Understand the Funding Process and What Investors Want to See

David S. Rose
5 Mar 2024

[The following is an edited excerpt from David S Rose’s book The Startup Checklist: 25 Steps to a Scalable, High-Growth Business.]

Some very small businesses—particularly those that offer the professional or personal services of a single individual—can be launched and grown with few or no resources other than human time and talent. But most businesses require some money before they can be started—to pay for software, buy tools or equipment, lease office space, or pay for the time worked by employees or outside contractors. Since most entrepreneurs are not independently wealthy, and since, as we saw in Chapter 13, banks won’t lend money to startups, it is often necessary to raise funds by exchanging an ownership interest in your business (known as equity) for money. The people on the other side of the table who are willing to make that exchange are investors, and their interests, motivations, and capabilities cover a very wide range, both in the amount of money they can provide and the stage your company needs to be at when they invest.

How much money can I raise, and from whom?

The amount of money you will be able to raise from a particular investor varies depending upon whether you’re talking about a family friend, an individual angel investor, an organized angel group, or a professional venture capital fund. To scale things for you, the average individual investment into a given company by business angels who regularly invest in early stage ventures in the US is roughly $25,000. Outside of the major tech centers, you might find individuals participating in the $5K–$10K range, and there are certainly high net worth individuals who can, and do, invest upwards of $1 million in one chunk into early stage deals.

The average amount invested by organized angel groups these days is in the range of $250K–$750K, which is roughly the same range as the so-called “super angels” or seed funds, who are more correctly described as “micro VCs.”

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Traditional venture capital firms have generally started their Series A investments in the $3m–$5m range, with follow-ons in later rounds going up to the tens of millions of dollars. However, with the rapidly decreasing cost of starting up a business, and the pressure at the low end from angels and seed funds, many VCs are now dropping down and, either directly or through special-purpose funds, making much smaller investments.

So, putting it all together, in very, VERY rough ranges, it looks something like this:
From $0–$25,000 you will likely be investing your own cash out of your own pocket, otherwise no one else will be comfortable investing at all. Once in, this money stays in, and is part of what makes up your founder’s equity (along with your work and your intellectual property).

From $25,000–$150,000 you will likely be rounding up friends and family to put in the first outside cash on top of yours. This will usually be documented as either a straight sale of common stock, or else as a convertible note that converts into the same security as the next professional round, but at a discount (which is actually better for everyone). I’ll discuss the mechanics of these investments in Chapter 22.

From $150,000–$1.5m you are in business angel territory, either by lucking into one really rich and generous angel, or (more likely) pulling together either a bunch of individuals (at $10,000–$100,000 each) or one or more organized angel groups, or one or more micro-VCs (“super angels”) or seed funds. They will invest either in the form of a convertible note (but with a cap on valuation), or else in a Series Seed or Series A convertible preferred stock round, using similar documentation to that used by larger venture capital funds (which we’ll cover in Chapter 22).

From +/- $1.5m up to about $10m you’re looking at early stage venture capital funds, which uses something like the National Venture Capital Association’s Model Series A documents. They will likely make their first investment about half of what they’re prepared to put in, with the rest coming in one or more follow-on rounds if you execute your plan successfully.

Finally, north of, say, $10m–$20m, you’d be getting money from a later stage venture capital fund whose paperwork will be similar to the earlier VCs. They will put in much larger amounts of cash, but your valuation will be much, much higher, so they may end up with a smaller stake than the earlier investors (who would likely have continued to invest in each round in order to maintain their percentage ownership).

Although this is the canonical progression, keep in mind that the number of companies that get all the way through it is very, very, VERY small. A majority of companies that are started in the US begin and end with the first stage: the founders’ own money. The number of companies that are able to get outside funding then begins to drop by orders of magnitude: the percentages (again, very, rough) are that 25% of startups will get friends & family money; 2.5% will get angel money; 0.25% will get early stage VC money; and probably 0.025% will make it to later stage VCs.

