From the author: Itisafact,failuresresultingfromaweakbusinessmodel,poorproductofferingoralackofvisiononthepartofthefoundersarenotascommonasonemightimagine.However,asignificantnumberofnewbusinessesdofailbecauseofinadequatecapitalization.Whilemostearlystagebusinessesrecog-nizeaneedforstartupcapital,manydonothavetheacumenrequiredtosecuretheseimportantresources.

WithovertwodecadesofSiliconValleystartupexperience,StartupFactoryhasfirsthandknowledgeoftherolethatcapitalplaysintheultimatesuccessofanewenterprise.Ithasneverbeenmoreimportantforourclientsandpros-pectstogainafundamentalunderstandingofhowthearcanestartupfinancingprocessworks.Manyotherwisebrightentrepreneursarenotfullyawareofthevariousformsoffinancingthatareavailableforeachstageofbusinessmaturityorgrowth.And,asavailabilityoftraditionalsourcesofcapitaldiminish;werec-ognizetheneedtointroduceourclientsandprospectstosomeofthenewanddynamicchangesthatarejustnowtakingplaceinstartupfinancing.Erringonthesideofcautionweofferthisseeminglyobviousreminder:Acceptingstartupfinancinginanyformcanresultindilutedequity,diminisheddecision-makingpower,andareductioninfuturerewards.

Wehaveorganizedthefollowingreportintothreegeneralareas:(1)thestagesabusinesstravelsthroughasitgrowsfromstartupthroughmaturity,(2)themeansbywhichacompanysecuresfundingateachstage,andfromwhomthisfundingmaypotentiallyflow,and(3)Crowdfunding,thenewparadigmincapitalfinancing.

Early Business Stages Requiring Startup Financing

Seed Stage Seedstagecapitalisrequiredtofinancetheearlydevelopmentofanewproductorservice.Theseearlyfundingsmaybedirectedtowardsproductdevelopment,proof-of-concept,marketresearch,ortocovertheadministrativecostsofstartingtheenterprise.Atrueseedstagecompanyhasnotyetestab-lishedcommercialoperations.Astartupinthisphaseestablishesproof-of-con-ceptbydemonstratingaprototype(productorservice)topotentialcustomersandenticesthemtobecomesourcesofcapital.Thecompany’sgoalinthisstageistotestthemarket,establishtheviabilityofthebusinessidea,andmea-sureinterestandattractivenesstoinvestors.

An Introduction to Startup Financing and a New Approach to Attracting Capital Resources. RobertT.Goldberg,PresidentStartupFactory,LLC

Quick Tips:■ When seeking startup funding it is critical to understand what stage of maturity your enterprise has reached

■ Be sure that the type and stage of funding you seek is in alignment with what funders are looking for

■ Financing can facilitate growth but it often comes at the expense of reduced equity and corporate control

Important terms:

■ Bootstrap stage

■ Seed stage

■ Startup stage

■ Early stage

■ Second stage

■ Third stage

■ Late stage

■ Liquidation stage

■ Mezzanine financing

■ Bridge financing

■ Angel investors

■ Venture Capital

■ Crowdfunding

Startup Stage Financingforstartupsenteringthisphaseprovidesfundsforproductdevelop-ment,someinitialmarketingandsomeadministrativeoverhead.Thistypeoffinancingisusuallyofferedtorecentlyorganizedcompaniesortothosethathavebeeninbusinessforashorttime,buthavenotyetsoldtheirproductintothemarketplace.Startupcompaniesinthisstagehave,oftentimes,assembledkeymanagement,preparedaproperbusinessplan,andhaveconductedduedili-genceonthemarketviabilityoftheirproductorservice.

Early Stage Startupsrequiring“early”stagefinancinghaveusuallybeeninbusinessbetween2-3yearsandhavelaunchedthecompany.Themanagementteamhasbeenestablished,commercialoperationshavebegunandfundingatthisstageisoftenrequiredtocovercashflowrequirements.Financinginthisstagealsostrengthenscapabilitiesintheareasofmanufacturing,sales,andmarketing.

Traditional Business Expansion Stage Requirements

Expansioncapitalfacilitatestheexpansionofcompaniesthatarealreadysellingproductsorservices.

