Lesson #125: How to Bootstrap Your Startup

Sourcing capital for your startup is never easy, especially when you are pre-product completion and before the proof-of-concept the traditional venture investors are looking for.  Oftentimes, the only way to get your business from a piece of paper concept to a venture-backable business is to bootstrap your efforts, via whatever means necessary. 

Below is a summary of the some of the most-used bootstrapping techniques:

Limit Product Scope.  Always start by building a minimum viable product to get something quickly and cheaply into the market.  Cut back on any unnecessary features and functionality, that add up on costs and slow down the launch.  Don't try building a "Rolls Royce" product out of the gate, when a "Toyota" will work just fine to start.

Personal Assets.  Tap into whatever cash resources you have access to, from your cash accounts, to credit cards to home equity loans to selling other investments.  The less cash you raise from outsiders, the more your personal stake will be worth, especially during the "infancy" stage of your business when valuations will be at their lowest point.

Co-Founders.  Co-founders can be a great source of cash investment or sweat equity from people who believe enough in your product to work without a cash salary.  Don't think you need to build your startup by yourself.  Find others who share your dream and complement your skillsets.

Friends & Family.  Sometimes it is easiest to raise capital from the people that know you best, and can vouch for your personal drive and skillset, much better than a stranger investor can.  But, be clear with them upfront that they could most-likely lose 100% of their investment in a risky venture and not to invest more than they feel comfortable "gambling" with.

Vendors.  Sometime startup vendors are willing trade all or a portion of their services for equity.  This is a great way to make a $100K tech build a $50K tech build, as an example.  Re-read Lesson #115 for when it is best to trade equity for services.  And, even if they require cash, maybe they can spread out payments over time to help you.

Angel Investors.  If you can uncover them, there are plenty of rich individuals looking for the next big thing.  The problem is finding them.  Re-read Lesson #5 for best techniques for finding angel investors.

Startup-Investor Marketplaces.  There are some great sites like AngelList and Gust, that have created networking sites with startups on one side and angel investors on the other.  Problem is getting your startup found within the clutter of other startups.  Re-read my case study on how StyleSeek successfully raised capital through AngelList.

Crowd Donations Sites.  Sites like KickStarter and IndieGoGo have even made it easy to raise capital via donations from a crowd, without giving away any equity in your business.  This works best for "edgy" consumer products businesses, where donating consumers can get insider access to the first products built.  Re-read my case study on how Pebble Watch successfully raised $10MM through KickStarter.

Crowdfunding Sites.  With the passing of the Jobs Act in 2012, which legalized startup investing for mom-and-pop investors, a whole slew of crowdfunding sites are in development, like RocketHub and EarlyShares.  Find the ones that best fit your industry.  Re-read Lesson #111 on crowdfunding startups.

Small Business Grants.  Sometimes free grants are available if your startup is helping to solve a bigger problem (e.g., healthcare, education).  Check out Grants.gov, to see if any grants are available in the market you are serving.

Small Business Loans.  Working with the banks as a startup is not usually advised, given how conservative the banks can be.  But, some banks are more startup friendly than others.  Silicon Valley Bank is one of those banks.  You may be able to get a $50,000 startup loan, basically set up like a new credit card account.

Venture Debt.  Similar to bank loans, there are loans from venture debt companies like Western Tech.  These firms typically work best for financing securable technology asset purchases, with financial terms very similar to credit card debt.

State Tax Credits & Programs.  In the unlikely event your startup is generating a profit, be sure to apply for any state tax credits that may be available for startups, to reduce your tax bills or offset salaries from new jobs created.  Re-read Lesson #113 for more information on state tax credits and other programs for startups.

Free/Discounted Resources.   Always keep your eye out for free or discounted resources for startups.  Don't pay for consulting, if you can get free mentorship from a peer.  Don't pay for rent, if you can hangout out at a free shared meeting place like Starbucks, Tech Nexus or 1871.  And, check out preferred vendor discounts for startups negotiated by organizations like Startup America.

The key for being a good startup CEO is learning how to stretch pennies into man-hole covers.  Hopefully, this post helped you learn how to best stretch your very limited cash resources and find cash resources from previously unknown methods.

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[INFOGRAPHIC] Key Strategic Buyers, Investors or Partners by Digital Vertical

A while back, I shared an infographic on key sources of digital investment capital from Luma Partners.  That infographic included a list of key venture capitalists in various parts of the country.  Luma Partners has recently built a new infographic highlighting key strategic buyers, segmented by digital industry vertical (e.g., technology, commerce, marketing, media).  This list would also apply for finding potential strategic investors or business development partners, depending on your specific needs.

Thanks again to the Luma Partners team, for producing such useful content.  If you cannot read the infographic above, you can find a larger version on the Luma Partners website.

