This post is the seventh installment of “Laying Down the Law” – a series where our attorney friends at Troxel Fitch give legal advice for budding entrepreneurs. View the previous post about Hiring Employees vs. Independent Contractors here.
Obtaining outside financing is a big step in any startup’s growth. While television and popular culture glorify the venture-capital-backed startup and big money investors, the reality of outside investment is frequently more humble. In reaching the point where VCs and other institutional investors seek to provide capital, most startups will obtain their first outside investment from family, friends or angel investors. In this installment of Laying Down the Law, we’ll cover where to find your first few thousand in outside investment to get you off the ground.
Family and Friends: Your First Source of Capital
Friends and family loans are the bedrock of startup financing in the United States. Although most deals between family/friend investors don’t make the pages of the Wall Street Journal, they nevertheless comprise the majority of startup investment for emerging companies. Investments from friends and family, whether in the form of a loan or equity investment, typically are made at relatively low dollar amounts, but come with significant advantages for the early-stage entrepreneur. Those benefits fall primarily into two categories: management autonomy and default risk.
First, a major advantage to family/friend investment is management autonomy. Where VCs and other major investors will require substantial control of your company, usually in the form of board seats and preferred stock, family/friend investors will not. Most family/friend investment is no-strings-attached capital, as they invest in you because they believe in you as a person, and they believe in your vision. You will want to honor that vote of confidence from your loved ones with hard work and dedication, but in the event that you do fail, your family and friends won’t foreclose on your house and repo your car.
In this way, family/friend investment provides a uniquely flexible route into startup capital that allows you to pursue your vision without outside interference. For the visionary entrepreneur with a vision that requires time to develop, this financing option can buy you time to prove your concept free from meddling investors.
Second, family/friend investment usually involves gentle consequences and low default risk. Professional investors will protect their investment above all else. This is because an institutional investor is spending another person’s money, and therefore is required to report on your growth metrics and answer for any deviations from predicted growth. They care about you to the extent that you are the best individual to protect their investment (and only to that extent). If you default on a VC loan or fail to hit certain growth targets, you will be discarded as CEO in favor of protecting the investment, your company will be swiftly sold, merged, or liquidated, and your position as CEO – not to mention your company – will cease to exist.
On the other hand, family and friends are investing in you. Therefore, if your company hits a rough patch, but you’re still committed, your family and friends won’t pull the rug out from under you. They will often allow you to strive for success, even if it sacrifices their investment in your company, because they invested in you. This flexibility can mean the world to an early-stage entrepreneur who will inevitably have clumsy stumbles in the beginning stages.
One company that used family/friend investment to get started was Whole Foods. Originally called “Safer Way,” the grocery store was founded in Austin, Texas with a $45,000 loan from family and friends. That loan ensured Safer Way’s survival until they could merge with another natural grocer to become Whole Foods.
Angel Investment: More than Money
Moving up the food chain one notch, we have angel investors. Angel investors are the bridge between family/friend investment and venture capitalists. They typically invest anywhere between $25,000 and $1,000,000 and can provide additional value in their expertise and vision. The primary considerations for the entrepreneur when evaluating angel investment should be access to future capital and non-monetary value. Angel investment typically comes at a critical moment in a startup’s growth: the point between proof of concept and full maturity.
If you are accepting investment near the six-figure range or greater, chances are you have successfully proved your concept and its place in the market. However, you haven’t succeeded to the extent where pure scalability becomes the goal, as is the case with VC investment. Thus, you are at the critical make-or-break point, where your decisions will determine whether you blossom into a company or take your place in the startup graveyard. As such, the moment of angel investment provides an opportunity to gain not only capital, but also a strategically valuable team member.
Access to future capital is an important consideration due to the interplay of angels and VCs. In most deals, VCs will rewrite the deal terms and wipe out many of the angel’s rights. Thus, when you bring VCs to the table, things get serious, and your position as CEO becomes more treacherous. If your angel is capable of floating you with subsequent investment and postponing the involvement of VCs, you’ll have more time to secure your position within your own company.
Next, because an angel will accompany you through some of the most trying times in your growth, their non-monetary expertise and vision can have immense value. An angel who knows your industry, has connections, and contributes to your vision will propel you through plateaus that may have trapped you without the additional wisdom. Because angels care about both you and their investment, they provide a fantastic resource in the form of wisdom, in addition to their capital.
In conclusion, there are multiple options for outside financing before you reach the big leagues with venture capitalists. In addition to providing added flexibility, family/friends and angels can bring critical expertise and experience to your team. For that reason, it is wise to deeply investigate the benefits of smaller investment in your company before you knock on the door of giants. If you are contemplating outside investment, it is wise to contact a business attorney who can guide you through the opportunities and threats unique to your business, as well as introduce you to trusted and vetted investors. For more information, contact the law firm of Troxel Fitch.
ABOUT TROXEL FITCH:
Troxel Fitch, LLC, is a law firm designed to meet the needs of businesses operating in the hyper-competitive modern marketplace. By combining low-overhead operations with efficient technological solutions, Troxel Fitch is built to provide you with responsive, professional, and affordable legal representation.