The Investment Process and the Funding Round

Investments in high-growth businesses are often described in terms of a series of funding rounds. Technically, a funding round simply means a company accepting one or more investments from one or more investors on similar terms within a certain period of time. As such, this could cover many different things, such as:

– Your parents lending you money to cover your expenses while you code your product
– 25 individual angel investors funding a startup on a convertible note
– Two angel groups investing money in Series Seed preferred stock purchase
– A single venture capital fund putting in the full amount as a Series A convertible preferred investment

In all cases, the one fundamental requirement is that the company and the investor agree on how much is being invested, and on what terms. These items are included in what is known as a term sheet. What the terms end up being, and how a company and the investor(s) arrive at that term sheet, can differ widely.

In an ideal world, an entrepreneur bootstraps a startup, gets traction in the marketplace and gets noticed, a smart investor calls up the company and says, “Hey, I think you’re doing great things, I’d like to invest a million dollars in exchange for 10% of your common stock,” the entrepreneur agrees, the lawyers quickly draw up the documents, the investor sends over a check, and the deal is done.

To say this is an extremely rare occurrence would be to wildly overstate the likelihood of it happening.

What does usually happen? First, a company gets started and gets some traction. (These days, it is difficult-to-nearly-impossible to get funded without having an operating company and a product that is pretty near completion.) Then, the founder starts talking to as many investors as she can find, ideally getting introduced to them by mutual acquaintances. This is known as starting a round.

With luck, at least one of the investors will make a funding offer by presenting a term sheet. If they offer the full amount the entrepreneur thinks she needs, and the terms they offer are acceptable (perhaps after some negotiation), then the paperwork is signed, the money wired, and the round is closed.

However, if the investor is willing to put in some but not all of the money needed, and both sides agree on the term sheet, the company then has a round in progress with a lead investor. At that point, the entrepreneur (assisted in some cases by the lead investor) goes out to other investors with the term sheet from the lead to try to “fill out” the round and get the full amount. Other investors will be invited to put in money on the same terms as the lead investor (and thus, as part of the same round).

In some cases, the term sheet will provide that the round will be closed (that is, stop taking in new investments and have the investors transfer in their money) by a certain date, regardless of whether any other investors join in. Typically, however, the term sheet will provide for a minimum amount to be raised before anyone, including the lead investor, will actually transfer the money. It may also provide for a maximum amount, beyond which no additional investors will be allowed to join in. In either case, since the terms of the round have already been negotiated and agreed upon by the company and the lead investor, the decision for all the following investors is a much simpler, take-it-or-leave-it choice based on the signed term sheet (and therefore much easier to get).

The challenge is that getting that lead investor is just about the single toughest thing in the startup world, because it means that someone needs to take the first step, similar to getting the first pickle out of a tightly packed pickle jar.

The ideal lead investor will likely have the following characteristics:
– “Smart money,” which means they know the startup business and the particular domain of the company, and can be helpful in many ways going forward.
– A strong commitment to the company, so they will devote time and effort to the company both during and after the fundraising round.
– A significant amount of money that they are willing to invest themselves (typically, at least 25–50 percent of the target raise)
– Deep pockets (that is, plenty more cash reserved for follow-on rounds).
– A network of other investors to whom they can introduce the company.
– Good personal chemistry with the entrepreneur.

However, because it is so darn difficult to get that lead investor, entrepreneurs will often have no choice but to try shortcuts. One of those is to draw up a term sheet themselves, setting a valuation, terms, and target amount. They then try to function as their own “lead investor” by presenting “their” term sheet to potential investors, getting quickly to the easy “take-it-or-leave-it decision” and entirely skipping the really tough step-up-and-lead decision.

Unfortunately, this is often problematic, because it is just about 100 percent guaranteed that an entrepreneur “negotiating” that self-proposed term sheet with herself will simply not end up with the same kind of term sheet that a smart, tough lead investor would have negotiated. And because (a) the pseudo-term-sheet will be less investor-friendly than a real one, and because (b) there will be no smart, committed, deep-pocketed, well-networked investor providing validation, support, and a good chunk of the funding for the round, the resulting easy “take-it-or-leave-it” choice invariably gets turned into an even easier “leave-it.”

What Are Investors Looking For?

