Entrepreneurs with innovative ideas and detailed execution plans often face the common start-up problem of lack of funds, particularly start-ups in industries such as technology, biosciences, and consumer goods where large amounts of capital are needed. Of course, founders usually do not want to give away the ownership of their businesses, making it harder to find investors.
The funding of start-up ventures is always a challenging process. In this blog post, we will review some aspects of the traditional funding process.
Sources of funds
The first source of capital to fund new venture projects is the money coming from the founders. It is expected that founders put a substantial part of their net worth into their projects. Everyone, especially potential investors, want to see that founders have “skin in the game.”
The second source of capital is often described as the three F’s – “family, friends and fools.” This group of investors is comprised of individuals with a personal connection to the founders who generally have no start-up investment experience. Since the vast majority of start-up companies are privately held businesses, these investors must be accredited investors.
Entrepreneurs quickly exhaust this group of inexperienced investors that are able and willing to invest. In order to continue funding the business, they must sell the investment opportunity to a different group of investors who are a more experienced in funding start-ups. These people are called Angel investors. Often times, these investors have started their own companies and were able to accumulate at lot of wealth in the process. The successful engagement of Angel investors generally determines the outcome of the fundraising effort.
Another group that contributes to the funding of young and high-growth companies is made of professional investment companies that are generally organized as limited partnerships. They are known as Venture Capitalists. Once a Venture Capitalist is engaged, the start-up has a high probability of meeting the funding needs if the concept and execution aspects are solid. Most start-up companies are never funded by a Venture Capital firm, but those who are have higher chances of success.
The final way young and high growth companies obtain funding is via an Initial Public Offering (IPO) or an acquisition from a strategic established industry player. It is common in this phase that the public or the strategic player funds the company and also provides an exit to funders, angel investors and venture capitalists. This exit has the potential to be extremely profitable, and this profit potential is what motivates founders and investors to take the high risks. Sometimes the founders and angels stay much beyond the IPO, as each company has its own exit dynamic.
Critical factors for success in start-up fundraising
To achieve successful fundraising efforts for a start-up, founders must be determined to achieve their fundraising goals. Critical factors for success include:
Iron will – Founders must be able to keep going and overcoming the inevitable setbacks.
Full commitment of founders – It is critical that the entrepreneurs are fully dedicated to the project. If there are competing activities that take the focus away from making everything happen, investors are less likely to act.
Professional team of advisors – Start-up fundraising can be very complex because it involves aligning people with conflicting interests. Valuation negotiations can be very difficult and legal aspects can be tricky. A high quality team of legal, accounting, financial and technical advisors is highly desirable.
Achievement of milestones – The funding of start-up companies with the potential for exceptional growth is done in stages or rounds of fundraising. The successful execution of the business plan with concrete achievement of milestones makes the next round a lot more likely to succeed, as well. With proven success, the financing of the project becomes easier and easier and the focus should be on running and growing the business.