Keep Your Second Round of Financing in Mind
When raising your first round of financing, be sure to protect your early investors from future dilution.
In the mad rush to close the first round of financing for your startup, it's easy to forget how your first-round investors will fare during subsequent rounds of financing. One of the most popular questions I hear from first-time entrepreneurs is how they should structure their first round of investment from relatives, friends and angel investors.
There are many ways to protect your early investors and ensure your business won't get squeezed by subsequent investors. But each of these techniques involves some tradeoffs between the rights of your early investors, your later investors and your business. How you manage these tradeoffs says a lot about your character, your goals and your negotiating leverage as an entrepreneur.
To help you figure out how to manage these tradeoffs while raising money, I've grouped entrepreneurs into four types--simple, immature, wicked and wise--and examined how each of them would handle their company's financing.
The Simple Entrepreneur
The simple entrepreneur is tempted to follow the advice of experienced elders, such as attorneys, accountants and business associates. They'll tell him to structure his first round of investment in the form of convertible debt. This protects his investors by providing them with a price discount compared to the next round of funding. It also allows him to avoid putting a valuation on his company during its startup stage, which would typically lead to overvaluation, then adjustment and dilution from subsequent rounds of professional investors. For more information on this form of financing, refer to " Raising Money Using Convertible Debt ."
The Immature Entrepreneur
The immature entrepreneur will be terrified of convertible debt since he views debt as a burden that could sink his company. Instead, he'll try to sell stock to his relatives, friends and other angel investors. And he'll try to get as high a price as possible for the stock, since that will allow him to brag that his company's valuation is high and he was able to keep most of the ownership for himself. In subsequent rounds, when the immature entrepreneur is faced with the prospect of raising more money from professional investors, he will be forced to do a "down-round" of financing with a lower stock price--and his early investors will be disappointed and believe they paid too much for the stock. Even if there are rational reasons for doing a down-round, the emotional consequences of a lower stock price are hard to swallow for everyone except the attorneys on the deal.
The Wicked Entrepreneur
The wicked entrepreneur will do whatever it takes to raise as much as money as possible without much regard for future dilution. For example, he may provide a high-price discount on convertible debt (e.g., more than 2 percent per month) and a high interest rate (e.g., 5 percent above prime) that will tempt angel investors to participate in the deal. Since they don't own equity and won't be able to prevent his next round of financing, he will be free to take money from any institutional investor even if they force a renegotiation of the discounts provided to early investors.
Alternatively, the wicked entrepreneur might sell his relatives and friends common stock rather than preferred stock, even if he knows that future rounds will likely be in the form of preferred stock. Both of these strategies might backfire, however. In the first instance, subsequent investors might force the entrepreneur to accept a lower price rather than force renegotiation of the convertible debt terms. In the second instance, selling common stock to investors might make it harder to get a favorable strike price on stock options for management. (This is because the strike price on options is determined by the fair market value of common stock.)
The Wise Entrepreneur
The wise entrepreneur will develop a financing strategy with the future in mind. For example, he may offer preferred stock to his first-round investors and include some anti-dilution provisions to protect them from future down-rounds. Anti-dilution provisions come in various forms, some of which are entrepreneur-friendly and some of which are investor-friendly. By selecting the specific nature of these provisions when the entrepreneur has maximum negotiating leverage--before negotiating with venture capital firms, for instance--he can select a favorable set of provisions. This has come to be known as the "broad-based weighted average ratchet."
The wise entrepreneur will know that once anti-dilution provisions are written into a company charter, they are unlikely to be changed substantially; therefore, he has effectively protected his company from having to negotiate less-favorable anti-dilution terms in the future and protected his early investors in the process.
The wise entrepreneur will also use convertible debt intelligently. Rather than raise his entire first round of funding in the form of discounted convertible debt, he will reserve this financing strategy for the few months before he's certain that he'll succeed in raising institutional financing. This will reduce the total cost of the price discount and ensure that the convertible debt won't get in the way of raising a venture capital round.