What everyone ought to know about raising equity
When the lightning strike of an idea hits you, the thought of your future greatness is exciting. More often than not a founder is not wealthy enough to get their idea off the ground. Let alone to the heavens.
This means they will have to raise cash by selling company equity to make their dream happen. At each stage of the business journey. There hide risks and costs when taking money from investors.
Aaron Spool at Eventus Advisory Group wrote an article titled “The Hidden Costs of Equity” discussing these costs.
We are going to expand on his article in this post. The hope is to help founders better prepare for the long and often costly business journey.
Idea But Empty pockets - Early Stage
With your new business idea you have two options to get the party started.
If you are one of the lucky who have personal funding you can get the ball moving. This situation is not the usual start for a founder. So if you fall in this camp, consider yourself ahead of the game. The more common path is starting to find investors. They believe in you or the idea you are pitching them.
Most investors at this stage are: friends and family, angel and seed stage funds.
Your friends and family are an easy first stop on the fundraising trek. As Aaron said, “...mainly they just want you to succeed”. This can be both a gift and a curse. For one - your friends and family likely will consider helping fund your dream with their heart. Not their mind.
This is where you need to manage their expectations. Statistics say 90% or more of startups will fail.
If friends and family investor(s) do not understand this, you could be looking at some awkward family holidays in the future. One suggestion is to make sure both sides of the table enter into an agreement document. This could outline what will happen in the likely event of a failure. This can help protect you.
People get weird when it comes to money. Yes, even your friends and family.
Angel investors on the other hand have many different objectives. The cost of their ticket to play the game is low. This allows them to enter into a lot of deals and start to craft a “persona” in investment circles. We are not saying they do not want you to succeed. You need to be aware they could be investing in startups more for social circle acceptance. Aaron highlights a great article that talks about this from Alex Danco called, “The Social Subsidy of Angel Investing.”
One suggestion is to make sure the person offering to write a check has a reputation of being beneficial. Think domain expertise to your new company, or they have been a founder themselves and know the struggles. I did not choose to use the term so often heard - being helpful. It is almost satire at this point about how many investors tell you, “Let me know how I can be helpful.” Some of them can be. But don’t immediately hear that siren song and think you have found salvation.
Your third option is to approach people who manage or run a seed stage fund. These investors like to be one of the first checks into an investment and have firepower to invest at the later stages. Many of the large venture capital firms have a fund and dedicated team to look at very early companies. A warm introduction is usually the best way to get their attention. That said, a strong cold email or DM on Twitter can also get them interested.
Pedal to the Metal - Growth Stage
If you made it through friends, family and angel investors you are on to level 2. This is where the stakes get raised. Assuming you don’t crash and burn your investor options open up but the costs get even more difficult.
Aaron calls these the “letter rounds: series A, B, C, etc.”
The purpose of investor funding at this stage is simple growth acceleration. You may even hear it explained as putting fuel on the fire. With this increased infusion of capital and new investors, there are significant things to watch our for.
Do What You Say You Were Gonna Do
During this money raise you have to sing the song of rapid growth and how you are going to blast through metrics.
The issue with this is that you ACTUALLY have to do it.
These investors gave you funds to expand, grow, and tackle specific tasks. If you don’t do that - you run the risk of souring your investors. Or worse - getting a bad reputation for your next raise or new company.
New People At The Dinner Table
This is also where you likely form a formal board of directors. Boards tend to be beneficial for your company but this is where you lose a great deal of control. While you will still be the CEO or founder of the company. The board is now your boss. And depending on how you structured your equity sale - you can be removed.
I like how Aaron thinks about looking at who may become a part of your board of directors:
“A common rule of thumb I use for the due diligence on a potential board member is that of a roommate. A board member is in your business, you’ve basically invited them into your home, and you’ve given them some power over how that home operates.”
Please pause to let that sink in.
Like signing a lease with a roommate. The board now has a joint right to the company. If things go sour - they can be very difficult to remove.
Return on Investment Over Your Plans
Investors by definition are focused on getting a return on their investment. If they were not, they would be in philanthropy. Because of this you need to be upfront and understand the investor expectations and time lines.
If the funding is to be used to meet certain goals that makes it pretty easy. Problems start when you take investor capital and do not understand when they want their rewards. Investors have time lines and returns to provide to their LPs and it’s best to make sure that you are aware of them. This can lead to them forcing you down paths you had no intentions of ever doing. Like selling to a competitor or pushing you to exit so they do not lose all their capital.
Prepare for Liftoff - Late Stage
Congrats you made it to level 3 of this game!
If there has been no acquisition you are probably thinking about going public. Having your company scroll across the CNBC ticker is what many consider the ultimate corporate success.
Like the other stages of the game - there are costs to confront.
Everyone Has Their Hand Out
When you are preparing to take your company public. There is a long line of professionals looking to get paid in the process.
The system operates in such a way that there are advisors, lawyers, investment bankers and more who need to be a part of the process. Think of them as the eels who suck to the side of a shark to eat the crumbs.
You did the work but everyone gets to eat.
Cross Your T’s and Dot Your I’s
The rules and regulations required to go public are long and involved. You as the CEO are likely not knowledgeable about this so make sure you have wise counsel.
The stock exchanges have rules. The SEC has rules. What you can and can not do as a public company gives you more rules.
Talk about all the fun being sucked out of this!
Are you sure you want to go public?
Don’t Cross the Owners
Now that you got your company on the public exchanges. Be ready for more scrutiny and potential mutiny.
IF you made it this far and are still the CEO. Know that you can be removed and replaced. The shareholders are now in charge and if they don't like what you are doing. You could be packing up your desk. The media might put a target on your back. Or a shareholder could build a large enough position in your company to push you around. Everyone has heard the term “activist investor.” Be careful when they come calling - you could be dealing with a robber baron in sheep's clothing.
The journey from initial idea to IPO will be a wild ride. Everyone feels they know this until they are on the path.
Make sure you think long and hard about how you want to tackle it. Be sure to align yourself with knowledgeable people like Aaron.
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