Technology: Early-Stage Company Financing Options – With Alternative Sources Offering Hidden Treasure
CohnReznick Partner and Technology Industry Practice Director
Great companies start with great business ideas. But turning those ideas into reality requires capital—sometimes, a sizable amount of capital. Many entrepreneurs dream of landing a huge round of venture capital to meet their funding needs. But in the beginning, that is unlikely to happen for early-stage companies. In fact, according to the National Venture Capital Association, only about 1,000 new companies out of the 627,000 new businesses initiated each year receive venture funding in the U.S.
Fortunately, there are more financing sources than ever for early-stage technology companies. But identifying the ideal source(s) of capital for your business can be tricky. Although early-stage companies may view a windfall of venture capital as the grand prize, CohnReznick encourages early-stage companies to explore other sources of capital until venture capital funding is more likely. As companies contemplate various funding options, it is also important to consult with professionals so that peripheral challenges and issues related to funding – such as due diligence and various tax implications – can be appropriately addressed.
Traditionally, some early-stage companies fund their businesses through bootstrapping. Young companies bootstrap their funding needs by relying on early customer revenue, penny-pinching, and even using personal credit cards to make ends meet. Bootstrapping means exactly what the term suggests: pulling yourself up without assistance from others and taking responsibility to finance your business through current earnings and assets. This often means taking a barebones approach and cutting everything out of your business but the bare essentials.
Friends and Family
Friends and family contribute approximately $60 billion to early stage companies each year, or three times more than venture capital, states funds, and angels combined, according to the Angel Capital Education foundation.
Raising money from friends and family for an early stage technology company can be a lot less complicated than trying to convince professional investors to believe in the company. Often, it’s also the company’s best chance of securing that all-important initial capital.
It’s probably the quickest and easiest way to raise money because, unlike other investors, friends and family do not have to spend time getting to know the start-up and conducting due diligence. A friends and family round provides the runway needed to hit those early milestones and prove to other investors that the business is ready for prime time.
Startups are a gamble and there is a chance that it will fail. Professional investors understand that. However, an aunt, brother, or best friend may not, which means the owner can end up destroying valuable relationships if the early stage company fails. In addition, owners may not be able to obtain sophisticated business advice from friends and family as they could from professional investors.
How to get it:
Requesting funding and expecting to automatically receive it may be unrealistic. Be prepared to present a detailed business plan that explains the business in a way that anyone can understand. It is also beneficial to provide information about the total capital needed, and exactly what you plan to do with the money. Don’t sugarcoat the facts. Being clear with friends and family as you would any other investor that there is a chance they could lose all their investment, or that even if the company does well, it could be many years before they receive a return.
An angel investor, or angel, is typically an affluent individual who provides capital in exchange for ownership equity. Some angels are individual investors, but many band together and invest as a group.
Angels are more active than ever. The median size of angel and angel group financing was $680,000 in the first quarter of 2013, up from $550,000 in the year-earlier period, according to the Halo Report from the Angel Capital Association and the Angel Resource Institute.
Angels also hold a special place for early stage technology companies, allocating 64 percent of all their money to Internet/mobile and healthcare companies.
Angel funding is obtained at an earlier stage in the company’s life cycle than venture funding. In any given year, angels invest in 60 times as many companies as venture capitalists, according to the University of New Hampshire Center for Venture Research. Another advantage is that angel investors are often successful entrepreneurs in their own right who can bring a wealth of experience, expertise and a network of contacts to the table. While both angel groups and venture capitalists have experienced entrepreneurs in their groups or organizations, angel investment tends to come earlier and in smaller dollar amounts. Angel funding tends to originate from individual investors versus venture capital, which is considered institutional money.
Angel funding can be expensive. That is because angels will require an equity stake in the business in return for their capital investment – typically about 25 percent ownership of the company. Some angels will also require a percentage of the company’s profits, often 10 percent or more.  Angel funding may also come in as convertible debt or simply as debt, depending upon the angel. Angel investors can also have very strong opinions about the business activities and goals of the early-stage company. That is often a positive attribute, however, it could prove problematic if the owner and its angel investor have radically different business opinions. To avoid conflict, opinions should be vetted before an owner takes an investment.
How to get it:
Angel investors tend to specialize in particular categories. For instance, some angels only invest in healthcare, while others will only invest in software deals. Early-stage companies can exponentially increase their chances of funding by doing some basic homework and targeting the right individuals and angel groups. In addition, angels generally prefer to invest close to home. So look for groups in your own backyard. According to the Halo Report, 81 percent of all deals are completed in the angel’s home state.
