we will discuss later on, many of the terms negotiated in an angel round will deal with the impacts and opportunities regarding these future rounds of financing. A company may not go through all of the stages laid out below, and it is also possible that they will do multiple rounds of investment in any one stage. Your goal as an angel investor is to get to an exit—a liquidity event—in order to realize a return on your investment.

Stages of Startup Funding

Bootstrapping

Bootstrapping refers to the entrepreneurs self-funding, typically through a combination of savings and debt. In the bootstrapping phase, founders are doing their initial research, testing their hypotheses about product demand and features, and perhaps creating a minimum viable product (MVP) to get early customer feedback. The founders may be working full or part-time elsewhere and are drawing no salary for their work on the startup. Hopefully they have engaged a startup attorney and have executed the standard set of legal formation documents, invention assignment agreements, and so on.

Minimum viable product (or MVP) refers to the product that the company has built which it believes it can sell and monetize. The product is far enough along to gauge whether customers will pay for it.

Friends and Family

Sometimes companies accept funding from friends and family. There are many stories of founders receiving very early investments from family or friends as they pursue their startups. Jeff Bezos received an investment from his parents to start Amazon (they are now fabulously wealthy). “Friends and family” rounds can be a few tens of thousands of dollars or even a few hundreds of thousands of dollars, and might be used to pay for a designer on contract, a part-time engineer, or some costs related to prototyping.

caution You should be aware that friends and family rounds are frequently not done in compliance with the law. While this very early funding may have helped a company come into being, it frequently represents what could be called “legal/regulatory debt.” We cover this in more detail in Fundraising and Securities Law.

Incubators and Accelerators

The term incubator generally refers to a company that generates its own startup ideas in-house. Using a resident team that is deeply versed in startup techniques, they will typically research the market, prototype the product or service, and test customer demand. If they see an idea getting traction, they look for a full-time CEO and help to build the core team of early employees. That team is then sent out to raise money as an independent entity. Incubators, which often refer to themselves as “labs,” retain a significant ownership stake in the startups they help create.

IdeaLab, founded by Bill Gross, was one of the famous early incubators and spun out such companies as CitySearch, Cooking.com, Shopping.com, Twilio, and eToys. Looking at their historical portfolio companies is like a walk down internet memory lane.

Venture capital firms are increasingly founding early-stage incubators in the hopes that they will be able to reduce the risk of investment by vetting business ideas early and advising founders early on. Firms with their own incubators can buy equity in these companies at the lowest possible price, at the very beginning. Madrona Venture Labs, associated with the venture capital firm Madrona Ventures, is one example based in Seattle. Many incubators will also accept entrepreneurs who have their own ideas but lack a team or other resources to test and validate those ideas efficiently.

More common are accelerators, institutions that take in cohorts of a dozen or so very early-stage startups, which go through a structured three or four month intensive program of education and mentoring. At the end of this period, there is typically a “demo day,” where all the startups pitch to potential angel and institutional investors. These demo days may be how you find some of your deals.

The better-known accelerators include: TechStars, Y Combinator, and 500 Startups. In addition to mentoring and a structured program, accelerators often provide a certain amount of cash to the company, taking a percentage of equity in return. Many of these accelerators are active in introducing their cohort companies to angel investors. They often have standard term sheets that they use as starting points for the financing rounds of their startups, like Y Combinator’s entrepreneur-friendly SAFE documents.

Angel or “Seed” Round

Whether or not a startup company comes out of an incubator or accelerator, the angel round or seed round, as it is usually called, is typically the first tranche of outside funding—that is, money from people the founders don’t know. There is a tremendous range in the amount of money raised at this stage. Investments can take the form of debt (typically convertible notes) or a priced round in which the founders are selling shares of stock in the company. Seed rounds can vary from $100K to several million dollars.

If the round is a priced equity round, then it is often called the series seed round. A company typically raises an angel round when they have full-time employees and have built a product; they may also have early customer traction. They need money to improve the product, hire key people in engineering or sales, and engage in marketing. Ideally they are raising enough money that they can last at least a year before they need to raise again.

