Thinking about investors when you start out

IT IS ONLY AN IDEA at this point but apparently a good one. The entrepreneur is striking out from a good paying job with an industry leading company to build a product he knows the industry needs. His wife works with a different employer and will support him through the effort providing financial stability and health insurance while he gets started. They have saved some in anticipation of this new venture.

After he provided his resignation and shared his plans, his employer offered to fund the development in-house and to let him lead the effort. When he said no, his boss offered to invest in his new company. He said he wanted to get in on the ground floor. Nothing specific – the entrepreneur has just begun sketching out his anticipated financial needs – but a firm offer to fund the start up in exchange for 50% of the company.

They have the money to fund the prototype development, which they estimate will take less than six months. The entrepreneur’s first inclination is the decline the offer. He and his wife have heard ‘horror stories’ about entrepreneurs taking on a big investor early. This is a new experience for the entrepreneur and he wants to be cautious.

What should he do?

A year’s funding might involve up to $200,000. The second year would be much more expensive. Complicating matters is the nature of the business the prototype might generate. It could be a product licensed to industry companies to improve their operations. Or, it could be the basis of a service business where the company uses the technology to deliver end products or experiences customized to industry client needs.

The investor is experienced in private investments but not with investments in companies like this one. The investor could provide contacts that would be helpful in the industry and possibly some credibility to this new venture.

The difficulty of getting a valuation for the company at this stage that would satisfy the investor and the founder is an important factor. So too, for this entrepreneur, is the desire to develop a prototype before valuing his company. The idea of conceding 50% of the venture’s future value for as little as $200,000 is a non-starter for this entrepreneur.

What we discussed, instead, was deferring the investor question until the prototype is complete or nearing completion. The risk, of course, is that the investor will cool to the investment during that time.

Alternatively, the entrepreneur could try to negotiate a percentage ownership now with the investor but this will take time and money the entrepreneur is eager to put to work on his invention. Another alternative is to offer to take the money in a non-guaranteed promissory note that converts to equity later when there is more information, and hopefully another investor, to give some substance to a company valuation.

Silicon Valley, specifically the Y Combinator in Silicon Valley, has come up with a third approach we do not see used much in the Southeast but which has proved useful for some companies I have worked with. That is the SAFE instrument (simple agreement for future equity). Basically, it is an agreement to invest now without a promissory note for the promise to convert the investment in the future for equity of the type being sold to other investors. Often, the instrument provides the investor with a discount to the future price.

That was my recommendation in this case, if the entrepreneur decides he needs to include the investor now. I also provided some introductions so he could get other opinions.

The devil, however, will be in the details. What size the discount should be and whether the investor wants to further complicate the instrument to the point that the exercise becomes too expensive or time consuming. Many investors, in their zeal to be protected and have all the terms their buddies have ever gotten, can overburden SAFE agreements with covenants that attempt to de-risk the investment beyond what’s rational.

Time will tell here with more conversations to come.