This post should be read in combination with Lesson #6: Structuring Strategic Partnerships for Your Startup and Lesson #64: How to Find Strategic Partners for Your Business.

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Lesson #124: Vesting of Founder's Stock

Founders of a startup are frequently surprised when venture capital firms or other investors ask for vesting provisions to be placed on the founders’ stock.  The investors are seeking to provide sufficient incentive for each founder to work through the company’s critical early formation and development phase.  If a founder leaves the startup early in the process, it would be unfair to the other founders and the investors for the departing founder to receive a “free ride” on the continuing efforts of the other founders.  The vesting terms cause a forfeiture of the unvested shares, or a repurchase at a low cost, upon termination of employment, thereby eliminating the free ride.

To get more professional guidance on this topic, I asked Jeff Mattson, a startup lawyer at Freeborn & Peters, to help us learn the key issues here.

A typical vesting structure is a period of four years beginning either upon the formation of the company or the closing of the first round of outside financing, with a one-year cliff, meaning that 1/4th of the stock vests on the first anniversary.  Thereafter, the stock vests ratably with 1/48th of the stock vesting each month.  In some cases, the stock instead vests annually with 1/4th of the stock vesting on each anniversary.  In either case, the founder is 100% vested on the fourth anniversary.

The logic of this typical structure is that it takes a full year to get through the formative stage, and thereafter, the value of the company increases incrementally.  The typical vesting schedule tracks this common growth pattern, rewarding the founder proportionately for services during these stages.

But, startups come in many shapes and sizes, and founders can request and obtain variations from the four-year vesting schedule in appropriate circumstances.  Following are a few of the most common reasons to adjust the vesting schedule:

1.  Other Contributions - If a founder has contributed money, intellectual property, or other assets to the company, the stock issued in return for those contributions should be fully vested, because the value has been provided in full and is not contingent on the future services.  Any remaining stock issued for services would still be subject to vesting.

2.  Prior Service – If the VC investment is being made after the formation of the company, the founders frequently are able to obtain credit for the prior services.  For example, if the VC investment is made one year after formation, the stock could be 25% vested upon closing the investment, and the remaining stock would be subject to a three-year vesting schedule.

 
3.  Shorter Startup Period – If founders reasonably anticipate a shorter period to bring products or services to market, profitability, or sale of the company, then investors have a shorter risk period and the vesting schedule can be reduced commensurately.

4.  Track Record or Expertise – If a founder has a proven track record or expertise that is particularly needed for the company, that founder may be able to leverage this strength into a shorter vesting schedule.  But don’t overplay this hand – if the investor is convinced a founder is critical, the investor may decide that vesting is even more important, to protect against the damage to the company if this key founder leaves the company.

Vesting stock commonly raises two additional issues: acceleration of vesting and the tax treatment of vesting stock.

Founders should always ask for the vesting of their stock to accelerate upon (a) a sale of the company or (b) a termination of employment without cause.  This formulation for vesting is called “single-trigger” acceleration, because the acceleration is “triggered” upon the occurrence of either one of the two events.  Investors usually want “double-trigger” acceleration, in which acceleration only occurs if the founder’s employment is terminated without cause following a sale of the company.  Investors are concerned that single-trigger acceleration will make the company more difficult to sell because, if all stock vests upon sale, buyers will be unwilling to take the risk of founders leaving the company shortly following the sale.

Finally, vesting stock creates a tax trap that first-time founders do not expect.  The tax code treats the grant of stock to a company officer or employee as compensation for services rendered.  The founder is required to recognize income equal to the value of the stock.  When a company is initially formed, the stock usually has no value, so the taxable income is $0.  But, if vesting is placed on the stock, IRS regulations deem the stock to be granted on the date of vesting.  If the company’s value increases over time, as anticipated, then the stock gains greater and greater value upon each vesting date and the founder must recognize income on each vesting date.  If the startup goes well, this income is quite significant, resulting in substantial income tax at a time when the founder may not have cash available to pay the tax.

Generally, founders can mitigate the above-referenced tax costs by filing an election with the IRS, called an 83(b) election.  The 83(b) election treats the stock, for tax purposes, as if there is no vesting, thereby eliminating the taxable event upon vesting.  But, be careful with this issue - the 83(b) election must be filed within 30 days of grant; no extensions are permitted; the election applies only if the stock is issued in connection with the performance of services; and the potential tax trap could be huge if you fail to file in the 30-day period.  Founders facing this situation should consult with knowledgeable tax counsel to determine the availability and effects of an 83(b) election.

If you have any further questions from here, Jeff is happy to offer his further assistance.  You can contact him at 312-360-6312 or jmattson@freebornpeters.com.