Crowdfunding is one of the most exciting innovations in years. Individuals from all walks of life contribute pocket change, typically $10s and $20s, to the companies and ideas they like best. If enough people like the company’s idea, those amounts can translate into a considerable amount of money. Early-stage technologies companies like Pebble, Ouya, and Ubuntu Edge have raised millions of dollars on these platforms in a matter of days.
The most popular crowdfunding site is Kickstarter, but new platforms appear to be emerging every day. They include sites like IndieGoGo, AngelList, RocketHub, and Quirky. Typically, early stage companies that pitch on a crowdfunding site have to set a cash goal and a time limit in which to raise money. If they don’t reach their financial goals on time, all pledges are returned.
Recently, the SEC voted to propose rules to allow start-ups to sell shares of their company through crowdfunding. While there will be an annual limitation on the amount of capital that can be raised through crowdfunding sites, these proposed rules may spark new interest in funding start-up companies.
Crowdfunded projects raised an impressive $2.7 billion in 2012, across more than 1 million individual campaigns globally. In 2013, the crowdfunding industry is projected to grow to $5.1 billion, according to the Crowdfunding Industry Report by research firm Massolution.
Most appealing to entrepreneurs is that crowdfunding financing has typically been philanthropic, which means that founders retain 100 percent ownership of their ventures. Some sites do offer equity crowdfunding, but only accredited investors (individuals with a net worth of at least $1 million, or an annual income of at least $200,000) can participate. However, new SEC rules will soon allow crowdfunded companies to issue equity to non-accredited, small individual investors.
The most significant disadvantage to crowdfunding is that the early-stage company now has potentially thousands of customers, or investors, who are eagerly and vocally awaiting the company’s product. Although these customers are a company’s biggest supporters, they can quickly become a nightmare for every week or month that a milestone is missed or a product shipment is delayed. Investor relations involving hundreds of investors can be expensive and time consuming. If they feel slighted or misled, they will not hesitate to voice their opinions on social media – and that can have devastating effects. Additionally, some venture capitalists may shy away from crowdfunded companies because it can create a messy ownership table. If your company has 1,000 small investors, for example, will you need everyone’s approval before you can approve a merger or move forward with an acquisition?
How to get it:
The most successful companies offer gifts to their donors; however this practice may change with modifications to the SEC rules. Pebble, for instance, promised prototypes of its smart watch to people that donated more than $100. It is also important to try to build momentum early. A study conducted by British crowdfunding site Seedrs found that companies that had reached 35 percent of their goal always reach 100 percent. So, early-stage companies should make efforts to tap into friends, family, and social networks to contribute or invest. By establishing early momentum, early-stage companies are more likely to succeed.
Tech companies may be surprised to learn that the government may be eager to support your startup. Federal and state governments spend billions of dollars every year funding early-stage projects. A study by ChubbyBrain found that the government invests a median of $1.1 million in every company it supports.
The newest federal initiative, Startup America, is designed to accelerate high-growth entrepreneurship throughout the nation by expanding access to capital. Long-standing initiatives like the Small Business Innovation Research (SBIR) program award grants to emerging high-tech businesses with the potential to bring innovative products to market. Companies like Symantec and Qualcomm got off the ground thanks to the SBIR program.
States are also actively supporting startup activity. Maryland’s Department of Business & Economic Development provides guidance to startups including information on the Maryland Venture Fund, a seed and early stage fund, in addition to loan programs offered by the state as well as guarantees. Massachusetts, for its part, formed MassVentures in 1978 as a quasi-public corporation to address the capital gap for start-up companies and to encourage the growth of early-stage technology firms. Virginia has the Center for Innovative Technology (CIT), a state-funded organization that makes seed-stage equity investments in Virginia-based technology, clean tech, and life science companies. And the New York City Economic Development Corporation launched Media.NYC.2020 in 2009 to incentivize media and technology companies through a variety of programs, incubators, and funds.
Many states offer tax incentives – such as tax credits or grants – for technology companies that have certain digital, media, and entertainment activities. While many technology companies may believe they do not qualify for these tax incentives, CohnReznick’s experience indicates that many technology companies ultimately do qualify for the incentives as, unbeknownst to them, they perform qualifying activities that enable them to claim the tax incentives.