Having spent many decades on both sides of the startup investment table, I’ve come to realize that founders and investors can look at the same company and see very, very different things. The visionary, optimistic entrepreneur sees a world of possibility (with perhaps a few potential road bumps along the way), while the pragmatic, rational investor sees a company that may or may not have the skills and resources to survive and thrive (with perhaps the potential of turning into a home run, if everything works out perfectly).

The smart founder looking to raise an investment for a startup will develop the habit of continuously examining his or her own business from the investor’s perspective. That’s because the sooner you start studying your company objectively as an investment possibility, the sooner you can get to work improving its prospects by making changes to enhance its attractiveness to those who have the investment capital you need.

Here’s what smart investors are looking for in your startup:

Strength of the management team
The entrepreneur or business founder is the key to the success of any new venture. This means that any smart investor will start examining a possible investment by reviewing and evaluating the founder’s business experience (that is, his history as a—hopefully successful—business manager and leader), his domain experience (his history in the specific industry where the startup is located), and his skill set (his concrete knowledge and ability in regard to particular activities that will be central to the startup’s success).

Almost as important is the founder’s flexibility—referring not just to the founder’s willingness to pivot when necessary, but also the personal characteristics that will make the entrepreneur easy to work with. One key issue is whether the founder will be willing to step away from the CEO role if it becomes apparent at some point in the future that this would be the best thing for the company. As an entrepreneur, you’ll want to start thinking hard about this question even before you begin talking with investors, since it’s an issue that often arises in the life of a growing company.

In addition, investors will carefully evaluate the completeness of the management team. If the CEO is Superwoman and able to do everything in all areas, this might not be crucial, but in most cases investors consider it crucial to get a very good idea of what skills the company already has in-house, and which need to be hired.

Size of the business opportunity
This refers primarily to the market size for the company’s product or service, including both the scope of the overall industry market and the specific amount of money that customers are already spending each year on substitute products for the one that your company will offer. If all the possible customers in the world are today spending only $20 million or $30 million dollars for similar products or services, it is hard for you to claim that your company is likely to achieve a monster hit down the road. Typically, smart investors look for market segments where people are already spending many hundreds of millions—or, ideally, billions—of dollars, with an actively growing field of potential customers.

One common way of measuring the size of the business opportunity—especially among angel investors—is by evaluating the startup’s potential for revenue within five years. There is nothing inherently wrong with a long-payoff venture, such as building a nuclear power plant. However, angel investors (as opposed to venture capital or private equity funds) don’t usually have very deep pockets. This means that large-scale, capital-intensive ventures that will take a decade or more to generate profits are typically not appropriate for angel funding. The question then becomes how quickly your company will be able to start and scale its revenues, and how much those revenues are likely to be realized within a reasonable time frame (say, five years, beyond which timeframe no one can project).

In addition, investors will consider the strength of the competition your business will face. Here, they are normally looking for the “Goldilocks” answer: not too much, not too little, but just the right amount. In an ideal world, your company will be entering a space that is not already over-crowded with entrenched, well-funded competitors. On the other hand, if it truly has “no competitors” at all, that will be a serious warning sign to a savvy angel investor. Why are there no competitors? By definition, it means that no one currently thinks that what the company is doing is worth paying for!

Product or service
If the product or service is something generic that “everybody” will want because it can do “everything,” your company may well be doomed to failure. Investors will be looking for a clear, focused, and distinct definition of what a specific need is for it, and precisely who be the market.

Next, investors will want to know how well your specific product fits the market need that has been identified—and even more important, why? Investors prefer to invest in “painkillers” that solve an existing problem rather than “vitamins” that are simply better/faster/cheaper.

The smart investor also wants to know about the path to product acceptance. Is this a solution where people immediately know what it is, why it’s of value to them, and how they can use it?

Finally, investors are interested in understanding the barriers to entry. How hard is your product or service to copy, and who is likely to do it? Sure, Google or Apple probably could knock it off, but is your product something that is likely to face stiff competition in the near term? If so, how would your company emerge as the winner? When speaking with investors, have sound, believable answers to these questions.

