Sources of Capital for High-Growth Companies
Understanding capital investment options early is key to business planning
When you are starting a business, raising capital may be the first thing you think about, but it’s not the first thing you do. Validating the market, differentiating your product, testing the value proposition, signing up customers—all these things come ahead of raising capital. BUT, that doesn’t mean an entrepreneur can postpone learning what you will need to know to build a credible strategy to secure capital investment when the time comes.
Here are some tips to help entrepreneurs become savvier about capital planning. The end goal is to develop a comprehensive capital investment strategy that gets investors’ attention.
1. Learn and understand the language of capital markets.
There’s a specific vocabulary for capital-speak. Here are the basic terms every entrepreneur needs to know.
Types of Investors/Investments
- Angel: Wealthy, accredited investors who provide capital for a startup business in return for ownership shares in the business or convertible debt. Angels often organize into angel groups or angel networks to share deal flow and to pool their investment capital.
- Convertible Debt: In these borrowing arrangements, the lender (angel, venture capitalist, or bank) has the option to convert the debt into shares of equity at a specified point in time.
- Entrepreneur’s Personal Resources: It’s impossible to start a business without taking a financial risk. Investors want to see entrepreneurs invest more than sweat equity. Savings, home equity loans, retirement accounts, or other assets are all potential sources of personal capital.
- Friends and Family: Often the first investors in a venture at the very earliest stage, family and friends may be more motivated by their interest and trust in the entrepreneur than in the possibility of significant financial returns.
- Grants: Grants come from businesses, foundations, and public and private sector organizations. Some grants require matching funds from other sources. Unlike loans or equity capital from investors, grants do not have to be repaid.
- Mezzanine: Mezzanine debt generally is financing that fills a gap between senior debt and equity. It’s typically used for growth and expansion opportunities.
- Venture Capital: Venture Capital (VC) is pooled investment capital from institutional investors and high net worth individuals. Most VC funds find it more efficient to invest $2 million or more in return for equity. They are more likely to seek advanced technology businesses that are producing revenue. The exception is life sciences funds. Corporate Venture Capital funds are becoming more common.
- Bootstrapping: Using personal resources and cash flow generated by the revenue of the business as a means of funding the business instead of raising equity capital.
- Dry powder: Experienced investors often hold back a portion of investment capital in anticipation of unexpected events.
- Equity Investment: Investments made in return for a percentage ownership in the company, which usually takes the form of common or preferred shares of stock.
- First Round, Second Round, and Later Rounds: Terminology used conversationally to describe venture rounds. The legal terms stated in closing documents may refer to A preferred, Series B common, etc. The sizes of rounds by stage can vary significantly, depending on the characteristics of the deal. For example, a first round can be one or many millions, depending on the milestones that the startup has accomplished. Sizes of rounds also depend on many other factors, including but not limited to the type of business, the industry, and the objectives and exit strategy of the investors.
- Initial Public Offering (IPO): An IPO occurs when a company first sells shares of its stock to the public.
- Portfolio: Collection of investments made by angels or venture capitalists.
- Syndication: Multiple investors, which may include individual angels, angel groups, and venture capitalists, pool their funds to provide larger investment rounds and to diversify risk.
- Valuation: Valuation reflects the value of the company before and after the investment of equity capital. Investors control the process and the valuation, not entrepreneurs.
2. Match sources of capital to the stage of your business.
Sources of capital are specific to the stage of the startup company. Investors also consider the size of the investment round, the industry and/or business sector, and the geographic location of the company.
Following are the typical sources of capital and (round sizes) available to startup companies by stage. Please note, that while the round sizes by stage (Concept, Seed, Early, and Growth) referenced here are considered typical, the size of rounds could be much higher at any given stage, depending on the deal.
- Concept ($25K-$250K)
Personal Resources × Friends & Family × Economic Development Funds
Bootstrapping × Strategic Partners × Grants × Banks × Angels × Concept Stage Investment Funds
Concept Stage financing initially comes from the entrepreneur and perhaps from friends or family. As milestones are met, there may be modest proof-of-concept funding from state or accelerator sources or from targeted Concept Stage investment funds. Funds are used for company formation, market validation, and to prove product technical and economic feasibility with minimally viable product development and unit cost analysis. At this stage, risk is great as expenses continue ahead of revenue.
Personal Assets: Don’t expect other people to invest in you, if you don’t invest in yourself. Investors want to see entrepreneurs invest more than sweat equity. Personal savings are always a key resource for early company funding. Do not quit your day job until you have concept and market validation.
TIP: Don’t tap into money you aren’t willing or can’t afford to lose.
