From the March 2009 issue of Entrepreneur

I received an education about money during the last recession. I was raising money for my startup by stringing together a series of small investments from angel investors, friends and relatives. It was a tough slog, but I eventually assembled a group of investors and a board of directors.

Not long after, an investor offered to make a sizable investment. But the share price he offered was lower than that paid by previous investors. I only had three months of cash in the bank and was desperate to accept, but the board turned down the offer. Despite my protests, I was back to the drawing board with 90 days to find an investor willing to pay a higher price. I eventually did find one, but only after two more years of stringing together small investments at incrementally higher share prices from angels, friends and relatives.

My story isn't unusual; entrepreneurs who have raised money through private investors know shareholders will fight to avoid dilution. The interests of founders, new investors and shareholders often diverge between the first and second round of financing, particularly during recessions. Here's how to raise your first round of financing with your second round in mind.

  1. Use convertible debt, not stock. This allows you to raise money without setting a price per share. You can set a discount or a bonus for early investors by enabling them to convert the debt to stock at favorable terms when a larger investor comes along. This protects and rewards your early investors and allows you more flexibility and control. Setting a share price for selling stock to early investors is arbitrary and could paint you into a corner. I recall times when I was embarrassed to even mention offers from new investors to my older investors.
     
  2. Set a fair price or an appropriate discount. The price you offer to early investors says a lot about your character. You want a high price because you're confident about your business; meanwhile, you want to keep the price low to avoid taking advantage of your relatives, friends and other private investors by setting them up for future dilution and acrimonious investor relations. Somewhere between these two extremes is the right answer. Similarly, when setting a price discount for convertible stock, you can set it too high to attract investor dollars. In that case, future investors will think you've been too generous.
     
  3. Communicate regularly. When you're raising money, it becomes second nature to brag about your business. However, don't let this affect how you communicate with shareholders. Rather than sending them only good news, send them updates on a regular schedule--annually at least, although I recommend quarterly. Even if your startup isn't generating any revenue yet, tell them what you're doing to move it forward. Sharing news consistently builds trust. You'll need that trust when it's time to raise your next round.