When all of the financial investment comes from the founders, things are less complex. Although the founders have assumed all of the financial risks by self-funding their venture, they will also maintain control including how the financial rewards are dispersed. Each of the other types of investment have varying levels of funding accessibility, value to the company, and risks to the founder as pointed out by Wasserman in The Founder’s Dilemmas as outlined below.
Friends and family – Although the size of these investments are small, they are the easiest to secure. Usually these investments don’t add a lot of other value beyond the funding. The risks to the founder are significant. Asking friends and family to invest can send an unprofessional signal. These investments don’t usually come with a lot of formal strings attached, so the possibility that founders might pursue less fruitful ideas is real. The most significant risk is the one to the relationships with each investor. It is good advice to refuse these investments if there is a significant risk of loss, as the risk to the relationship is probably not worth it at that point.
Angel investors – The size of these investments are usually medium to large, as the angel investor is looking to invest his or her personal wealth with a goal of profitability. This type of funding is often more available than you might think (and almost certainly more than friends and family can invest) through networking and angel forums. It is possible that these investors could bring significant business experience and want to be directly involved on the board. Additionally, most angel investors have strong social capital, which you can leverage as needed. Risks associated with angel investors include the potential that oversight and assistance may not be as strong. It is also possible that your angel investor may be difficult to manage. Having angel investors in the mix can make things more challenging later on when looking to add additional investors.
Venture capitalists – Venture capitalists will be looking to invest much larger sums of money, but will expect to be brought in as partners, take an active role on the board, and be in regular communication with the founders. This is the hardest source of funding to access, but sometimes angel investors can facilitate an introduction. This funding is greater and more predictable than that of angel investors. Venture capitalists bring significant social capital to the table. It is a very good sign for the business when it receive VC funding, so the reputation and brand could get a bump as a result. There are risks to the founder related to both wealth and control:
- Wealth risks – Venture capitalists demand equity stakes in the company. The effect is a diluted stake for the founder. Arrangements regarding liquidation can impact exits from the organization. Typically, founder equity is going to be vested outright, which means that allocation among the teams will also be impacted.
- Control risks – Venture capitalists may expect additional board seats, which can make the founder’s control of the board weaker. If the VC receives preferred stock, supermajority voting might be a reality and cause conflict related to a differing financial risks from founders.
The lessons from The Founder’s Dilemmas continue to point to the complexity of the decisions a founder faces. On the surface, especially in a cash strapped startup, it would be tempting to accept funding from ANYONE who is willing to invest in your dream. Recognizing the risks and trade-offs associated with each source of investment can really help a founder make careful decisions and negotiate the best possible position for the founders and the team.
It is a reality that a false move with an investor can result in the founders ending up with nothing to compensate them for the hard work they have put into starting and building their company. It is also a reality that control can be completely lost if consideration for decision-making power and balanced representation for voting are not taken into account. Ultimately, it comes back to the lessons at the beginning of the book about consciously choosing between wealth and control.