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Raising Capital? 3 Tips for Entrepreneurs (Part 2)

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I've been helping entrepreneurs raise capital as a securities lawyer for 17+ years, and there are certain fundamental mistakes that I've seen entrepreneurs repeatedly make. Accordingly, I thought it would be helpful to share three basic tips for entrepreneurs in connection with raising capital. This is part two of a three-part series.

Tip #1: Only Sell Securities to "Friends & Family" as a Last Resort. Many entrepreneurs initially reach-out to friends and family as a source of capital. This is understandable, but generally a mistake for two significant reasons: first, friends and family investors are often not "accredited investors" under SEC Rule 501, which generally triggers tricky compliance and disclosure issues (as I discussed in detail in part one of this series) and second, they are inappropriate investors from a business perspective.

Indeed, the ideal investor is an experienced, sophisticated angel who can add substantial value through his or her domain expertise and/or rolodex. A sophisticated angel investor understands how the startup game is played and the role that he plays. More importantly, he understands that most startups fail and that he may lose his entire investment -- which is why sophisticated angels typically have 20 or more investments in different startups (and are merely looking for a few of them to succeed to get a strong return).

This mistake is further magnified by a large number of friends and family investors. For example, having 15 or more family members, former college classmates and neighbors invest $10,000+ each is a recipe for disaster. Not only will this scare-away many sophisticated angel and VC investors, but also the founders will likely find themselves constantly peppered with questions about their company and how things are going; not to mention turning holidays, like Thanksgiving, into stockholders' meetings. ("Hey Steve, can you pass the salt -- and by the way, how's the company doing? How much money have you made so far? When will I get my first dividend check?", etc.)

Tip #2: If You Don't Know Any Sophisticated Angels, Hustle and Build Relationships. If you're an entrepreneur looking for seed capital, but don't know any sophisticated angel investors, you need to hustle and build relationships in order to get "warm" introductions. This is how the game is played. Entrepreneurs must first determine who would be the ideal investor for their company. They then must work hard to get an introductory phone call or email from a middleman whom the investor trusts and respects (ideally, another entrepreneur whom that investor has backed).

How is this done? By banging on doors. By getting-out and attending conferences and meet-ups, by blogging, by reading and commenting on other blogs, and by engaging on Twitter and other social media sites. In short, it takes tenacity and resourcefulness -- qualities that every great entrepreneur possesses.

David Hornik, a partner at August Capital and a very smart investor, confirms this approach in his interview on Sprouter:

So if you are new to the area or to entrepreneurship, how do you get the right . . . intros? What you need to do is build relationships from the bottom up. Spend a ton of time meeting people, talking with them about what they are working on, and sharing what you are working on. Over time you will find people with whom your idea resonates and they will introduce you to folks with whom they are close.

In his book Mastering the VC Game, Jeffrey Bussgang, a general partner at Flybridge Capital Partners, explains how he got an introduction to superstar VC John Doerr of Kleiner Perkins when he was a first-time entrepreneur:

[W]hen we started Upromise, Michael Bronner and I knew we wanted to get to John Doerr. We networked to him through three sources -- one of my [Harvard Business School] professors who knew him well, a Silicon Valley CEO friend of Michael's who knew him, and a Fortune 500 CEO with whom Michael was friendly. After hearing from us from these trusted sources, even a guy as busy as John Doerr decided it was worth taking a meeting.

Tip #3: Unless You're Raising $750,000 or More, Issue Convertible Notes. Finally, unless the startup is raising at least approximately $750,000, it generally is not in the company's interest to issue shares of preferred stock. Indeed, sophisticated angel investors will generally push hard for shares of preferred stock because they want to receive special rights and preferences for their money and to share in the increase in the company's value that they argued helped create. However, preferred stock financings are complicated, time-consuming and expensive (despite the "Series Seed" documents and other stripped-down forms).

Moreover, the company would need to be valued at the time of the investment, which is obviously difficult at an early stage and could be extremely dilutive to the founders. Accordingly, entrepreneurs are usually better served by issuing convertible notes to angel investors, which would automatically convert into shares of preferred stock in the Series A round. This approach will keep the financing relatively simple and inexpensive and will defer the company's valuation (i.e., the pricing) until the Series A round.

What about issuing shares of common stock? Sophisticated angel investors will rarely accept shares of common stock; and if they do agree to accept convertible notes, they will often push for what's called a "cap" (i.e., a set value at which the notes convert).