How to Finance Your Start-Up

The process of obtaining money to fund a new idea or start-up company, can be frustrating and sometimes fatal for the new enterprise.

Often the entrepreneur chases prospective financing that is not appropriate for his or her business opportunity. While this can succeed occasionally, the effort can sidetrack corporate management just when they are most needed to prove the business concept, complete R & D, prepare for initial sales, etc.

In this article, we will discuss some of the factors that can help you to succeed in fundraising while continuing to develop your business concept. Financing your start-up can be likened to competing in a decathlon: there are many events, and you need to excel in several -- but to successfully compete, it is important that you do a credible job in all of the components of the competition.

Many of the points raised here require a realistic assessment of your ideas and the competitive situation you are likely to face in several years when your product is out there in the marketplace. Unfortunately, most entrepreneurs are not able to stand back and evaluate their plans with a realistic view of market factors and potential threats to their plan, both through technology development (yours and theirs) and other unknowns.

One way to proceed is to view the process of financing your Company as sequential, although in fact it is often necessary to overlap the stages. Recognize that the overlapping of normally sequential events adds risk to the process, and it becomes important for the entrepreneur to adroitly re-order their efforts in response to changing conditions. This is a very useful ability in all aspects of corporate development.

The stages of the fundraising process can vary; in this article a ten-step model will be presented -- the Decathlon model.


Step 1. Evaluate your business concept and organization as an opportunity: its strengths and limits will help define your potential capital sources.

Banks and other lenders evaluate the safety of their money, focusing on the factors that ensure that they will get their money back when it is due.

On the other hand, venture capitalists and other early professional investors are willing to risk their entire investment -- but only when a realistic possibility exists that their investment will be multiplied many times. Thus businesses that can initiate or dominate markets that can grow only to $5 or $10 million are not of interest to venture or seed funds, in most cases.

Market opportunities of $100 Million or more excite investors -- provided they believe that you have the ability to exploit the market opportunity, and that your business can protect itself from the future competition that will certainly develop once you have defined that opportunity.

The possibilities for funding can also be defined by the quality of the management team. A non-ideal market opportunity can be made attractive when the effort is led by management that has succeeded before.

With an inexperienced management team, it can be advantageous to add one or more seasoned members. For most start-ups there is insufficient cash to compensate seasoned managers, making use of equity compensation common. It is also common to initially build an experienced management team with part-time staff.


Step 2. Determine how much money you will need soon (and later)?

The glib answer is, "(much) more than you think". Even without significant equipment or related capital needs, it is surprising how much cash is needed to fuel a start-up beyond the initial stage, when the whole enterprise is existing on sweat equity and chewing gum.

Many entrepreneurs think that when they begin to sell product, the cash crunch will be over. When the product is shipped and if sales are great, this actually generates more cash needs -- not less.

Growth of 50%-200% per year, common for high-tech start-ups, typically requires cash to support growing receivables, selling and product support costs, and a myriad of other functions. Sometimes it is possible to get customers to fund the company's growth, but this is not usually true.


Step 3. Realize the likely type(s) and level of financing your start-up will attract.

Most start-ups are initially funded by the entrepreneur and his family or founding team. But it is rare that the level of available funding from these sources is sufficient. Bank financing is not usually available to start-ups unless fully collateralized by deposits from the entrepreneur or a sponsor. Even then, the bank will be reticent unless it has confidence in one or more of the principals. It is helpful to have a founding team which includes high liquid-net-worth individuals.

If your start-up is capable of creating and defending one or more large market segments (see Step 1), then major venture capitalists should be targets for your financing. In a rare case, the entrepreneur can choose from many offers of seemingly unlimited funds. Usually, funding of only $50-100k is offered at the seed stage, and $250-750k in the first full investment round.

If your concept does not address the largest opportunity, then regional SBIC or seed funds may still consider funding you.

Individual investors, including professional "angels" and "rich uncles", can be the source of initial funds beyond those provided directly by the founding team. But these funds are generally inadequate and it is necessary to develop professional financing relationships as early as possible.

When your start-up has been through due diligence and received an investment from a respected seed or venture capital group, then additional investments are facilitated.

In some cases (based largely on the type of technology and potential products to be developed), federal, state, or commercial R & D funding is an important source of early-stage financing.


Step 4. Complete the management team.

At a minimum, the entrepreneur must be able to name a management team with financial, marketing, and (if appropriate) technical leadership. Identifying talented operations/manufacturing and sales management may also be important. Clearly, this team may not as yet all be on-board, but you should have letters and accompanying vitae indicating that they will join the start-up, and on what basis and conditions.

When you complete the initial Business Plan (see Step 5), the timetable and financing model for the management team should be complete. If you cannot identify an individual for one or more of the critical management roles, describe how the Company will effectively operate until such members are found and recruited.

Remember, it is acceptable in all but the largest start-ups to rely on part-time staff and consultants to fill several management functions. But the Business Plan needs to include supporting documentation regarding these people and indications of commitment of sufficient effort over the necessary time period.

Although it may seem premature to include a long-term management plan in a Business Plan, it is important to wrestle with a few issues right at the start.

One issue important to investors is the succession plan for CEO. Obviously, investors must have a great deal of confidence in the entrepreneur serving as CEO at the time of the investment even while recognizing that the entrepreneur may not be an appropriate CEO at a future stage of the Company's development. Investors appreciate founders who recognize this fact and can define continuing personal roles that will enhance the Company's future prospects.