Friends and Family: These people often invest because of their relationship with the entrepreneur than in their expectations of the business plan. Have an attorney prepare the appropriate legal documentation and ensure that the capital raise complies with securities laws. Repay this debt as rapidly as possible.
TIP: Do not exchange shares of the company for friends and family money if you anticipate future venture or angel rounds.
Grants: Ohio Third Frontier grants, federal grants, the Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) programs, and other private grant funders are relevant sources of non-dilutive financing.
Grants, especially SBIR and STTR, are very competitive. Grants cover a range of milestones, from research and development to full commercialization. Any entrepreneur founding a technology business should research potential grant opportunities.
TIP: If grants present a significant funding opportunity, consider adding an individual with grant experience and success as an advisor or board member.
Debt and Convertible Notes: Banks are a source of lines of credit as well as traditional loan products. JobsOhio loan programs also may be a possible source of funds, but typically follow angel or seed fund investment. Angel investors and venture capitalists sometimes use convertible notes (or similar convertible securities) instead of equity. These notes are typically structured to be convertible to equity at the option of the lender or when certain events occur. Angel and institutional investors using convertible notes often require the note to carry above market rates of interest, reflecting the risk inherent in a Concept or Seed Stage company.
TIP: Build a working relationship with a bank that has a local presence, and/or experience working with early stage technology companies.
Angel Investors: Angels are accredited investors who put their own money and time into companies that are at Concept Stage, Seed Stage, and beyond. Angel investors often provide more than capital—including their own expertise, mentoring, contacts, and experience.
Angel investors, who tend to invest where they live, may have a targeted initial investment amount and investment term in which they prefer to invest. Relationship building is key
TIP: Build contacts with angels early, well before you start fund raising, through warm introductions from professional and personal contacts.
Concept Stage Investment Funds: These funds target startups with a market-validated solution and business model that is economically feasible. Rev1 Ventures is an active investor in high tech high growth startups at the Concept Stage of development.
TIP: Concept Funds are often the first “outside” money invested in the company.
Bootstrapping: Companies who are successful at bootstrapping, a credible and attractive source of capital at any stage, manage resources, especially cash, very closely. The more the company bootstraps from Concept through Seed Stage, the easier the path will be to raising equity capital. Consider if the opportunity for substantial growth exists before pursuing outside funding to pursue such growth
TIP: It is usually preferable to self-fund as long as possible, rather than taking on significant outside capital.
- Seed Stage: ($250K-$2MM)
The above, plus Seed Funds × Corporate Venture Funds
The business is established. The product is in the market; the company has early revenue. The financial model, based on a solid unit cost analysis, is in place. Funds are used to introduce a working product prototype, expand commercial product development, make critical hires, and validate the economics of product pricing and expense structure with early customers.
Seed Funds: Seed funds are organized venture capital funds, often regionally focused, and may be attached to a venture development organization and/or research institution. Seed funds typically seek five- to ten-year returns of 10-20X their invested capital. Seed funds take an active role in the governance of their investments and use institutional investment documents.
TIP: Develop realistic expectations regarding valuation and investment terms.
Corporate Venture Funds: Recently, there has been a proliferation of newly formed corporate venture funds operating in industries as diverse as food and beverage, automotive, insurance, and technology. Increasingly, these funds are managed by venture capital investment professionals and seek financial returns consistent with traditional venture capital funds.
TIP: If your product aligns with the strategy of a specific industry, a strategic corporate venture capital investor may be an appropriate investor to target.
- Early and Growth Stage: ($2MM+)
The above, plus Venture Capital
The business is fully launched and generating revenue. Capital funds product iterations, expanding market share, increased investment in talent, and progress toward exit (either acquisition or IPO).
Venture Capital: VCs are institutional investors with a typical investment threshold of at least $1-2 million in exchange for convertible preferred equity. Venture capital funds seek meaningful market validation in the form of early and significant customer and user adoption and revenue, hold their investments for five- to seven-years, and target returns of 10X-20X or more. Venture capital financing is the exception, not the norm, among start-ups.
TIP: Historically, fewer than 1% of U.S. companies have raised capital from VCs.
3. Build an exit strategy into your business plan.
In entrepreneurship, there will always be a morning after. One fact that is certain—outside investors are going to want their money (and return on investment) back. Savvy entrepreneurs anticipate future scenarios. Acquisition will be on that list; identify corporations and other industry leaders that would be strategic partners or potential acquirers. Scenario planning may include the consideration of an initial public offering (IPO), but be clear, IPOs are few and far between.
Focusing on the appropriate capital source for the stage of the company and then identifying key milestones that will be accomplished using that capital adds credibility to the business plan and can simplify the capital raising process for any entrepreneur.
Limited portions of this material first appeared in The Entrepreneur’s Path, a Handbook for High Growth Companies.