Funding a startup? Finding the right source is critical

Imagine that you are the president of a fast-growing enterprise and have scheduled a day to interview several promising candidates for a position as your vice president of marketing. One of your top prospects enters your office and you begin with a few general questions to break the ice. You then ask the candidate a very important question about how the company should differentiate its product in the marketplace.

He looks at you blankly. It is obvious he has no idea what you are talking about.

Can you imagine how disappointed you would be in the candidate's knowledge -- or lack of knowledge -- about something so vital to business success? If so, then you have some idea of what potential investors in new startups feel when they figure out that the company founders who approach them do not really understand the funding process.

Successfully charting your path to the proper funding source is made easier by following a few simple guidelines and using the right terminology.

If you require startup capital, sometimes called seed capital, consider the investor group "friends and family." These investors are literally what their name signifies: your friends and/or your family. This round is typically a few hundred dollars up to $50,000, depending upon your needs to develop a prototype, test a product in the market or find the first customers. In return for their money, they will take either an equity position in your company or make you a loan.

Angel Investors fill the next level of funding. In this round, you are either going to market or completing product development. Angel investors can be individuals or groups of investors with a common interest in investing in emerging businesses and helping them reach full commercialization. This round ranges from $50,000 to $1 million or more, with many angels preferring convertible preferred equity. Preferred stock gives them a preference on liquidation and offers them a chance to convert to common equity. Some angels have recently moved to convertible debt, allowing for a higher preference upon liquidation but again providing the option of converting to equity if your company is successful.

A financing round to fully commercialize your product or service will most likely be filled by venture capitalists. These firms specialize in providing funding from $1 million to $20 million and will help you reach full-scale manufacturing, develop your management team, expand your market and customer base and prepare for a future merger/acquisition or an initial public offering. VCs often ask for preferred equity and will want a board seat.

Some companies will acquire several rounds of VC financing for market expansion and product line extension. It is important to select a firm that is either large enough to support the growing needs of your company or a VC that can lead a syndicate of other VC firms in funding your future requirements.

Several other groups exist to support a business that is expanding, targeting an IPO or heading to an M&A event. Typically known as private equity groups and investment bankers, these firms vary in their focus but are most often interested in later-stage companies. They may take equity, provide bridge financing or arrange for additional debt to support the proposed strategy. Sometimes they will combine all three financing options as they move your company to liquidation in the marketplace.

In addition to focusing on the right source of capital, navigating the world of venture financing also requires you to be acquainted with the terminology used by these professionals. Make sure that you are comfortable with the following terms: liquidation preference, anti-dilution, voting rights, conversion, information rights, registration, right of first refusal, dividends, redemption and participation rights and no-shop clauses, among others.

An entrepreneur who understands how to chart the course and how to communicate with professionals in the industry is much more likely to reach the desired destination.

Gary Williams is affiliated with the BYU Center for Entrepreneurship. He can be reached via e-mail at [email protected].

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