Introduction
An entrepreneur may work for years—spending every spare hour they can find—to perfect their idea. Many startups reach a point where they just cannot take their idea any further—or grow their company quickly enough—without seeking outside capital. This is typically due to the fact that organic growth from retained earnings will not be fast enough to outpace competitors.
The classic trade-off in seeking outside investors is control vs. growth. Accepting an outside equity investor can help accelerate needed growth, but it dilutes the founders’ ownership in the process. Often by the time the Series B funding round has been completed, the founders no longer own a majority of their company.
Rookie entrepreneurs often make the mistake of thinking that their sweat equity has financial value. Investors typically only want to know about the amount of cash the founders have contributed. A frequent question from potential investors is, “How much of your own money have you invested?” This is a critical question to the investor and one that kills many an entrepreneur who does not understand how to answer it.
The majority of entrepreneurial ventures are bootstrapped, initially relying upon the founders’ investment of personal savings to get started.[1] This is a positive signal to the investors who want to see significant investment of both time and money by the founders.
However, even though sweat equity is assumed by the investors, they do not actually count it in the valuation. The fact is that investors already assume the entrepreneur has worked hard and sacrificed much to have built the company to its current state. Thus, hard work is not a differentiator, so it does not add any comparative value. What is more important to potential investors is to know who else has previously written a check. Namely, there are three groups of people they desire to have put a “hard cash” investment into the company:
- The Founding Team
- Friends and Family
- Outside Members of the Board of Directors
Failure to find any such investment from all three of the above categories can raise serious concerns that will prevent or delay an outside investor from making an investment. In this paper, the authors discuss the three types of prior investment that venture capital providers prefer to see. The authors also provide evidence that investment by outside directors is associated with improved firm performance using data from the Pepperdine Private Capital Access survey.
The Founding Team
The potential new investor views the financial commitment of the founders as “skin in the game,” and this positive signal has been shown empirically to increase investor interest in the firm.[2] This is certainly a rational reaction by the investors since founders’ skin in the game has been shown to be significantly correlated with startup success.[3] If the entrepreneur has not yet taken a financial risk for the company, then the investor will see this as an unfair distribution of risk. For example, if there is a major setback for the company sometime in the future, or even a personality conflict, the entrepreneur could more easily walk away if there was not a financial risk to them in place. Also, an entrepreneur who is making the argument that their company is a great investment yet has not invested, himself or herself, comes across as insincere. If the entrepreneur truly believed this was such a great opportunity, they would “put their money where their mouth is.”
The common counterargument from the entrepreneur is that they came up with the idea and are putting in substantial sweat equity, so an actual cash investment is unnecessary. Most investors do not see it that way. Ideas are considered either worthless or suspect until proven to have value. The proof only comes when others begin to accept the idea and pay for it. Thus, most investors want the entrepreneur to be the first to demonstrate a financial commitment to their own idea.
Sweat equity is not considered a comparable substitute for a cash investment for two reasons. First, sweat equity does not differentiate their startup from any other startup—all founders typically work hard. Second, cash is considered the universal symbol of commitment in the investment community. When an investor sees a founding team pulling out their checkbooks and investing in their own idea, this is highly convincing that they truly believe in the idea, themselves. That said, cash investments do not necessarily have to come in lump sums. A common mistake made by rookie entrepreneurs is to not keep detailed records of every cent they have spent on their project. All of these expenses are legitimate cash investments. The wisest and cleanest approach is to avoid paying company expenses personally and, instead, write the lump sum checks to the company as equity investments or loans.
Founders should understand, however, that personal loans to the company may never get repaid. Venture capital investors will often insist that loans from founders, friends, and family be converted from debt into equity.
Even though sweat equity will not be counted by investors as a cash investment, it is still a good idea to keep track of all unpaid hours worked by the founders and what their time is legitimately worth. It is even a good idea to add this number to the founders’ cash investment in the cap table. Of course, the potential investors will probably remove that number in their own calculations, but they will still be impressed.
It is also important for the entrepreneur to demonstrate how responsible they have been so far with investor money. The following is a common (and unfortunate) scenario:
- The entrepreneur has taken investments from prior investors (such as friends and family), and…
- The entrepreneur has not invested their own money, and…
- The startup has no revenue yet, and…
- The founder is taking a salary (even if it is a low one).
The above four-fold scenario is the most lethal combination to present to an investor. It sends a message that says the entrepreneur wants other people to support the entrepreneur in their personal business experiment. It is simply not considered a responsible use of investor capital.
All of this begs the question of how much money must the founder invest in order to prove their commitment? It depends a great deal upon the status of the entrepreneur. A 40-year-old founder will typically be expected to make a much larger investment than a 20-year-old one. Consideration is always given to the entrepreneur’s economic state, but if poverty is going to be the founder’s defense, an investor is going to want to see a demonstration of some extraordinarily creative ways of stretching a nickel, or the investor will be forced to decide that the founder was too naïve to start the business in the first place.