Second Stage Secondstagecapitalfinancingfacilitatestheexpansionofcompaniesthatarealreadysellingproductsorservices.Atthisstageacompanyraisesadditionalequitycapitaltoexpanditsengineering,technologyplatforms,sales,marketing,andmanufacturingcapabilities.Manycompaniesinthisstagearenotyetprofit-ableandtheyoftenusethefinancingobtainedinthisstagetocoverworkingcapi-talrequirements,andtosupportorganizationaloverhead,andinventorycosts.

Third Stage ThirdStagefinancing,ifnecessary,facilitatesmajorexpansionprojectssuchasplantexpansion,integratedmarketingprograms,thedevelopmentofalargescalesalesorganization,andnewproductdevelopment.Atthisstagethecom-panyisusuallyatornearbreakevenorprofitable.

Traditional Late Stage Financing Requirements

Mezzanine Financing Phase Mezzaninefinancingisalatestageformoffinancingforstartupsandisoftenusedformajorexpansionofthecompany.Thistypeoffinancingcanalsofundanemerginggrowthopportunityforthecompany.Atthispointthecompanymaynotwishtoseekanadditionalroundofequitydilutinginvestmentandmaypreferthehybridformoffinancingthatmezzaninedebt/equityfinancingoffers.Inaddition,entrepreneursmaystillbeunabletoobtaintraditionalbankloansatthispoint.Mezzanineloaninvestorsareabletoobtainahigherdegreeofsecuritythananordinaryinvestmentinequitysincetheirrights,asdebtholders,areseniortothatofshareholders.

Third Stage financing facilitates expansion projects such as plant expansion, integrated marketing programs, the development of a large scale sales organization, and advanced product development.

Bridge Financing Phase Companiesseekingbridgefinancingaremature,profitable,andareenjoyingexpansion.Thistypeofshorttermdebtfinancingisprovidedforacompanyexpectedto“gopublic”withinsixmonthstoayear.Thefundsareoftenusedtofinancevariousrequirementspriortomakingapublicofferingorsomeothermajorrestructuringevent.Often,bridgefinancingisstructuredsothatitcanberepaidfromtheproceedsofaninitialpublicoffering(IPO).Bridgefinancingcanalsoinvolverestructuringofmajorstockholderpositionsthroughsecondarytransactions.Thisisdoneifthereareearlyinvestorswhowanttoreduceorliq-uidatetheirpositions.Bridgefinancingmayalsobeconductedfollowingaman-agementchange.Thisenablesthefounderstopurchasebacksharesfromformermanagementandindividuals(friends,relatives,associates,etc.)priortotheIPO.

Liquidation Phase Thebusinesslifecycletendstoworklikethecycleoflifeitself,evenforthemostsuccessfulofstartupenterprisesthathavesucceededbeyondtheirwildestimaginations.Forthoseenterprisesthathavemadeitalltheway,thequestionsof“howandwhen”to“cashout”maybeinevitable.Asstartupsenterthisfinalphase,knownastheliquidationphase,therewillbenoshortageof“investmentbanking”expertsfromWallStreetandWallStreetWestofferingtheirservicesandmoneytoyou.Greatcaremustbetakenatthisstage–sellyourselfdearly.Mostliquidationsoccurviamergerandacquisition,IPO,orleveragedbuy-out.

Traditional Sources of Startup Capital Funding

Astheworldcontinuestobattleitswaybackfromthefinancialmeltdownof2008,andthroughthemostsevereglobaleconomiccrisissincetheGreatDepression,entrepreneurshavehadtoadapttotheharshestfinancingcondi-tionsinrecenthistory.Traditionalbankfinancingforexistingbusinesseshasdriedupforallbutthemostcreditworthyofborrowers,andaccesstotraditionalsourcesofcapitalforstartupsisscarce.Assuch,itisimportantforstartupentrepreneurstounderstandthattheconventionaltypesoffinancingparadigms(thathaveservedstartupsthroughthelatterhalfofthetwentiethcenturyupuntil2008)areundergoingdynamicchanges.Muchofthisisduetoglobalfinancialforcesbeyondtheircontrol.

WearenowenteringaNewAgeintheworldofstartupfinance,whereclear-cutmethodologiesforfinancingaregrowingscarce.Financingforstartupsisclearlyenteringadisruptiveperiod.Inascrambleforpreciousresources,astartupmayfinditselfdrawingonahybridcombinationoffinancingsources,andthesesourcesmaycomeintoplayinnosetorder.Asaprecursortounderstand-ingtheNewsAgeofstartupfinancing,wefeelitisstillimportanttobecomefamiliarwiththetraditionalsourcesofandmethodsforseekingcapital.

