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Startup Funding: Raising Early-Stage Capital from Your Personal Network Part 2.
Part 2 - Potential Pitfalls
The other day, I was reminiscing with a client about the ups and downs of financing his startup.
Back when he was in capital formation mode, he’d assured me that he knew “a great source of money.” It turned out the source was his mother, who had made a minor fortune in real estate.
Certainly, she was a qualified investor. Specifically, she met Regulation D qualifications, meaning she had plenty of capital. At that time, she was willing to invest up to $2 million.
On the surface, she was very shrewd, with years of experience in real estate sales and finance – generally traits desirable in a business partner. However, my client’s startup had nothing to do with real estate. It was a tech startup built around highly specialized cybersecurity.
This was the first pitfall in his plan to raise capital – a common pitfall when it comes to investing within your personal network of friends and family.
Seeking accessible money vs. smart money
A fundamental rule of startups is that you should seek “smart money” for financing. Smart money is capital from a party that knows your business. For example, if you’re running a biotech startup, you’d want the support of the powerful venture capital firms that have a history of funding many biotech startups and have built up a strong network of contacts in that space.
While smart money investors tend to demand greater control and accountability, they also provide the guidance and expertise that come from being long-time insiders in their sectors.
My client was a technical expert in his field; however, he was not a business expert. To succeed, he needed experienced hands-on deck. Though his mother was an expert in real estate, she could not provide any connections, insights, or guidance on how to grow a successful tech startup.
Another key benefit to smart money – it gives you credibility. If you have seasoned investors in your business, it convinces the outside world that you are more likely to succeed. Having smart money investors makes it easier to attract more investors down the road.
Giving board control to friends and family
Typically, when you raise money, you sell equity in exchange for capital. The equity is usually sold in the form of preferred shares that go with governance rights, including a seat on the board.
The next pitfall to consider is what to do when friends and family put up enough capital to merit governance rights.
The conflict is less about capital and more about giving governance rights to a person with no knowledge of your business yet has a bona fide stake in the risk of said business. Where friends and family provide money with no expectation of directing or operating the company, this may not be an issue. However, in this case, if my client had taken his mother’s money, she would have provided enough capital to become a director in a business that she (by her own admission) knew nothing about.
Her options would be to take a seat and while she would be invested in the success of the business, she would not be able to supply the needed expertise.
Alternatively, she could appoint someone in her place that (hopefully) would be better suited to the business and experience needed.
However, as mentioned before the challenge here is that the the appointee would not have “skin in the game” so to speak. Of course, they would want to do a respectable job, but that is different from running the risk of losing money personally or bearing personal liability for failure to perform. They may not be as diligent or thorough as an actual stakeholder.
As you can see – neither possibility is as ideal as having “smart money” on your board.
Managing startup woes with inexperienced investors
Even the most successful startups hit rough patches, especially in the beginning. While startups are expected to run at a loss in their early years, that’s not an easy reality for many to acknowledge, let alone live with when it is their investment or even livelihood at stake.
An inexperienced investor may have trouble interpreting the roller-coaster ride that is the startup experience. Days may be missing from payroll, pitches are shot down, and deals are canceled.
These are the regular growing pains of a startup, but they can easily be misunderstood as a sign of deep trouble.
My client’s mother was wealthy enough that a loss of 2 million would not leave her destitute, but she did not become wealthy because she was cavalier about money.
Investing impacts personal relationships
Don’t get me wrong – having a rich parent is a nice problem to have.
My point here is not that you should never ask friends and family for capital. That happens all the time, especially in the pre-proof concept stage. And we have made recommendations how to receive investments from friends and family.
My client ended up getting his funding from a former entrepreneur who had recently cashed out. The two had worked together before and were good friends. In this decision he seemingly avoided the pitfalls mentioned above. I’d like to say that everything worked out between them, but it didn’t. But that’s a story for another time, another post.
However, my client is still on excellent terms with his mother. They can talk about the weather and her health, instead of her asking how she’ll get her $2 million back, or him feeling uncomfortable with her
To me, and I suspect to my client, maintaining a great relationship with our loved ones is the most important thing.
The above post is Part 2 of "Startup Funding: Raising Early-Stage Capital from Your Personal Network"
To learn about the benefits and considerations, click below for Part 1: Startup Funding: Raising Early-Stage Capital from Your Personal Network Part 1.
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