Venture Capital Rounds

Venture capitalists (or VCs) generally invest $1M or more (sometimes, a lot more) in a round of financing for a startup. They typically invest through a VC firm. Most VCs are looking to make $3M-$10M initial investments, with that number rising in follow-on rounds. They typically look for companies that have real traction with paying customers, though occasionally they will back successful serial entrepreneurs who have only an idea. They often like to invest when the company has achieved product/market fit, thereby dramatically reducing the risk of early failure. They invest when the company needs cash to accelerate its sales and marketing and scale up its engineering team to flesh out the early product. A company may raise many rounds of venture capital, and many VCs keep money aside to invest again in subsequent rounds for the winners in their portfolio (the “follow-on” investment).

Currently, the first VC round is commonly called the Series A round (although there are seed stage VCs as well). Each subsequent round adds another letter: Series B, Series C, and so on. If things are going well, each of those subsequent rounds is a bigger investment at a higher valuation.

Venture capitalists raise their funds from outside limited partners, or LPs. VCs have a duty to those partners to do rigorous due diligence. VCs make their living (and reputation) from the returns on their investments, so tend to seek advantageous terms when they invest, and often sit on the boards of directors of their portfolio companies in order to monitor progress and exercise more control where they can; VCs can be quite aggressive in protecting their interests when things go sideways.

VC funding is typically the first money founders will raise from institutional investors.

Institutional investor refers to an entity that is in the business of investing either its own money (like a family office) or other people’s money. They are usually sophisticated in their legal knowledge and are savvy negotiators of early-stage deals, because they are in the business of making investments. In some cases they might be quite aggressive in the terms they seek from entrepreneurs.

Liquidity Events: How Angels Make Money

In a liquidity event (or exit), the company in which you invested is sold or the company goes public, allowing investors to cash out of their investment.

Acquisition

Acquisition is a kind of liquidity event that occurs when a company buys at least a controlling interest in another company, for cash or stock of the acquiring company or a combination of the two. Being acquired by another company is the most common outcome for startups, excluding total failure. In 2018, 90% of the exits were acquisitions, while 10% were IPOs*.

Often startups—which are all private companies—are acquired by public companies, in which case the startup’s investors will get either cash or shares in the public company. But the investor may not be able to cash out on those shares right away—they may be subject to a lockup agreement.

A lockup agreement is an agreement with the issuer of the securities (the company) that you will not sell your shares for some period of time, sometimes for as long as a year.

If the shares in the public company are not subject to a lockup agreement, then the shares will be tradeable on the public markets.* If the acquiring company is another private company, and they use their shares rather than cash to buy the stock of your portfolio company, then after the transaction you will own different shares that you still cannot sell. You will have to wait for the acquiring company to be sold or go public.

Initial Public Offering

Acquisition is not the goal of every startup—many hope to eventually make it to an IPO.

An initial public offering (IPO) is the first sale of a company’s stock to the public where the sale is registered with the Securities and Eschange Commission, specifies an initial trading price for the stock, and is generally financed by one or more investment banks.* This type of liquidity event is colloquially referred to as “going public.”*

Early investors may have a lockup period of three to six months post-IPO, after which they will be able to sell their shares and reap the rewards of their early-stage angel investment.

important While IPOs typically represent the largest multiple in terms of return on investment for an angel investor, it is almost always a long wait to get there—11 years on average in 2020. Companies typically need to be of significant scale (hundreds of millions of dollars of annual revenue) with robust, profitable businesses to be able to bear the burden of the significant regulatory, legal, and accounting expenses of being a public company, and to be able to engage the investment bankers who will underwrite the offering and guide the company through the rigorous IPO process.

Secondary Markets

There has been some movement in recent years toward trying to make shares in private companies more easily saleable even in the absence of a public market transition. For example, in 2015 Congress enacted Section 4(a)(7) of the Securities Act of 1933, enabling secondary transactions in non-generally solicited exchanges with an accredited investor buyer.* However, secondary market transactions in private company shares are still rare, and you should not expect that this will be a ready source of liquidity for you.

The Process of an Angel Investment

For entrepreneurs, raising capital from angels is frequently a grueling process that takes months of pitches, meetings, document preparation, and negotiation—all while trying to build a company.

In a best-case scenario, an entrepreneur may be able to close a round in a month or two. In a more challenging scenario, they might be pitching to and negotiating with multiple angel groups and super angels and smaller VCs for a year to get the round closed. There are no hard rules about this process, and an entrepreneur may be finalizing terms with one angel or group while still preparing to pitch to others.

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