Seed Stage Financing Seedfinancingforastartupenterpriseisoftenthemostdifficultinthatitrepresentsthegreatestrisktoinvestors.Thisisthefinancingstagewherethe

foundersofthestartuphaveusuallybeenbootstrappingtheirenterprisefromper-sonalsavingsandcreditcards.Reachingthispoint,foundersrealizetheneedformorecapital.Moreoften,thenextroundoffinancingisprovidedbyfriends,familyandwellknownassociates.

Atthisjuncture,startupsmayconsiderReg.“D”PrivatePlacementMemorandumstoraisecapitalfromaninitialgroupof“outsideinvestors.”PrivatePlacementMemorandumsorPrivateStockOfferingsrepresentthepointatwhichthestartupbeginstoexchangeshareownershipforneededcapital.Privateplacementinvestorshaveevaluatedtheseopportunitieswithaneyetowardsmakingareturnof10x-30xtheirinvestment,buttheyusuallyhavenosayinthemanagementofthecompany.Inaddition,standardsoninvestmentreturnexpectationsforhighriskcapitalcannolongerbeassumedduetotheuncertaineconomicclimateoftoday.IssuingaPrivatePlacementMemorandumisnotago-it-aloneprocess,andanexperiencedsecuritiesattorneywillberequired.AlthoughexemptfromSECregistration,Reg."D"Offeringsarestillconsideredsecuritiesandmustmeetcertainregulatoryrequirements.

Angel Investor Financing AngelInvestorsoftenprovidearequiredroundoffinancingtostartupsthatareontheearlystagepathtoprofitability.Inmanycases,startupshaveover-lookedthecategoryofangelinvestorfortheirfinancingneeds.Someacademicsplaceangelinvestorsintheseedstagecategoryofcapitalsourcesandothersidentifyangelinvestorsasfillingthegapbetweenseedstagecapitalandventurecapital.Angelinvestingis,inactuality,ahybridbetweenthetwo.

Angelinvestorsareoftenaffluentpeoplesuchassuccessfulentrepreneurs,whowishtostayinvolvedwiththeirindustrybyassistingthenextgenerationofstartups.Itisnotjustmoneythatmotivatesangelinvestors;providingneededandvaluableguidancetomanagementofthestartupisgratifyingaswell.Startupfoundersneedtotakeacloselookattheirownneedsandrequirementsbeforeenteringcustomizedagreementswithangelinvestorsastheymayfindthem-selvesgivingawaymorecontrolovertheircompaniesthantheyreallywantto.Angelinvestorsrequireareturnoninvestmentintheareaof20x-30xtheirinitialinvestment.Theseinvestorsarenotinterestedinslow-growthor“lifestyle”busi-nesses.Theyareafterbusinessesthatcangrowatanannualrateof40%ormore.Unlikeventurecapitalists(VCs),manyangelinvestorsdonotcalculateInternalRatesofReturn(IRR)andothermeasuresofinvestmentperformance.Angelsoftenregardthesetypesofcalculationsastoospeculative.Startupscanalsoexpectachangingplayingfieldwhennegotiatingreturnexpectationswithangelinvestors.

AngelInvestorsplaceagreatdealofemphasisupontheselectionoftheentrepreneurstheychoosetofund.Angelstypicallyfocusonfactorssuchastheentrepreneur’senthusiasm,trustworthiness,andexperience.Obtainingangelfinancing,oranyfinancingforthatmatter,isakintomakinganyotherhigh-ticket

Issuing a Private Placement Memorandum is not a go-it-alone process, and an experienced securities attorney will be required. Although exempt from SEC registra-tion, a private placement is still considered a security and must meet certain regulatory requirements.

sale.Goodfirstimpressionsplayanimportantrolewiththeseinvestors.Angelinvestorsareoftenpivotalinfundingtheseedstageorveryearlystagestartuprequiringaninfusionof$500,000orless.

