If you are reading this post, I’m going to assume that you have already chosen a legal form — hopefully a Delaware C corporation if you anticipate VC money down the line, as I discussed in my last post. I’m also going to assume that your company is now just barely past the ‘concept’ stage – you have your idea, you possibly have a prototype, but you do not have a working ‘final product’ or revenue, and need time to get to that stage.
Although these days it is not terribly expensive to start a company (especially a tech company with a technical co-founder), the old adage ‘you’ve gotta spend money to make money’ certainly rings true to an extent, and your next decision is how to go about raising some money – also known as “seed stage capital” in startup/VC lingo.
I think it’s called ‘seed stage capital’ becausethe idea here is that the little seed of money that the investor plants into your startup now will hopefully end up turning into a big tree full of money down the road; the earlier an investor gets in, the bigger the potential returns he receives. Of course, the flip side is that the risk an early stage investor faces is that much greater; anybody with gardening experience knows that most seeds that are planted never survive!
The high level of risk involved at the seed stage means that most seasoned investors, will demand terms that compensate them for the risk involved. Partly because of this, many entrepreneurs at the early stage turn to “friends and family” for funding. Indeed, this pursuit makes sense if you know people with money, since the people who know you best hopefully have a (possibly irrational) faith in you and will be willing to assume the risk of their investment partly because the perceived risk for them is lower, given their private information of your ability to succeed.
Assuming you find some “friends and family” willing to invest (note the term ‘friends’ can be pretty loose here, basically any accredited investor who has some connection to you), how much should you ask for from each person and what form should the investment take?
Although there is no ‘right answer’ to these questions, I’ll take each in turn.
How much to ask for from each investor?
My own experience talking to a lot of entrepreneurs and angel investors is that if people are making real investments (in which they hope to earn a return down the road), you’ll want to keep the total number of investors to a manageable level – with each investor putting in at least 10% of the total investment. For example, if you are raising $250K you will probably want each investor to put in at least $25K and if you’re raising $100K you will probably want each investor to put in at least $10K. This is my own rule of thumb just because I think the legal fees, paperwork, and time/effort involved communicating with each investor should not be ignored and if you have 250 investors each giving $1000 you will end up spending all of your time communicating with investors instead of running your business and creating your product. That having been said, if you only have one or two investors you risk giving up a lot of control to one or two parties – this isn’t necessarily a problem, you’ll just want to make sure they are the kinds of people you are comfortable with potentially having this kind of control.
What form should the investment take?
The ‘convertible note’ is by far the most common form of investment for seed stage investments, and it is the form that I suggest. The main benefits of convertible notes are that they avoid putting a valuation on your company (which is likely to be objectively low at this stage), they are relatively cheap to issue (in terms of legal fees and complexity), and popular (so future investors know what to expect). See my next post on convertible notes for more detail.