Friday, December 23, 2011

Raising Money From Informal Investors

This article was written by Asheesh Advani, in Entrepreneur Magazine, December 2011, reprinted by permission

The devil's in the details when taking money from--and structuring a deal with--friends, family and angel investors

No matter who you're raising capital from and no matter whether you're raising money in the form of debt or equity funding, you'll be faced with the prospect of financing agreements that are written to favor the investor over the entrepreneur.  Over the years, the agreements used by more informal investors have come to mirror the investor-friendly agreements used by venture capital firms. So it's critical, especially during the startup stage when your negotiating leverage with investors is often weak, to know the difference between what is tolerable and what is intolerable when it comes to structuring a financing deal.

Your guiding principle should be this: Look into your crystal ball and choose your first investor carefully.  Don't agree to terms that will limit or restrict your ability down the road to grow your company or attract additional investors.  When raising money from angel investors or relatives and friends, the terms negotiated by your first investor in a financing round tend to be the terms that last for the entire round.  Similarly, the terms you agree to in your first round set the stage for later rounds.  And giving away too much could come back to hurt you or your business.

So here are a few tips about what to look out for to get a deal that works for you:

Don't give pro-rata rights to your first investors.  If your first investor (or his or her attorney) negotiates pro-rata rights (which means the investor is given the right to maintain ownership in the company through future investment rounds), all the investors in the round are likely to also want those rights, even if most wouldn't have otherwise requested them.  Although anti-dilution provisions are in the interest of early investors, they're off-putting to later investors.  So you'll need to balance the needs of your early investors to protect their stake in the company with how attractive your company will appear to later institutional investors.

Avoid giving too many people the right to be overly involved. The follow-the-leader mentality described above gets particularly problematic when you give up control of the business and require investor consent for business decisions.  If you're not careful, you may find yourself in the tedious and time-consuming position of needing signatures from all or most of your shareholders to make future financing decisions or management choices--all because you gave these rights to your first investor. Similarly, some investors will want detailed reports on a weekly, monthly or quarterly basis. Agree to this only when it seems necessary.  Spending a lot of time preparing and mailing reports, and requesting and collecting signatures, is probably not the best use of your time.