Venturecapitalfirmsarerarelyinterestedinsuchsmallinvestments.Someangelinvestor-backedcompaniesgoontoreceiveventurefundingasaprecursortomakingapublicofferingandreachingindustryleaderstatus.Angelcapitalcan“pavetheroad”towardventurecapital,aslackingthiskeyfinancing,manystart-upswouldnotgrowtothestagerequiredtoattracttheinterestsofventurecapitalfirms.However,unlikehighprofileventurecapitalfirms,angelinvestorsoftenstay“undertheradar”toavoidbeingdelugedwithbusinessplansandrequestsforcapi-tal.Mostpotentialinvestmentsareintroducedtoangelsbytheirbusiness,profes-sional,andpersonalcontacts.Seventy-fivepercentofstartupfounderssayanangelinvestor’sactiveparticipationbenefitsthefirm,sobesuretoselectangelinvestorswhocancontributetherelevantexpertise–aswellascapital–toyourfirm.

Venture Capital Financing Venturecapitalisasourceoffinancingthatusuallyfollowsseedstagefund-ingandangelinvestorfundingthatisutilizedintheearlierstagesofthestartup’slife.Thistypeofgrowthfinancingisprovidedtohigh-potential,growth-orientedcompaniesthatrequireasubstantialroundofinvestment.Theamountsareusual-lyinexcessoffive-hundredthousanddollarsanduptotensofmillionsofdollarsormore.However,itshouldbenotedthatventurecapitalfundingcanoccuratanytimethroughoutthestartup’sinitialphasespriortoIPO.Venturecapitalfirmsbearahighdegreeofriskinvestinginstartups,includingacompletelossoftheirinvestment.Assuch,mostventurecapitalinvestmentsaredoneinapooledfor-mat,whereseveralinvestorscombinetheirinvestmentsintoonelargefundthatinvestsinmanydifferentstartupcompanies.LargepooledfundsofVCfirmscanrangeanywhereinsizefrom$25million–$1billion.TheVCfirmwillgenerallytakeaseatontheBoardofDirectorsofthestartupandwilltakeanactiveroleinbringingtheirmanagementexperiencetothecompany.ManyVCfirmsspecializeincertainindustriessuchastechnology,biotechnology,andhealthcarewheretheybringdeepindustryexpertisetobear.

VC’smostoftentakeequitypositionsinstartupcompaniesinexchangefortheircapitalandexpectannualratesofreturnofbetween30%-50%.Itshouldbenoted,however,thatratesofreturninthiscategoryaresubjecttoawidevarietyoffactors,notleastofwhichhasbeenthedifficultyinraisingpoolsofcapitalforventurefinancingoverthelastseveralyears.VC’srequirehighratesofreturnbecause,inmanycases,theirinvestmentsinstartupsarehighlyilliquidandrequireanywherefrom3-7yearstocometofruitionthroughafavorableexiteventsuchasanIPO,mergerandacquisition,oraleveragedbuy-out.ItiscriticalforstartupstoperformtheirduediligenceonVCfirmsbeforejumpingintobedwiththem.WhileitistruethatVCfinancingisdifficulttoobtain,itisprobablyagoodideatoavoidVCfirmswithalongstandingrecordofbeing“VultureCapitalists”.

SomeVC’shavenoproblemfiringeveryoneinthestartup,includingthefounders,andshuttingdownthecompany,iftheydeterminethereisafinancialadvantage(forthem)todoso.

Traditional Sources of Late Stage Capital Financing

Late Stage Financing AsStartupsmovethroughtheearlyandexpansionstageoftheirlifecycleandapproachthelatestageofthestartupphase,thedegreeofriskdecreasesforinves-torsandsodoesthepotentialforreturngoingforward.Entrepreneursatthisstagehavebecomemuchsavvieraboutfinancesimplybecausetheyhavesurviveduntilthispoint.

Mezzanine Financing Mezzanineisaformoflatestagefinancingandisusuallyahybridofdebtandequityfinancing.Mezzaninefinancingcanbeprovidedbycommercialbanks,but,oftentimes,itisnot.StartupsseekoutMezzaninefinancingwhentheyrequirefundsforamajorexpansionbutlackthecollateraltoputupforatraditionalbankloan.Mezzaninefundingisalsoprovidedformerger&acquisitionopportunities,restructuring,specialprojects,orcashflowneedswhenothersourcesofcapitalareunavailable.Mezzaninefinancingallowsthecompanytomoveforwardwith-outthebusinesslosingitscontrolormajorityshares,butitisexpensiveandwillcostthestartupanywherefrom14%-25%ayear.Inaddition,mezzaninelendershavetherightstoconverttoanownershippositioninthecompanyiftheloanisnotpaidbackintimeandinfull.Mezzaninefinancingisgenerallysubordinatedtodebtprovidedbyseniorlenderssuchasbanksandventurecapitalfirms.Thereislessriskandlessreturnforinvestorsatthisstage.TypicalMezzaninefinancingisprovidedforatermof2-5years.SourcesofMezzanineFinancingarevariedandmayinclude:CommercialBanks,VentureCapitalFunds,InvestmentBankingFirms,InsuranceCompanies,PublicPensionFunds,Mutualfunds,andInstitutionalInvestors.