The bottom line is that if the entrepreneur’s age or resume says that they could not afford to contribute much, a token investment of $5,000 to $10,000 would be sufficient (roughly equal to the minimum investment expected in a “Seed” funding). The source may come from a retirement account, a child’s college fund, or the classic run up of credit card debt. It is not the source that matters, it is the sacrifice. And, as pointed out above, the sacrifice may have been made slowly over a period of years. Having documentation to that effect is critical. However, those whose net worth would allow more are expected to contribute more. The only real exception to this rule is that very rare instance when the entrepreneur has developed something so amazing that investors are literally “beating a path to her or his door.” This almost never happens, so the vast majority of founders needs to quickly disabuse themselves of the notion that they are in this rare category.
Friends and Family
Potential investors can have mixed emotions about investments made by friends and family. On the one hand, this group is often the least discriminating when it comes to making an investment. On the other hand, they are often the hardest group for an entrepreneur to approach and ask.
In their paper “Start-up Financing, Owner Characteristics, and Survival,” Astebro and Bernhardt state:
There appears to have been a substantial number of start-ups with high survival rates that did not receive bank loans. These companies made significantly more use of other sources of borrowed capital [such as friends and family] than did those companies receiving bank loans.[4]
It should be noted that friends-and-family loans cannot generally be distinguished from equity investments since the Series A venture capital provider (VC) will generally demand that these loans be converted into common stock (but not be repaid) as a condition for making their investment.
Thus, when friends and family invest, investors may interpret that as a sign that the entrepreneur truly believes, since they were able to muster up the courage to ask this group to help them. In addition, Conti, Thursby and Rothaermel empirically show that equity investment by friends and family is a positive signal to both angel investors and venture capital, but it is significantly more important to angels.[5]
Investment from friends and family can also mitigate the negative optics of low financial investment from the founders themselves. For example, if the founders are college kids with little money of their own, potential investors will be more willing to find their low financial commitment acceptable if there is significant investment from friends and family.
Members of the Board
The importance of the board of directors is often overlooked by rookie entrepreneurs. Ideally, potential investors like to see the following evidence that that company has a serious board:
- The company actually has a board of directors.
- The board has outsiders (e.g., non-founders, non-employees).
- The outsiders have invested.
For a new venture, it is not typically important whether the board is a formal board of directors with official meetings or just an informal board of advisors. What is much more important is that the board consists of members beyond just the founders and other insiders. Generally, investors like seeing that the founders have managed to attract outsiders to their board, particularly if the outsiders have impressive experience. However, that positive impression will be quickly erased if it is discovered that their only contribution was to “lend their name” and then have no further commitment to the success of the company. The first key measure of a quality outside board member is the degree to which they are willing to get involved.
The ultimate measure of board member involvement is their financial commitment to the company. If the potential investor sees that the board has invested, it adds to the credibility of the company and its vision—investors usually do not want to be the first outsider to write a check.
“Clearly the quality and relevant industry experience of a board member will make a lot of difference in how seriously I will consider a deal—it has an enormous effect,” says Robert Kibble, VC and founder of Mission Ventures. “It is an even more powerful signal if the advisor has also invested their own money in the startup. But this must be combined with industry knowledge. Celebrity advisors without deep experience in the field will typically not influence the opinion of potential venture capital investors.”[6]
There is a subtle balance to strike between attracting top-quality people to join the board and then asking them to invest. All board members should be encouraged to do their own due diligence prior to joining the board. A common solution is to agree on a set of milestones that, when reached, will result in an investment. Board members, as potential investors, will generally respect this arrangement. The minimum that investors like to see for all board members is an investment of $2,000 to $3,000. However, if the startup has attracted an industry leader to the board, then potential investors prefer to see a more substantial commitment comparable to what would be expected in the first round of funding ($10,000 to $25,000).
Evidence supports the investor idea that having outside board member investors are associated with better startup performance. The 2017 Q4 Private Capital Access (PCA) Index Report[7] indicates that 678 private companies were asked questions about their board of directors. Of these, 305 firms actually had a board of directors. 128 of these had outside members on their board, and only 53 of those boards with outside directors had members who were also investors (Figure 1).
Figure 1: Characteristics of Private Company Boards
Table 1 reports the relationship between company performance and having outside board member investors, controlling for size and age of the firm. The only viable dependent variable available as a proxy for firm performance in the PCA survey data is the revenue change percentage over the last 12 months. Table 1 shows the testing of three ordinary least squares OLS regression models representing different proxies for firm size: log of revenue (Model 1), log of assets (Model 2), and full-time employee count (Model 3).
Table 1: Relationship Between Company Performance and Outside Board Member Investors
The results from Table 1 are consistent with the proposition that having outside board members that are also investors is associated with higher revenue growth. High revenue growth is a standard signal of startup success—and success is attractive to investors. This relationship is statistically significant across all three size models.
Conclusion
Rational investors like to maximize return while minimizing risk. Thus, potential investors in startups generally prefer not to be the very first equity in the venture. To a potential equity investor, the validity of the startup’s business model can be inferred from the list of previous investors. When this list—at a minimum—includes the founders, friends and family, and the outside members of the board of directors, the potential new investor will have a greater comfort level and a much higher likelihood of writing a check.
