Friends & Family, Angels, and VC Funding
Another topic about which there's a lot to say. You've decided you need to raise money to grow your business, and you are trying to decide how you should fund it - Angels, Friends and Family, or Venture Capital. My cofounders and I have done all three, so I'll offer some quick highlights. This by no means covers the topic completely.
First of all, one quick way to think about this is the farther up the professional investor chain you move (from family to venture), the more you'll have to have the company setup in specific ways. For example, you may be able to setup your company as an LLC or S-Corp if you're not funding the company with venture money. The most obvious advantage of setting up an S-Corp as opposed to a C-corp is that the profits and loss pass-through to the shareholders on a pro-rata basis, and there's no double taxation like you get with a C-corp. Why does venture funding mandate that you create a C-Corporation? For the simple reason that VC terms will mandate that they get a separate class of stock (preferred) with rights that are different than those of the common stock, and you can only have one class of stock in an S-corporation. Note that if you haven't decided how to fund your company, you can always convert an S-Corp to a C-corp as part of a financing, but always remember, when you're talking about changing company structure, articles of incorporation, etc., somewhere an attorney is going to get paid a lot more than you think they should.
So, if you lose the tax benefits of an S-corp with venture funding, and VC's are going to insist on spending $30k to have the company's finances audited every year, why not just track down a bunch of rich folk who will buy a chunk of your common stock in a private placement? There are a couple major reasons to choose venture funding or sophisticated Angels that understand your industry if you're planning on building a big business. First of all, although all individual investors need to be accredited (legalese for "i declare that i'm a millionaire on some ledger somewhere"), and some people are more accredited than others. If the market tanks, you don't want to be responding to panicky emails wondering if you've talked to shmucky.com yet about buying the company. You want investors who will be patient through growth. VC's are always going to encourage you to keep growing when you're growing. They've got a portfolio of investments, they're managing risk across a portfolio, and they're not going to be antsy to jump off a speeding train. Secondly, as you're building the company, experienced VC's are going to have been through multiple examples of whatever strategic and tactical issues you're dealing with, and it's very helpful to have people who've fought these battles before sitting in board meetings discussing the issues. The guy who invented rollercoasters may be rich, but he might not be very helpful with your sales force automation issues. (I suppose it's sexist of me to assume it was a guy who invented rollercoasters. It may very well have been a woman, or rollercoaster may even be two words; I have not done my homework on these points).
What do I mean by "sophisticated Angels"? I'm referring to folks who have made multiple investments in your industry, understand the space well, and maybe even still have operating roles in the market.
Reid Hoffman is a great example in the consumer Internet space, and there are lots of others.
Particularly in a "bubbly" market like the one we seem to be in now for investing in technology startups, I think it's wise to look to more formal investors like VC funds and sophisticated angels for the reasons I mention above.
I wouldn't generally worry about how negatively an Angel/Individual investor will affect you in a future VC or other institutional financing. If your company is growing and strong and a winner, people will find a way to put capital to work. May cost you a chunk of money in legal and accounting fees to get everything refactored for professional investors down the road, but even the simplest financings cost too much in legal fees, so I don't think that's particularly insurmountable.
This post is only leaving out about 41 other points to consider, so we'll come back to those another time.