Bridge Financing BridgeFinancing,asthetermisusedincorporatefinance,isadebtformoffinancingforStartupEnterprisesthatcanbeusedforseveralpurposesincluding,butnotlimitedto,thefollowing:

• Toinjectsmallamountsofcashtocarryacompanysothatitdoesnotrunout ofcashbetweensuccessivemajorprivateequityfundings.

• Tocarrydistressedcompanieswhilesearchingforanacquirerorlarger investor(inwhichcasethelenderoftenobtainsasubstantialequityposition inconnectionwiththeloan).

• Asafinaldebtfinancingtocarrythecompanythroughtheimmediateperiod beforeanInitialPublicOffering(IPO)oranacquisition.

Bridgefinancingisshort-terminnature,usuallyofferedfor6-12months.Itisalsoreferredtoas“gap”or“swingloan”financing.Bridgeloansaretypicallymoreexpensivethanbankloansinordertocompensatelendersfortheadditionalriskstheyaretaking.Bridgeloanscarryinterestratesofbetween10%-15%andalsochargepointsandothercoststhatareamortizedoverashorterperiodoftime,andvariousfeesandother“sweeteners”(suchasequityparticipationbythelenderinsomeloans).Bridgeloanlendersalsomayrequirecross-collateral-izationandalowerloan-to-valueratio.Theproceedsfromabridgeloanareoftenpaidbackfromthelongertermfinancingevent,suchasanIPO,whichisexpect-edtotakeplaceinthenearfuture.Typicalsourcesforbridgeloansincludetheinvestmentbanksthataretakingthecompanypublic,venturecapitalfirmsthatspecializeinthistypeofdebt,financingarmsofsomeinsurancecompanies,andprivatelenders.

Introducing CrowdfundingHere are a few points practically everyone agrees on:

• Themostimportantjobcreatorsintheeconomyaresmall,high-growthstartups.

• Withtraditionalcreditmarketsstalledfromthefinancialcrisis,startupsare, inmanycases,starvedforcapital.

• MillionsofAmericanswouldliketoinvestinthesecompanies,buttheycan’t becauseofobsoletesecuritieslawsfromthe1930s.

• AfewsimplereformscouldallowAmericanstomakemodestinvestments (upto$10,000)insmallbusinesseswithouttremendousrisk.

Aburgeoningnewsourceoffinancingforstartupsintheseedstagephaseisjustbeginningtoemergeandisknownascrowdfunding.Itisourbeliefthatthisformofcapitalfundingwillrepresentasignificantopportunityforstartupcompa-niesgoingforward.Webelievethatcrowdfundinghasthepotentialforprofoundlychangingthelandscapeofglobalstartupfinance.

Althoughcrowdfunding,(alsoknownascrowdsourcing),hasservedthefinancialneedsofcharitablecauses,bands,authors,andnon-profitinitiativesforsometime,itwasthefinancialcrisisin2008thatdrovetheneedforanewpara-digminsmallscalefinancingforcommercialendeavors.Theideabehindcrowd-fundingisbothsimpleandprofound.CrowdfundingneutralizestheadvantageofthepowerfulWallStreetInvestmentBanksbydistributingtheabilitytoinvestandprofittothepeople.

To learn more about crowdfunding, ask for our article entitled:An Introduction to Crowdfunding—the New Paradigm in Startup Capital Funding.

Startup Factory, LLCrobert@startupfactory.biz•www.startupfactory.biz

©2012StartupFactory,LLCallrightsreserved

A burgeoning new source of financing is just beginning to emerge and is known as crowd-funding. It is our belief that this form of capital funding will represent a significant opportunity for startup companies going forward.