Step 5. Prepare for fundraising: refine the business idea; write the Business Plan and Executive Summary.

You may have already written your initial business plan, but most likely no formal plan is yet on paper. It is critical that you do this now; your (future) management team and other advisors can assist you in completing and refining the Plan, and in developing realistic and complete financial projections and assumptions (this is particularly difficult for inexperienced entrepreneurs).

It is important that you and your advisors validate as many of your assumptions as is possible. This is particularly true for the Market Analysis and Competition sections. Most entrepreneurs fail to recognize that new competitors will arise even if there are none at this time. It is critical to recognize competition from alternative approaches, as well as possible direct competitors. It is also crucial to realize that some big companies can effectively take over your market in a very short time.

After you have completed the Business Plan and it has been critiqued by your advisors, refine the Executive Summary. This 1 to 4 page document is all that will be read by most of the potential investors you will contact. Keep it as short as possible, but fill it with enticing information about you and your business opportunity.


Step 6. Evaluate & confirm the legal issues.

Before actually completing the Business Plan and seeking financing, review all of the legal aspects of your business. This is one area where the help of outside experts is critical because you need to anticipate the due diligence (see Step 8) concerns your investors will raise, so that you have time to adequately resolve them -- preferably before they are even raised.

One key area of concern will be your legal rights to the intellectual property underlying your business concepts. If patent and trademark searches have not yet been conducted to be sure that your intellectual property does not infringe the rights of others, now is the time to do so.

Similarly, now is the time to put in place strong agreements with employees and consultants protecting the confidentiality of your proprietary information, as well as confirming your rights to intellectual property they may have assisted to develop. When due diligence questions about the validity of your intellectual property are raised, you want quick, clean and clear responses.

Patent and trademark applications should be filed at this time -- before proprietary ideas are exposed to numerous investors who you don't know and can't control. You will also need to develop a good confidentiality agreement for potential investors to sign and will need to decide just how much proprietary information you will give to investors and at what stage of your negotiations.

Other legal areas you need to be concerned about include:

* Developing a clear written record of all of your equity owners and persons having legal rights to purchase your equity.
* Putting in place written agreements describing employment terms for management and key consultants.
* Understanding the limitations that the securities laws place on how you raise capital so that you don't find yourself in the position where you have to turn away a ready, willing and able investor because of a technical violation of applicable rules.


Step 7. Make contacts; find lead investor(s).

Networking -- the key word for all entrepreneurs. Recognize that most professional investors do not select their investments from business plans mailed to them. Personal recommendations from sophisticated members of the entrepreneurial or investment community count a great deal in getting the attention of big money.

For example, in Michigan, regular participation at regional Entrepreneurial meetings sponsored by the Michigan Technology Council, Ann Arbor's New Enterprise Forum, the Southeastern Michigan Venture Group, etc., can be invaluable for identification of Angels, Bankers friendly to small business, venture capitalists, and others. In addition, being familiar to these communities will benefit management recruiting and satisfying other needs.

Once you have one or more initial outside investors, they will act as advocates for your business; their standing in the investment community will affect your future financing, as will known, strong members of the management team.


Step 8. Begin due diligence.

The process of due diligence begins when a potential investor asks questions about your current status and business concepts. Due Diligence practices vary significantly, but almost always contain financial and legal reviews, independent marketing and technical analysis (the latter when appropriate), personal and/or client reference checking, and much more.

The process can distract company management, stalling or reversing company development. However, due diligence also produces information that is highly useful to management and is difficult to otherwise obtain. Entrepreneurs rarely take the time to develop this information in the absence of the due diligence process.

Start-up companies may need assistance in successfully meeting due diligence requirements. This is particularly true in typical cases where the entrepreneur has not kept a complete paper trail on past events.


Step 9. Close financing -- in stages if needed.

Completing new investments can be quite rapid for financing from relatives or Angels, but most venture funding requires 3 to 6 months or more from first contact to closing. The speed of closing investments can be inversely related to the need for the money, and the old axiom about seeking financing when you don't need the money is valuable advice.

In reality, start-ups always need money, but your financing plan should recognize that, at certain times, your business will be more attractive to others. Success in funding can depend on your skill and luck in timing, as much as on other factors.

It can be helpful to Close initial funding with one or more investors while due diligence proceeds with others, although it is important to not make commitments that are contingent on other possible investments. You should also reward and protect your first investors for their prescience.


Step 10. Follow the Business Plan, as it continually changes.

Your investors will expect you to live up to your Business Plan. The term sheet of most venture capital investments punishes the founders with dilution if the Company does not achieve goals given in the Business Plan (usually measured by financial performance).

Nevertheless, the Plan should be continually adapted to changing circumstances, so that you and your investors have realistic expectations of the future. An informed, but albeit disappointed, investor is much easier to deal with than a surprised investor.

As a result, major changes in the Business Plan should be considered by the Board of Directors, usually with input from large investors. In addition, this is typically the best time to approach investors for revisions in financial performance criteria. Once you have actually missed the standard, investors have little incentive to make such revisions. Finish.

When you have successfully raised your first round of external financing, you will feel like you have just completed a decathlon (or the one-event marathon). But you will also be exhilarated and on your way. The next challenge will be to spend those funds wisely in the development of your business.

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This article was written by George C. Levy, Ph.D., of Ann Arbor, Michigan, & Thomas S. Vaughn, J.D., from Detroit, Michigan.