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State of the Internet: 2012

In case you have not seen the recently-published "State of the Internet: 2012" report by Henry Blodget at Business Insider, it is a must read for getting up to speed on what the key trends are in the digital world.  It is jam packed with data on overall trends, digital media, social media, e-commerce, mobile and stock valuations.

To read the full "State of the Internet:2012" slide deck, click here to read it on the Business Insider website.

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Lesson #123: Crowdfunding Details Starting to Emerge

Last week, I had the pleasure of sitting on a crowdfunding panel with Sherwood ("Woodie") Neiss, a serial entrepreneur and one of the original authors of the crowdfunding bill, who was meeting with Chicago's startup entrepreneurs, investors and service providers to gather our input on what desires we have for specific language to be incorporated into the Jobs Act.  Woodie was then going to take Chicago's collective comments, along with the comments from other startup regions around the country, back to the White House, so the President can get a better sense of what the startup ecosystem is looking to acheive via this law, and lawmakers can incorporate such goals into the law.

As part of this discussion, Woodie also presented some more details about where the current drafts of the law are heading.  Understanding this is still a moving target at this point, it should help you better understand whether crowdfunding is a good financing choice for your startup.  Please re-read my original blog post on Crowdfunding Startups as a refresher on what we are talking about here. 

Below were some of the highlights I took away from the presentation, as it relates to startups:

• You must be a U.S. based startup--foreign issuers will not be allowed
• Funding must be pursued via a registered crowdfunding portal or broker-dealer
• You can be either a C-Corp or an LLC, corporate structure does not matter at this time
• You can raise up to $1,000,000 via a crowdfunding effort, although bigger raises come with  higher requirements
• But, don't ask for too much, as it is "all or nothing" in order to close your financing--you need to raise the full amount asked for, before funds will be released to you
• Financings over $500K require a full accounting audit; financings over $100K require a CPA review; financings under $100K require a CEO letter speaking to financials
• You will be held to strict monthly financial reporting requirements (via compliance tools)
• It is still being determined if you can run "parallel financings" at the same time (e.g., concurrent equity and debt), but you can only raise equity on one portal site at a time
• You will be limited to general solicitation of investors only (e.g., via your social networks)
• You can have an unlimited number of investors participate in your financing
• Investors are limited to $2K for up to $40K income; 5% of income for $40-$100K income; 10% of income for over $100K income (up to a total cap of $100K invested per year)
• Investors can live anywhere--foreign investors are allowed to invest in U.S. startups
• Shares issued could be either voting or non-voting stock, depending on your needs (still TBD)
• Funds raised could be either direct shareholder investments, or via a special purpose entity which aggregates all investors into one investor pool for simplicity (still TBD)
• There will be a one-year holding period for all investors in a crowdfunded startup
• Thereafter, it is anticipated that a "secondary shares" market will develop to sell your shares
• Full background checks will be performed on the CEOs of all companies raising funds
• It is anticipated there will be 100's of crowdfunding portals to choose from, both generalists and niche specific (so choose carefully based on reputation and industry)
• It is anticipated that crowdfunding will work best around "community driven" initiatives (e.g., local town wants a new restaurant, and those citizens finance and use such restaurant)

I am still a huge fan of crowdfunding, as it will fill the financing hole until your product is built and "proof of concept" is acheived before the traditional venture capital investors take interest.  And, it will open up more startup capital outside of the tech industry (e.g., retail, CPG), where VC's typically do not play.  But, buyer beware.  As you can read above, it does come with a lot of strings attached (e.g., 1000's of investors to keep happy, primarily from your social network of friends, monthly reporting requirements).  Not to mention, this is simply "dumb money", as crowdfunding investors are most likely not coming in with a Rolodex of relationships or past startup experience to help you build your business (which is preferred).  That said, I am feeling better fraud will be kept in check based on the auditing requirements, the required background checks of CEOs and startups having to rely on their own social networks of friends to solicit investors.

If you would like to read the full act, click here.  If you would like to read a high level summary on the act from the SEC, click here.  If you would like to read comments on the act submitted to date, or you would like to submit your own comments for lawmakers to consider, click here.  Lawmakers are particularly focused on six areas: (i) how startups communicate the offering and spread word; (ii) how to mitigate fraud within social media; (iii) how to avoid a "messy cap table" for future VC's; (iv) how underserved communities can access capital; (v) how to build a local ecosystem for success; and (vi) how best to educate investors on startups in an "eyes wide open" way.  So, feel free to chime in.

Historically, small businesses are responsible for 50% of our country's job creation, and funds available to those startups have only represented 1% of the available capital. Hopefully, crowdfunding will help to rebalance this, and we can finally get our economy and job creation back on solid footing.

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