So you have an innovative and novel business idea that you want to form a business around and start ASAP. That’s great!
But you realize that it’s going to take a certain amount of funds to get started. If this is the first time you’re considering getting an investment for your business idea, let’s take a beat here and discuss getting investments. There are different sources of funds, as well as deal terms that can set you up for success or failure right out of the gate.
As easy and exciting as it may sound, setting up a startup isn’t all that easy. It requires a lot of dedication and hard work simply to get to the funding stage.
We’ve covered some of the preliminary startup activities in earlier articles like figuring out who your customers are, building teams, and creating budgets and financial projections. All those will add up to a solid business plan that you’ll need to present to investors, whether in an in-person pitch presentation or a full business plan drop-off.
Remember that investors have made it to a point that they have the disposable funds to invest in businesses like yours. They didn’t get there without doing their due diligence when succeeding in their own businesses.
Most if not all startups initially start with funding injected by the founders of the business, and friends and family. However, even your friends and family members will want to understand what you’re doing and need some form of a business plan, even if simplified.
Whether your investors are friends, family, external investors, do your homework on why your business will succeed. And if you’re able to have an experienced lawyer with you, that’s ideal. Experienced lawyers know the ins and outs, so they’ll be able to help you navigate what’s important and not, getting you the best deal terms possible.
Pre-Seed Round of Funding
Investors want to believe in you and your idea, but they also need to be sure that they’ll be able to receive a return on their investment in your business.
If your startup is self-funded or funded by your friends and family members then you can consider this as the pre-seed funding stage. Friends and family members will be more sympathetic to your cause and will have less stringent conditions, because they know you well.
Pre-seed funding can be considered as an informal form of funding because in the majority of cases pre-seed investors don’t have an equity stake in the business. Most pre-seed funders are the founders themselves, who are simply trying to get the business up and running. Pre-seed funding can take a lot of time or it can happen very quickly, this depends on a case to case basis.
At this stage, be sure to have some form of agreement if you’re receiving money from friends and family. Whether it’s as a loan or as a convertible note, be sure to have a contract. It’ll help save your relationships with your friends and family in the future because there won’t be any confusions about what was or wasn’t said/agreed to.
Seed Round of Funding
Formal funding begins with the seeding phase that comes once the business is running. Seed funding can also be provided by friends and family members, but since in most of the cases the amounts required for the seed stage are quite high, this is where external investors come into the picture.
Before we talk about investors, let’s take a quick look at the concept of seeding. Consider the seed stage as planting the seed for a tree. When a seed is planted, the investment is for the future of that seed. In the beginning, the seed won’t be returning anything, but the one who planted the seeds knows that the seed will grow into a plant and then into a tree full of fruits.
Startup seed funding works in a similar manner. Seed funders invest in the business in return for an equity stake. Their aim is not only to help get the business up and running with the right strategy and product development, but seed investors are also looking at the potential future profits of the company to recover their initial investment and more.
Two of the most common seed investors are:
- Angel Investors
- Venture Capitalists
Angel investors are high net worth individuals who usually invest with their own private funds into a startup in return for an equity stake or a convertible note. Some angels may also look into convertible notes that they can convert into an equity stake in the future, so the investment deal can finish quickly and the entrepreneur can get to work. The valuation of the equity will be determined in the next round of funding and the angel will usually have a floor and/or ceiling of the valuation to protect their investment.
Angels can be accredited investors or simply individuals with an interest in startup funding. Many angels investors also have prior experience with running their own startups, so angels can provide more than just financial resources to the business. They bring much needed personal experience and guidance to the business across all facets of a business.
Most startups don’t have a knowledge base to benefit from and therefore the experiences of an angel can help guide entrepreneurs to grow their business quickly, while avoiding the mistakes that most entrepreneurs make. On the other hand, this can also be seen as a downside sometimes if you have a highly-involved angel. This however is part of the cost of receiving their funding. Entrepreneurs can’t expect the angels to invest their funds and then leave the entrepreneurs to do as they wish.
Many angel investors also may just look for monthly or quarterly updates, while being available whenever the entrepreneur needs help. Angels who are able to offer support that helps the entrepreneur grow their business are ideal. It’s a win-win for both the angel and the entrepreneur.
Venture Capitals are investors who look for startups and young companies that have high or perhaps exponential growth potential. The funds that venture capitals bring in to the table are significantly higher than angels. Most venture capital deals are $1 million and above.
Venture capital comes in the form of funds and therefore they not only bring in a lot of finance, but they also bring in significant institutional knowledge that can help the business grow exponentially in a short amount of time.
In addition to this venture capitals also bring in a lot of industry connections that may help the business acquire suitable and talented employees as well as attract other investors and therefore more funding. They have a large network that they can tap if the startup needs access to certain people or companies.
Venture capitalists seek an equity stake and board seats. Venture capitals differ from angels in the sense that they have a clearly defined path about what they want from their investment. Venture capitals look for a minimum rate of return on their investment and therefore they may give guidance on how to achieve the minimum earnings so that they can achieve their return on investment.
Venture capital funds require an equity stake in the business as a safety net and position on the board where they can exert their influence as long as they are involved with the business. Most venture capital funds invest in a business for about 7 to 8 years and aim to exit their investment at the end of this period either through acquisition or an IPO.