To learn more about federal government grants, check out Grants.gov. This is a searchable directory of more than 1,000 federal grant programs.
Grants have considerable advantages over other funding sources. The biggest is that, unlike angel investors or venture capitalists who receive equity in the company, the bulk of government grants are “free money.” That means there is no dilution in ownership for the entrepreneur. Further, government organizations are not afraid to fund high-risk initiatives, such as cutting-edge technology companies. A government grant can also serve as a stamp of approval for customers and follow-on funding sources such as venture capitalists.
Grant funding can be competitive and slow. It can also require extensive paperwork and tedious compliance requirements. Early-stage companies looking to raise money quickly may want to explore more efficient funding options over government grants. In addition, if the early-stage idea doesn’t mesh well with what the mission of the particular government funding source, you will probably be out of luck.
How to get it:
Early-stage companies can start by researching government funding sources, including low-interest loans, whose mission and values align with theirs. A good approach is to identify a few companies in the company’s space that have already received government grants and then target those programs. To reduce the extent of paperwork required, developing a list of the company’s three to five top government sources is helpful. In addition, building relationships with those organizations has advantages. This could mean attending the right conferences or making the company known to the people who sit on the funding panels.
Startup accelerators continue to grow in popularity. There are now about 200 around the world and the number of applicants they attract has exploded over the past few years. A startup accelerator functions somewhat like an assembly line. But instead of spitting out widgets, it churns out innovative companies.
Accelerators typically run 12-16 week programs to propel startups quickly from concept to product. They offer seed money—as much as $150,000 per company— and mentoring in exchange for equity, normally around 7 percent. Programs culminate in a demo day, during which graduates pitch their startups to investors.
The top accelerators, including Y Combinator, TechStars, and 500 Startups, have consistently produced an impressive roster of graduates that have gone on to raise substantial venture rounds, including the likes of DropBox and Airbnb.
Good accelerators are like good universities. They foster a strong sense of community among entrepreneurs, alumni, mentors, partners, and investors. They also provide access to industry luminaries that can help early-stage companies reach the next milestone. Graduating from a reputable accelerator is like earning a degree from Harvard or Stanford. Venture investors, in particular, look more closely at companies that come out of top accelerator programs.
The biggest downside to accelerators is that, generally, a significant stake in the early-stage company’s equity is given to the accelerator to join a program that only lasts a few months. Some programs, like 500 Startups, take just 5 percent of equity, but others will demand as much as 20 or 30 percent. Some accelerators will even charge up to $25,000 in cash just to participate in their programs.
How to get it:
The top accelerators in the world—programs like TechStars and Y Combinator—receive thousands of applications for just a handful of spots each session. So how does an early-stage company get in? A great application is the most obvious element of success. It is vital to demonstrate a couple of qualities, including a well-rounded startup team and a company’s passion for its product. Using other means to network is also helpful – such as “friending” mentors on social media. If the company can get someone who is actively involved with the program to be its champion, it will drastically increase its chances of being accepted.
- Unless you are a serial entrepreneur who has had successful exits and provided large returns to your past investors, consider bootstrapping your new venture until you have at least developed a beta version of your product or service. Being able to show your investors a working product that is in the hands of potential users will help persuade them that you have a business they could invest in. Put your own money in first before you ask others to invest. Sweat equity is expected and generally does not take the place of your invested cash.
- When you fund your business from angel investors or venture capitalists, there is an expectation that you will create a liquidity event for your investors within the next 5 to 7 years, if not sooner. If you see your business as a “lifestyle” business, outside investment is not advisable unless your investors understand the kind of return and the time period over which they can expect. With outside investment comes heavier expectations about how you will manage and accelerate the growth of your company.
- Outside investment to grow your company and reach your intended market quickly could be exactly what your company needs. When talking to investors, consider who will be a good strategic investor – they will have the ability to help you grow your business through their contacts and experience. Since many investors ask for seats on your Board, you will want to make sure that you have the right mix of insight and experience from those investors.
- Lastly, always be ready to respond to requests from potential investors. It is encouraged that those seeking capital be prepared with a sound business plan. Keep your business plan and projections current and your records organized. Demonstrating that you are operating a real business with a plan for growth will make your company a more attractive potential investment.
 According to statistics provided by the Small Business Administration (SBA).
 Angel Investors Sacrifice Ownership Stake for Profits, Private Wealth Magazine, http://www.fa-mag.com/news/a-new-tool-for-angel-investors-13957.html.