Type of industry
If the industry you are entering is based on rapidly advancing and highly cost-effective information technology, that will be a plus in the eyes of investors, because a small investment can help such a company go a long distance. So would a business-to-business venture, or even a consumer-facing startup that is highly scalable (that is, susceptible to easy and rapid growth). But a traditional business that demands a lot of cash up front but doesn’t provide investors with a lot of leverage can be viewed by investors as problematic.

Sales channels
How will your product actually get into the hands of customers? Have your proposed methods for selling, marketing, and promoting the product actually been tested and implemented, or do they exist purely in theory?

Stage of business
Is your business just an idea? A run-away smash hit with happy, paying, repeat customers? Or something in the middle? Different investors prefer to invest at different stages: a seed investor will not make a Series B investment, nor will a late stage VC fund a seed round.

Quality of business plan and presentation
While the correlation between the quality of your business plan and its presentation and the prospects for your business isn’t perfect, it is much more accurate than most entrepreneurs would like to think. If you have a clean, comprehensive business plan, presented in a cohesive, persuasive way, the odds are good that your business has a better-than-average chance of succeeding. Conversely, a confusing, sketchy plan presented in a way that is sloppy and unappealing suggests a business that is likely to struggle.

Yes, Virginia, there may actually be some free money.

Although most startups are funded by their founders, their friends and families, or early stage investors, the full funding picture actually includes one additional source of capital that might be available for you.

The closest thing to “free money” for a company is when the government gives it cash and doesn’t expect it back. Governments at virtually all levels, in virtually all countries, provide grants of some type to small companies, with the goal of supporting entrepreneurial development.

In the U.S., the Small Business Innovation Research (SBIR) program, established in 1982, encourages domestic small businesses to engage in federal research/research and development (R/R&D) that has the potential for commercialization. The theory is that “by including qualified small businesses in the nation’s R&D arena, high-tech innovation is stimulated and the United States gains entrepreneurial spirit as it meets its specific research and development needs.” Each year, federal agencies with outside R&D budgets that exceed $100 million are required to allocate 2.5 percent of such budget to these grants.

As of this writing, 11 federal agencies participate in the program. SBIR enables small businesses to explore their technological potential, and provides the incentive to profit from its commercialization. Through the end of 2013, over 140,000 awards had been made totaling more than $38.44 billion, and over 2,400 companies that received grants went on to receive venture capital financing. The program’s goals are four-fold:

– Stimulate technological innovation.
– Meet federal research and development needs.
– Foster and encourage participation in innovation and entrepreneurship by socially and economically disadvantaged persons.
– Increase private-sector commercialization of innovations derived from federal research and development funding.

The SBIR program issues grants to companies in two phases. The objective of phase I, which offers grants up to $150,000, is to establish the technical merit, feasibility, and commercial potential of the proposed R/R&D efforts, and to determine how well the company can deliver on its promises. Phase II grants of up to $1m are intended to continue the R/R&D efforts, and funding is based on both the results achieved in phase I and the scientific and technical merit and commercial potential of the project proposed in phase II.

A second federal program, run in parallel with SBIR, is the STTR program for technology transfer grants. The two programs are very similar, except that STTR projects must be done in conjunction with a university, and the program allows the principal investigator to not work full-time at the company (which is a requirement of SBIR grants).

Each agency administers its own program, designating general research and development topics in their solicitations. They accept proposals from small businesses (which to them means “under 500 people”), and awards are made on a competitive basis. What’s interesting (and not widely known) is that the award rate is roughly 25 percent…which means that a company with a viable proposal is 10x as likely to be able to get an SBIR grant as it is to get angel funding (as discussed below), and 100x as likely as venture funding!

Every state and many local governments have economic development agencies dedicated to assisting new and established businesses to start, grow, and succeed. Services provided by these agencies typically include start-up advice, training and resources, business location and site selection assistance, employee recruitment and training assistance, and financial assistance. Including loans, grants, tax-exempt bonds, and—in many instances—state-funded seed and venture capital funds, these agencies expend a great deal of money and effort trying to help new businesses get off the ground.

Okay, now that you have a broad-brush understanding of the early stage investment process and funding sources, let’s see how to find those elusive investors, and get them excited about your venture.

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This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.