One note, if you don’t have high-growth goals for your business, then venture capital is not for you. Venture capital funds have their own investors who put in tens to hundreds of millions of dollars into the funds. They want the venture capital funds to manage the money to achieve high returns for them as well.
Let’s take a look at some aspects of dealing with negotiations and getting to a terms sheet that you’re happy with.
How to Negotiate
Now when you manage to secure the interest of investors in a pitch meeting and the investors follow you up with a round of negotiations, then you need to be careful for a few things.
Negotiating with investors is a power game. You’re a party and the investors are a party. These two parties are looking to enter into an agreement where both parties have their interests protected. At some point, both parties will have to make some concessions and think about the long term advantages.
Investors know that they will be in this for the long run, so they’ll want to make sure that they get a suitable rate of return. They aren’t running a charity, they’re there to help you, your business, and make money in the process. So as long as their deal terms aren’t egregious, it should be good.
But apart from money, investors also look for a long term work relationship because they understand that your business will have to be developed almost from scratch. It’ll be a while before they reach an exit and they’ll want a good working relationship with you. They’ll look for an entrepreneur who’s communicative and open to suggestions and guidance.
This means that apart from the monetary perspective the investors will be looking to build a trust-based partnership and this is what you should be looking for as well. Money, is a byproduct of business activity and you’ll get the money, but trust between an entrepreneur and the investor is more important than money. Why? Because trust is a resource. The investor will think of more ways to help you out if you have a relationship built on trust and honesty.
Trust however takes time to build and in a negotiation, the most that you can do is exhibit your openness and willingness to form a trust-based relationship.
Think about what would happen if you squeezed the investor into a smaller amount of equity than they originally wanted. The investors still invested, because a small slice of a big pie is still better than no slice. When it becomes evident that you’re going to need help in your business, you go to your investors asking for help. But wait, they’re busy with another startup where they have a large pie slice in. They’re unable to provide you any support because they want to make sure their bigger investments are successful first.
While you may have a larger slice of the pie, that pie isn’t looking so good. So it’s important that you’re building a long term, honest relationship with your investors.
Don’t Show Your Cards Right Away
When you go to a negotiation meeting, don’t make the mistake of placing your desired deal terms on the table first. Listen to what the investors have to offer, what they think of your idea and its potential, and how much they are willing to invest.
Most of the time, you’ve already told them how much you’re looking to raise in your round, so they know the total amount of financing you want. What’s still on the table is the valuation of your business.
Listen closely to what the investors like most about your idea and what puts them off. Consider this as an objective analysis or SWOT test for your startup. They may also surprise you with their insights, showing you they provide much more value than just cash in the bank. I’d personally give a discount to those investors who can actually provide additional value – smart investors. I love them.
Ask questions and probe
Don`t hesitate to ask questions, probe where possible because asking questions will open the investors up and give both you and them more insight into each other. Expect them to do the same, this is a two-way street.
Try to see what the investor is most interested in. If an investor is looking for a greater degree of control than you are prepared to give, then this may perhaps indicate that the investor isn`t convinced by your personal ability and more interested in your idea. This isn`t always the case though. Some investors who really want to invest in the project may genuinely ask for greater participation to not only secure their end, but also to help your business. So this will once again depend on how the meeting goes and what question are raised by both parties.
In my experience and talking to investors, they genuinely want you and the business to succeed. Many investors will say they invest in the entrepreneur because they believe in the entrepreneur. Ideas are a dime a dozen. It’s the people who can execute who investors want to partner with.
Know Your Lines in the Sand
You are coming to negotiate for the future of your startup idea, don’t take this lightly. Do your homework. Draft a cheat sheet of your terms and conditions. Points that you simply can’t compromise on. Mark the points that you’re flexible with. This will give you clarity of thought throughout the negotiation.
Know Your Investor
This really goes without saying. Do your due diligence on your investor, their investing history, their preferences, the projects that they have been involved in, and how they helped or harmed the startups they invested in. This will give you a rough idea about what you’re getting into with the potential investor.
Art of Leveraging
Investors’ interest means that your startup has got something that they are interested in and the fact that you need their investment shows that you lack something that they have. So both parties have something the other needs. It’s mutually beneficial. But there’re still some chips that can be used for leverage, if needed.
The investors will try to use their funding to push you on the back foot and you should use your strengths to push them on their back foot. In the end, both parties will agree somewhere in the middle but this is an exercise that happens in almost every negotiation round. It’s rare that either side will cave completely unless there’s absolutely no other choice.
If the investor, for example wants more control than you’re willing to give, then you can position yourself as the leader and originator of the idea. The great team you’ve assembled is there because they believe in you, not the investors. Loss of control might make the top talent leave.
You can also keep your choices open by engaging with multiple potential investors. This way, the investors will know that they are in competition with other investors and therefore they may alter their deal terms in your favor to get the deal.
In the end, everything will depend on your negotiation skills. If you’re not too confident, then have your team with you. They’ll support and help give clarity, but remember, this isn’t a bargain purchase, this is a negotiation for your start up and whatever you decide will have implications in the long run on your business. So choose wisely.
The seed round phase for startups is one of the most hectic phases of starting a business. This is where the entrepreneur has to convince others that the idea is worth investing in. It’s easy to convince yourself, but the most difficult thing in the world perhaps is to convince others to believe in you.
Investors are investing in you and your idea, so remember that you’ll need to plan well. You should know what type of investor you are looking for and most importantly how to negotiate and get the best deal in the end.